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5 THE INTEREST RATE
CONUNDRUM, Part 1 Economics of
denial By Henry C K Liu
earlier efforts to fight
hyperinflation and, worse, destabilized the
economy unnecessarily. When mortals play god,
other mortals die unnecessarily.
On May 6,
1980, with the New York Fed's Open Market Desk
furiously trying to reverse a raging money-supply
shrinkage, pumping in money to the system by
buying government securities
and
depositing the funds in banks to create new
additional "high power" money by increasing bank
reserves for lending, interest rates fell sharply
and abruptly. The FFR dropped 500 basis points in
two weeks, from 18% to 13%, the bottom of the FOMC
range in the new operating procedure, and was
actually trading below the low FOMC target range
at one point.
The Fed was in danger of
losing control of its FFR target to the market and
jeopardizing it own credibility. The New York Fed
notified the FOMC that it could continue to follow
the new operating procedure by injecting more bank
reserves to let the FFR fall below the low limit
set by the FMOC or to tighten up the supply of
bank reserves to get the FFR back up to the 13%
set by it. But it could not do both, any more than
a train could go in opposite directions
simultaneously.
Volcker opted for
continuing the new operating procedure and staged
an emergency telephone conference of the FOMC to
authorize a new low FFR target of 10.5%, down from
13%, way below the inflation rate of more than
12%.
Market conditions were such that
interest falling below 10% would mean
below-neutral negative interest after inflation
adjustment, which would start another borrowing
binge to exacerbate further inflation. The
fundamental fault of monetarism was being exposed
by real life. The claim that stabilizing the money
supply would also stabilize interest rates was
shown to be inoperative by events. In reality,
attempts to stabilize the money supply actually
destabilized interest rates and pushed them down
in a fast-reacting dynamic market in an
environment of shrinking liquidity.
Desperate, the Fed under Volcker, with
concurrence from an even more panic-stricken
Carter White House, started to dismantle Emergency
Credit Controls as fast as administratively
feasible, so that demand for credit would not be
artificially shut down, in hope of making market
interest rates rise from more borrowing. Still, it
took until July 1980 before the last of the credit
controls were lifted. Back in April, the New York
Fed had injected additional reserves into the
banking system at an annualized rate of 14% and in
May at a 48% annualized rate in non-borrowed
reserves, pushing interest rates down and laying
the ground for future inflation.
It was
obvious that Volcker had panicked, spooked by the
sudden economic collapse set off by his own
credit-control program to slow the rise in money
supply. By the last week of July, the FFR fell
below the 13% discount rate and hit 8.5%, down
from 20% in late March. For one trading day, it
dipped to 7.5%, and for a time the Fed lost
control. The short-term rate that monetary policy
regulates most directly was free-floating down on
its own, unhinged from the FFR target. With the
FFR below the discount rate, the FFR could fall to
zero by banks responding to market forces. So the
pressure to lower the discount rate was
overwhelming.
The financial markets had
never seen anything like it. The money market
became a game in which the guards had thrown in
the towel and the inmates were running the asylum.
Correcting one overshoot with another
The FFR dropped from 20% in April 1980 to
8.5% in 10 weeks, in effect banishing
interest-rate gradualism out to the wilderness. In
the autumn of 1979, the Fed had seized the
initiative to push the price of money up 100% to
fight inflation. Now, barely seven months later,
the Fed allowed the price of money to fall even
more rapidly to reverse the money-supply
shrinkage, with "damn the inflation torpedo - full
speed ahead in the sea of liquidity" frenzy.
The recession was abruptly ended by the
Fed's overreaction and Volcker, the self-ordained
slayer of the inflation dragon, became overnight a
breeder of baby dragons of even more aggressive
inflationary DNA. The US economy now was facing a
worse, and more interest-rate-immune, inflation
problem than when he had become Fed chairman in
July 1979 less than a year before.
Many
businesses that had been profitable under a steady
interest-rate regime went bankrupt during this
brief period of sudden Fed-manufactured volatility
in liquidity, but the banks were dancing in the
street with windfall profits and excess cash to
lend. Volcker's "new operating procedure"
experiment put the Fed back on its traditional
path: focusing on interest rates and not
money-supply numbers and vowing again to focus
only on the long term. Yet for the long term,
money supply was the correct barometer, while for
the short term, interest rate was the appropriate
tool. The Fed did not seem to have learned
anything, despite having made the United States -
and the world - pay a very costly tuition.
Volcker's high-interest-rate policy caused
the dollar to rise in the foreign-exchange market,
making US exports less competitive, but US
investment overseas less expensive. The rise in
import prices was moderated by lower profit
margins made affordable to foreign importers whose
dollar earnings now were worth more in local
currencies.
Instead of restructuring the
US economy and reforming the terms of globalized
trade to address a mounting structural US trade
deficit, treasury secretary James Baker under
president Ronald Reagan took the easy way out and
engineered the Plaza Accord on September 22, 1985,
to push the dollar down by coordinated
intervention by the central banks of the United
States, Japan, West Germany, France and the United
Kingdom. Two weeks earlier, on September 6, the
Fed had raised the FFR target 25 basis points to
8% from 7.75% set mid-July, putting upward
pressure on the dollar as the Treasury was trying
to push the dollar down.
The Plaza Accord
when finally put in place pushed the Japanese yen
down by more than 50% against the US dollar with
central-bank intervention. But it had little
discernable effect on the US trade deficit. It did
allow the United States to export deflation to
Japan to use the dollar's low exchange rate to
boost US asset value nominally. The Plaza Accord
decoupled dollar interest rates from the exchange
value of the dollar and also decoupled the
traditional link between rising interest rates and
falling equity prices.
Time magazine
reported on January 26, 1987, that John Makin,
director of fiscal-policy studies at Washington's
American Enterprise Institute, argued that the
value of the US dollar was "totally irrelevant. If
the budget deficit isn't going to improve very
much, the trade deficit isn't either."
Sidney Jones, an economist at the
Brookings Institution, also warned of a danger if
the dollar's exchange rate continued to serve as
the main instrument for altering the trade
balance: the risk that the US inflation rate,
about 2% in 1986, would flare up. "Once those
import prices do go up, then you can get away with
increasing domestic prices. That's probably a
greater inflation risk than simply the increase in
the price of imported goods," Jones was quoted as
saying.
Yet the US House of
Representatives passed a highly restrictive
omnibus trade bill, though it stalled in the
pro-trade Republican-controlled Senate.
China enters the trade
picture Predictably, the same Passion play
over trade with Japan seen two decades ago is now
being re-enacted with China. And if China yields
to US pressure as Japan did to revalue its
currency upward against the dollar, China will
face decades of deflation as Japan did.
China launched its economic reform and
"open to the outside" policy in 1978, and a good
part of the excess global liquidity resulting from
the recycling of oil revenue after the 1973 oil
crisis went into China after 1978, and to other
economies in Asia, to fund the newly
industrialized countries, known as Asian Tigers,
eager to trade with and invest in China. For
almost three decades, China has been riding on a
liquidity boom created by the US Federal Reserve's
stealthy devaluation of the purchasing power of
the dollar.
Ironically, pundits of all
colors have since applauded China for its "wisdom"
in adopting market capitalism as a path out of
poverty, while the whole world has become addicted
to easy money
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