Jude Wanniski & David Gitlitz
April 19, 1995


The steady decline in the dollar's yen value is primarily due to the Bank of Japan's deflationary treadmill, which causes it to extinguish yen liquidity in a misguided attempt to weaken the yen by lowering interest rates. As we see in the accompanying chart, which tracks the dollar/yen rate against the dollar/gold rate, there is a secondary feedback effect from the yen deflation. This is because the dollar and yen compete as reserve currencies in third countries, where individuals and enterprises have the option of contracting in their own sovereign currencies or in the currencies of another country. The Deutschemark is the third currency that competes in this reserve role, and a chart of the dollar/DM against the dollar/gold shows a parallel track in this feedback effect.

In other words, there are in Asia and Europe holders of currency who are indifferent at a given moment as to whether they hold yen, dollars or DM to meet contractual obligations as they come due. As it begins to make a difference to these otherwise indifferent holders, on the margin they will shift their balances from one to another. Since January, the direction of errors being made jointly by the Bank of Japan and the Federal Reserve remains the same: The BoJ is starving would-be yen holders by extinguishing yen instead of printing them. The value of the yen against gold is rising, which is enough to turn indifference into a difference. Balances shift out of dollars into yen, which means dollars are now in surplus. The Fed, which is also targeting interest rates, does not see the surplus dollars on its screen, which it would if it were watching the price of gold. The surplus dollars bid up gold as this unwanted liquidity comes on the market. The dollar gets even weaker relative to the yen.

The natural response of those who are making these terrible mistakes is to do more of the same. The Japanese, who have now lowered their discount rate to 1% from 1.75%, argue that the Federal Reserve should be raising interest rates again, from the current 6% overnight rate to something higher. On this side of the turbulent Pacific, the leading advocate of interest-rate targeting is Wayne Angell of Bear Stearns. In the Sunday New York Times, Angell insists that the Fed do what the Japanese say, raising the fed funds rate to 7% or to a point so much higher that holders of T-bills will not want to sell them. Then, he says, the Fed will not have to print more money in order to take unwanted T-bills off the market's hands. Our old friend Angell, who would like to be Treasury Secretary in the Dole administration, has become a true fanatic. He also argues that the Bank of Japan's 1% discount is too high and should be made negative presumably to make short-term instruments so unattractive that people will not want to hold them and the BoJ will not have to extinguish reserves in order to get Japan's T-bills out of the market's hands! When fed funds gets to 100% and the BoJ rate gets to minus 100% and the exchange rate stabilizes, the price of gold should be in the vicinity of $10,000 an ounce. Angell's gold target, remember, is $320. He then has to wonder what happens when the Fed lowers fed funds to 99%. In his framework, holders of T-bills will of course be forced to dump them at that lower rate, and the Fed will have to print money again to acquire them.1

We continue to observe the BoJ perversely destroying yen in order to prevent them from rising in value. Since March 20, it has drained more than Y10 trillion from the markets, only part of which, perhaps Y1.3 trillion, represents futile sterilized interventions to stabilize the dollar. Most of the drain has been required to prevent the overnight interest rate from rising on the theory that a higher rate will strengthen the yen! While the BoJ was cutting the discount rate to 1% last Friday, in the process driving down the inter-bank market rate to 1.5% from 1.75%, it drained about Y3.4 trillion - the equivalent of $40 billion! We have conveyed our apparently unorthodox concern about these procedures to high officials of the Federal Reserve and the government of Japan.

It is like trying to squeeze a square peg into a round hole. History means nothing to these experts. Early in 1994, when short rates were 1% apart in Tokyo and New York, the yen was at 112 to the dollar. Now the spread is more than 4%, yet the yen is at 80. Our financial markets may not need to worry as much now about the Fed raising interest rates another notch. This is partly due to Fed Vice Chairman Alan Blinder being a domestic Keynesian, who doesn't give a yip about the yen. He's happy to see the U.S. economy dragging its feet The rise in the gold price, as a feedback effect of currency substitution, means that another inflation error is creeping into the bond market, however. This increases the risk that the Fed might soon do its solemn duty to raise interest rates again.

Jude Wanniski and David Gitlitz

1 In this hopeless quest, Angell appears to have American monetarists as well as international Keynesians on his side. Michel Camdessus, the nincompoop who runs the International Monetary Fund, is back in the news, insisting that the Fed meet its solemn obligations to international currency stability by raising interest rates. At his side, presumably, is Stanley Fischer, his chief economist, formerly of MIT, the close friend of Larry Summers, President Clinton's Treasury Undersecretary of International Affairs and Ted Truman, chief international bureaucrat at the Federal Reserve. This is the same team that destroyed Mexico at Christmas. They have, though, succeeded in stabilizing the peso for the moment, by having the U.S. Treasury buy up Mexico's national debt. (Don't ask what happens when we ask Mexico to buy back its debt.)