The sell-off on Wall Street today reflects market disappointment with the obvious uncertainty at the Federal Reserve. Going into today’s market calculus, we had a draw at the Fed’s highest level in predicting the path of the real economy: Chairman Alan Greenspan sees a soft landing with a small chance of a technical recession; Vice Chairman Alan Blinder sees a bumpy landing with a higher chance of a hard recession. Last night, on PBS’ Nightly Business Report, Gov. Larry Lindsay more or less broke the tie by siding with Greenspan. Today’s report on the Producer Price Index, with higher core inflation than expected, added to the problem that is causing Greenspan to hesitate. The market sell-off also compounds Greenspan’s problem because it is telling him that maybe Blinder is right -- that unless he does cut fed funds forthwith (We would do no less than a half point ASAP), the economic ground coming up to meet us will be loaded with giant potholes.
What is Greenspan’s problem? It remains the error the Fed made by allowing the price of gold to rise by 10% in the fall of 1993, to $385 from its optimum plateau of $350. It was an easy error to make, in that the Fed has no direction from the government on where gold should be. Nevertheless, it is the best signal Greenspan has for future inflation and he treats it with great seriousness. He knows that if gold stays at $385, eventually all dollar prices will rise by 10%. The key word behind this big number is eventually. If the real economy grows rapidly, the 10% inflation will show up sooner in the price indices -- as the costs of the factors of production rise. If the real economy grows slowly, the 10% error will take longer to show up in the price indices. Inasmuch as the economy is going to take the 10% sooner or later, we would prefer that it be sooner, and so would the financial markets. Holding back real economic enterprise in order to forestall the inevitable surfacing of a mistake is kind of like sweeping dirt under the carpet.
If this were the only part of Greenspan’s problem, he would probably urge a half-point cut in fed funds ASAP. The markets clearly were expecting even deeper cuts, to judge by the spreads in Eurodollar futures. These inferred a 5% funds rate by September, before weakening sharply the last two days. Greenspan has left enough of a paper trail to be able to explain away higher numbers showing up in the CPI and PPI. What really worries him, we think, is fear that a half-point cut would cause the gold price to climb even higher! This would only happen if there is some quirk in the Fed’s operating procedures that would cause it to add excessive liquidity, but there’s no apparent reason why this should happen. Lowering the funds rate would cause an increase in the demand for dollar liquidity, which would mean the gold price would continue to remain in its $385 range. What might cause gold to fall? Downward pressure would occur with a cut in tax rates, reversing the Clinton administration’s tax increases that we believe triggered gold’s rise in late 1993. What might cause gold to rise? The tariff increase on Japanese autos would put upward pressure on gold by reducing the demand for dollar liquidity. If you have noticed, in recent weeks Greenspan has been willing to side with the tax-cutters in Congress and has been warning the White House of the financial effects of a trade war with Japan. He has very little room to maneuver and is getting no help from GOP leadership in Congress. Senate Majority Leader Bob Dole remains officially in support of the hard line on Japan. Senate Finance Chairman Bob Packwood, who should be providing a forum for Greenspan to develop these views, is submerged by his ethics problems. Chairman Connie Mack of the Joint Economic Committee seems boxed in, immobilized by the presidential politics of his Senate confreres. Speaker Newt Gingrich is out selling books.
It’s awfully lonely at the top of the Fed at times like these, so it’s easy to see why Greenspan hesitates. Our guess is he will go ahead, taking comfort in his readings of the financial markets -- which clearly have been swinging up in expectations of a rate cut, down with disappointment. He will still have Japan to worry about, and the shameful fiscal games being played between the White House and Capitol Hill. One thing at a time.
Tokyo stocks have sold off by 4% the past two trading sessions -- the Nikkei dropped 2.5% in trading last night -- as continued dithering by financial and monetary authorities increasingly leaves market participants wondering whether the Japanese financial system can survive its current problems without a major cataclysm. The proximate cause of the latest sell-off is disappointment with a government plan to deal with an emerging banking crisis. The deflation of the past several years has left Japanese banks with a portfolio of non-performing loans now estimated at some Y40 trillion, about 6% of total lending. The most prominent feature of a long-anticipated “rescue” package was a statement of the Bank of Japan’s authority to provide emergency liquidity, a policy already defined in the central bank’s charter as lender of last resort. In the meantime, BoJ officials continue to discourage any hope for a shift in policy to provide greater liquidity to the market. A discussion on this point, which we opened with the BoJ in The Wall Street Journal last month, is now at least in the air. Tokyo market players are increasingly coming to recognize added liquidity as the only route to relieving the deflation which is at the core of the bad loan problem. Today’s Financial Times quotes one Tokyo analyst: “The Bank of Japan could simply increase the amount of liquidity it ploughs in every day to the banking system. That would help to lift many banks away from their asset quality problems. But it still chooses not to.” In the midst of Friday’s market turmoil, the BoJ drained Y300 billion from the banking system. While the central bank’s intellectual vacuity is certainly the driving force of Japanese markets at the moment, the growing likelihood of U.S. trade sanctions must also be regarded as a contributing factor. Given its already weakened condition, the tariffs against as important a sector as the auto industry would be a major body blow to the Japanese economy.