Selling on the Deflation Bias
Jude Wanniski
August 22, 1997


The sell-off on Wall Street, with the blue chips leading the way, continues the trend we noted a week ago, built around the increased risk that monetary policymakers will make errors -- especially at the Federal Reserve, the Bundesbank, and at the Bank of Japan. The anxiety last Friday gave way to optimism earlier this week, but when the Fed Thursday issued its minutes from July 1, anxiety was back in the saddle. But our interpretation is not as bearish as the market reaction to them. This is because a lot of information has gone over the dam since July 1. We trust that Fed Chairman Alan Greenspan is much happier today than he was when the FOMC was unanimously voting July 1 to hold interest rates steady, but to tighten at the slightest sign of upward pressure on “aggregate demand.”

The minutes make scary reading even now, but remember there was no budget deal back then, and that even with the “asset price inflation” on Wall Street, we know Greenspan must be delighted to see that his inflation gold signal continues to behave itself well down at $325, on the deflationary side of $350. We also have the benefit of Greenspan’s July testimony before the Senate and House banking committees, which took place while the budget deal was firming, and which already showed less anxiety than the July 1 minutes. Our guess is that when the minutes of this week’s FOMC meeting are published in September, they will show less anxiety about inflation. At the September meeting there will still be Fed governors and regional presidents ready to vote their concerns about too many people going to work, too many “demand pressures,” but Greenspan would not vote to tighten, knowing the global dangers of further dollar deflation.

Uncertainty regarding the German and Japanese policy outlook is manifest in the extreme volatility in foreign exchange markets. This is feeding the sense of unease being registered at the long end of the Treasury yield curve, which is in turn being transmitted to equities. Confusion continues to reign among Japanese policymakers. Accumulating signs of further economic weakness for now have squelched talk of an outright tightening that would involve a hike in the Bank of Japan’s benchmark discount rate, which has been at a record low of 0.5% for nearly two years. But the mysterious dictates of the BoJ’s byzantine operating procedures are forcing it to keep a lid on yen liquidity creation, to the extent that it has provided no surplus reserves to the Japanese banking system for more than two weeks. Since then, the Nikkei 225 has fallen by about 1,000 points to a four-month low of 18,650, and already depressed Japanese bond yields have dropped another 10 basis points to a near-record low of 2.05%, which can be explained as representing a competitive real return only if bondholders expect deflation. Meanwhile, the yen has gyrated wildly, falling from near 119.5/dollar to less than 115, and bouncing today from 116 to above 118.

The bias toward deflation is also obvious at the Bundesbank, which roiled the currency and bond markets yesterday by announcing that it will now make weekly, rather than bi-weekly, adjustments in its repo rate, if deemed necessary. With the German central bank having already expressed concern about the inflationary consequences of the mark’s “weakness,” the announcement clearly was intended to give the markets a not-too-subtle warning not to dismiss the possibility of a near-term German rate hike. In this confusion, with central banks unable to distinguish dollar strength from their own currency’s weakness, the chances of policy error rise accordingly, making for a wild ride in the markets.