At the Fed, All's Well that Ends Well Jude Wanniski March 31, 1986

Executive Summary: Preston Martin's departure seemed worrisome, given the hijinks surrounding the 4-3 vote February 24 to cut the discount rate. But there was less than meets the eye in the supposed conflict indicated by the vote. The problem had been generated by dual objections that flowed from the September 22 G-5 meeting in New York – lower interest rates and a cheaper dollar. The Gang of Four gave Treasury Secretary Baker and Fed Chairman Volcker what they needed to move the wary Germans, an impatient prod. Martin leaves at his peak, with the White House seeing a third term for Volcker in '87. That may be an imperative if the President is to get the international monetary reform he and Baker want to leave as their legacy. This will smooth things out at the Fed. Coordination of lower interest rates should follow reaction to the deflation now hitting Europe and Japan. Everybody's happy, even Martha Seger. The Gang of Seven?

At the Fed, All's Well that Ends Well

The March 21 resignation of Federal Reserve Vice Chairman Preston Martin finally gave us something to worry about in the otherwise carefree bull market. Indeed, when news that Martin would be holding a 4:30 press conference was announced at 2:30 on the afternoon of the 21st, the Dow was up 9 in territory it had never seen before. A press conference could only mean a resignation, and as The New York Times reported March 23, the market began its tumble to a 35-point loss on the day as rumors of Martin's impending resignation swept Wall Street.

Yes, there was that "triple witching hour" explanation of the market's nosedive — the simultaneous expiration of contracts on three kinds of options. But we reject all explanations of market movements that are inherently circular. Market shares don't decline in price because they are "overbought" or because of "profit taking." Prices are based on expectations of supply and demand as well as instantaneous supply and demand conditions. A barrel of oil sells at $15 in part because the seller doesn't believe he will be able to get $16 tomorrow, and because the buyer doesn't believe he will be able to get it for $14 tomorrow. A change in price always involves a change in expectations, not because it was unaccountably too high or too low, and certainly not because a contract between a potential buyer and a potential seller expired according to a long-known schedule.

The point is made here with emphasis (and we will return to it later in this paper in discussing exchange rates) because it is crucial to understanding the potential of the bull market in stocks and bonds, and the pitfalls. So too with Preston Martin's resignation, which clouds our expectations of monetary policy just when it seemed at long last under control. At 2:30 p.m. on Friday March 21, we knew that four of the seven member Fed board of governors were both willing and able to force a cut in the discount rate, under certain conditions, and would be in a position to do so again under similar conditions. An hour later, it was clear there were only three votes on each side, and there surely would be a political struggle inside the Reagan Administration to fill the new vacancy at the Fed. The market decline may have been an appropriate adjustment to this new set of expectations, but perhaps there's less to worry about than meets the eye.

A great deal has been written about the 4-to-3 vote of the Fed board of governors on February 24, with the "Gang of Four" in the majority and Tall Paul Volcker on the short side of the decision to cut the discount rate to 7% from 7 1/2%. Most of the coverage focused on the human dynamics, which is great fun compared to the intricacies of monetary theory: Did Martin spring a surprise vote, to embarrass Volcker, get him to resign and then win his job?; Did Volcker miscalculate, but recover by persuading Wayne Angell into changing his vote?; Did Martha Seger get her revenge against the chairman, for the indignities she suffered in the year her appointment was kept on ice? But is she now isolated, with Martin gone?

These matters are of small importance compared to the way policy unfolded, however. The fact is that out of the group dynamics Volcker got what he wanted, coordination with Japan and West Germany to keep exchange rates in line, and Martin, Seger, Johnson and Angell got what they wanted, the discount rate cut. And nobody lost. Volcker was happy to see the discount rate cut as long as it was coordinated, and while the four would have taken it anyway, they were surely pleased that Japan and Germany participated. All's well that ends well.

The root cause of the conflict, after all, was not even inside the Fed, but within the Reagan Administration. From the time of the G-5 meeting of finance ministers, September 22 at New York's Plaza Hotel, the Administration has been confused about its objectives.

One faction, preoccupied with trade issues, saw G-5 as a way to get the dollar down against the yen and D-mark. Commerce Secretary Malcolm Baldridge and Special Trade Representative Clayton Yeutter, persuaded that a weak dollar would spur exports and inhibit imports, used the foggy G-5 accords as an excuse to talk down the dollar. The Reagan appointees at the Fed, on the other hand, were primarily concerned with the impact Volcker's deflation was having on the nation's farms, mines and mills. They pressed for lower-interest rates, but Volcker held firm with the argument that easier money would risk a "precipitous" decline in the dollar's international value — reigniting inflation and shutting off the capital inflows necessary to finance the federal deficit.

To the easier-money faction at the Fed and in the Treasury, G-5 was the answer to this problem. By consultation and coordination, the finance ministers could promote lower interest rates without "precipitous" movements in the currencies. The net effect, in addition, was to reduce Paul Volcker's power and independence. Henceforth, U.S. monetary policy would not be merely a domestic matter, but an international one, and Volcker would now be sharing power with Treasury Secretary Baker.

There were, then, dual objectives: Getting the dollar down and getting interest rates down. Unfortunately, Secretary Baker never quite understood the potential conflict in these goals. Few did.

By the time of the February 24 meeting of the Fed governors, the dollar had seemingly fallen to 180 yen — from 230 in late September (and 260 a year earlier). But this was just an optical illusion. The dollar was rock steady against commodity prices, as Wayne Angell pointed out at his Senate confirmation hearing January 23 when asked about the inflationary implications of the dollar's fall. It was the yen that was climbing against the dollar and commodities.

The Bank of Japan had tightened monetary policy even as G-5 invited an increased demand for Japanese liquidity. The finance ministers had practically advertised that holders of dollar balances could score a capital gain by switching to yen. Insofar as prices are determined by expectations — and this includes the price of dollars in yen, the exchange rate — currency speculators were told to expect higher yen prices, so they bought. A similar, albeit lesser effect was seen in European currencies.

According to the trade theory that promises a lower trade deficit for a cheaper currency, the U.S. should be experiencing some benefit already from the 30% decline against the yen. Yet the trade deficit hasn't changed much. Classical theory, on the other hand, predicted an increased trade surplus for Japan if its rate of economic growth slows — as it did under the deflationary pressure of higher real interest rates. But the cheap-currency theorists are never satisfied, and in early February they had Commerce Secretary Baldridge and Trade Representative Yeutter calling for an even weaker dollar.

What about the lower interest rate faction? In early November, Gov. Martha Seger had begun calling for a cut in the discount rate. Yet there was always some new inflationary threat conjured to nix that idea, the "precipitous" decline of the dollar being one such fear. But it was only The root cause of the conflict, after all, was not even inside the Fed, but within the Reagan Administration. From the time of the G-5 meeting of finance ministers, September 22 at New York's Plaza Hotel, the Administration has been confused about its objectives.

One faction, preoccupied with trade issues, saw G-5 as a way to get the dollar down against the yen and D-mark. Commerce Secretary Malcolm Baldridge and Special Trade Representative Clayton Yeutter, persuaded that a weak dollar would spur exports and inhibit imports, used the foggy G-5 accords as an excuse to talk down the dollar. The Reagan appointees at the Fed, on the other hand, were primarily concerned with the impact Volcker's deflation was having on the nation's farms, mines and mills. They pressed for lower-interest rates, but Volcker held firm with the argument that easier money would risk a "precipitous" decline in the dollar's international value — reigniting inflation and shutting off the capital inflows necessary to finance the federal deficit.

To the easier-money faction at the Fed and in the Treasury, G-5 was the answer to this problem. By consultation and coordination, the finance ministers could promote lower interest rates without "precipitous" movements in the currencies. The net effect, in addition, was to reduce Paul Volcker's power and independence. Henceforth, U.S. monetary policy would not be merely a domestic matter, but an international one, and Volcker would now be sharing power with Treasury Secretary Baker.

There were, then, dual objectives: Getting the dollar down and getting interest rates down. Unfortunately, Secretary Baker never quite understood the potential conflict in these goals. Few did.

By the time of the February 24 meeting of the Fed governors, the dollar had seemingly fallen to 180 yen — from 230 in late September (and 260 a year earlier). But this was just an optical illusion. The dollar was rock steady against commodity prices, as Wayne Angell pointed out at his Senate confirmation hearing January 23 when asked about the inflationary implications of the dollar's fall. It was the yen that was climbing against the dollar and commodities.

The Bank of Japan had tightened monetary policy even as G-5 invited an increased demand for Japanese liquidity. The finance ministers had practically advertised that holders of dollar balances could score a capital gain by switching to yen. Insofar as prices are determined by expectations — and this includes the price of dollars in yen, the exchange rate — currency speculators were told to expect higher yen prices, so they bought. A similar, albeit lesser effect was seen in European currencies.

According to the trade theory that promises a lower trade deficit for a cheaper currency, the U.S. should be experiencing some benefit already from the 30% decline against the yen. Yet the trade deficit hasn't changed much. Classical theory, on the other hand, predicted an increased trade surplus for Japan if its rate of economic growth slows — as it did under the deflationary pressure of higher real interest rates. But the cheap-currency theorists are never satisfied, and in early February they had Commerce Secretary Baldridge and Trade Representative Yeutter calling for an even weaker dollar.

What about the lower interest rate faction? In early November, Gov. Martha Seger had begun calling for a cut in the discount rate. Yet there was always some new inflationary threat conjured to nix that idea, the "precipitous" decline of the dollar being one such fear. But it was only The outcome was optimum. A little messy, perhaps, but more democratic than anything we've seen coming out of 20th & Constitution in memory. Things will never be the same.

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Vice Chairman Martin resigned at the peak of his influence, but his calculations were probably correct. He did not wish to serve another term as vice chairman, the first ending March 31, but he told the White House he'd stay if he could be assured he would move up to the chairmanship next August, when Volcker's second term ends. The assurances were not forthcoming.

The reason is that the White House isn't sure it wants to replace Volcker. Chief of staff Donald Regan at times has left the impression that he can't wait to get rid of Volcker, but that simply reflected the obsession of CEA chairman Beryl Sprinkel and his monetarist friends, who fantasize about getting one of their number into his chair — George Shultz or Alan Greenspan, a quasi monetarist with a zest for austerity.

The overriding consideration about 1987, which Regan knows he must sooner or later confront, is that the President expects it will be his last chance to fashion an international monetary reform. And if something resembling a new Bretton Woods is to develop in 1987, it can't without someone at the Fed with the standing, prestige and experience of a Volcker. This is behind Regan's remarks to The Washington Post March 28 that he sees "no reason" why Volcker should quit and why he wouldn't rule out the possibility of a third term for him. "I don't rule anything out. I would never commit to anything, particularly in the economic and monetary fields, 15 months in advance."

In this light, the probability of Volcker being reappointed next spring — or even earlier — is becoming very high. The longer Baker, Regan, and Volcker contemplate a historic monetary reform in 1987, the more they must realize it could only happen with Volcker at the Fed. President Reagan, who continues to tell private groups that he hopes to leave behind a convertible dollar when he retires to the ranch in '89, has surely figured out the Volcker imperative. Without him, meaningful reform would await the next President. It is hard to imagine Preston Martin (or anyone else we can think of) getting the job done.

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Meanwhile, as the smoke clears at the Fed, the possibility of future conflict recedes. As the deflationary results of the G-5 exercise last autumn finally hit Europe and Japan, their central banks won't have to be cajoled into allowing rates to come down. Coordination with further Fed discount rate cuts is easier to contemplate, as long as commodity prices don't act up and gold stays below $350. (Alan Reynolds now expects the long bond at 7% in the second quarter.)

There's talk of Manley Johnson being named Vice Chairman — Volcker has been smitten by Johnson's pleasant, easy-going manner, his respect for the institution, and his grasp of the issues. The Martin vacancy must go to one of four regions, Atlanta, St. Louis, Dallas or California. Almost any nonmonetarist will do. Volcker is giving Martha Seger the executive assistant she's wanted. Wayne Angell, of course, is in solid. We wouldn't be surprised to see the board of governors soon be called the Gang of Seven.

Isn't Ronald Reagan lucky?

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