Executive Summary: President Reagan put monetary reform on the agenda sooner than we expected, adding clout to Treasury Secretary's G-5 moves to get interest rates down. Divergent moves in oil and gold prices after the timetable, with Volcker and the monetarists citing $350 gold as reason not to ease further. A political equilibrium seems to balance at that price. Mundell urges the Treasury to pledge gold sales at $375 to offset inflationary expectations and assist Volcker. There are arguments, though, that $400 gold may be needed to offset deflation in oil and farm prices. In any case, the oil price can't stay below $20 forever without a Fed tightening or an import tax to invite recession. It won't happen. Expect the Fed to shave fed funds, watching bond and commodity markets, but no big policy move until April in Paris, Tokyo in May economic meetings. With the economy on a better growth track, tax reform prospects okay, federal deficits head down – relieving Gramm-Rudman pressures. President Reagan is out of the white water rapids and there's clear sailing ahead.
For Awhile, Clear Sailing
International monetary reform is back on President Reagan's agenda, a bit sooner than many had expected, with possibilities of significant progress just around the corner. When Mr. Reagan gives his delayed State of the Union address Tuesday, he will have a line or two in it about monetary reform, something about a study on exchange rate stability, and perhaps even an invitation to our trading partners to consider an international monetary conference in 1987. As Leonard Silk of The New York Times observed in his January 31 column: "It is most unlikely that the President would dramatize the importance of international monetary reform by including it in his State of the Union Message unless he meant to propose significant change in the existing system."
There were expectations that the President would leave these matters in the hands of his Treasury Secretary until after the November elections, but it seems clear that Secretary James Baker III needs a little of the President's clout to move things along in 1986. Most importantly, with the Reagan Administration still divided between dollar fixers and floaters, Baker has to persuade the Europeans that he, not George Shultz and Beryl Sprinkel, has the President's commitment on monetary reform and they will not waste their time by pitching in. In addition, the fall in the price of oil and the jump in gold have complicated the debate over monetary policy, forcing an adjustment in timetables and Treasury strategy.
When the price of gold was at $325, a month ago, the Administration was in a better position to argue for monetary ease at the Federal Reserve than it is now that gold has climbed over $350. Where you could not get the deflationists to acknowledge the existence of gold while its price was falling to $325, the rise to $350 is now cited as a primary reason for not cutting the discount rate from 7 1/2 to 7%. The monetarists, who know they can't get the Fed or Treasury excited about M-1 targets anymore, have now shamelessly taken to viewing $350 gold with alarm. Fed chairman Paul Volcker has also informed Treasury officials that the gold price rise is cause for concern in discount rate considerations. The Administration's two new Fed appointees, Manuel Johnson and Wayne Angell, made clear at their confirmation hearings January 23 that they will fight a Fed tightening as long as commodity prices remain relatively low. But with gold over $350, they don't have much room to argue for further ease — and if gold were to climb to $375 or thereabouts, we could expect to hear more talk even from them of a snugging up. As advocates of a price rule, they are concerned about their credibility, and want to be just as willing to raise interest rates when the rules call for it as to lower interest rates when the price is falling.
As we have warned for years in approaching this point, once the optimal gold price is reached by inflationary and deflationary trial and error, long-term interest rates can no longer be brought down by day to day policy manipulations. From this point on, to get dramatic decreases in long rates — to the 5 and 6% range — requires government assurances that the price of gold will not thrash about in the next decade as it has in the last, with the value of foreign exchange, oil and other commodities churning in its wake.
While we have been critical of Volcker from time to time in bringing us to this point, believing there could have been more trials and fewer errors, we at least applaud his arrival. In retrospect, we could have improved on his performance in theory. But because we would have faced the same array of forces, our greater conviction might have been offset by our lesser political skill, and we might have lost rather than gained time in the balance.
There is now a high probability that the gold price will settle around $350, exactly ten times the official price under the Bretton Woods agreement of 1944, with de facto bands at perhaps $325 and $375 as we await formal agreements in 1987. If the price were to drift lower, Volcker and the monetarists would lose their arguments for not cutting interest rates. If the price were to climb above $375, the President's four Fed appointees — Martin, Seger, Johnson and Angell — may reduce pressure for further ease, in worrying about their credibility.
Does this mean there will be no cut in the discount rate, which the markets have been anticipating for three months at least? Not quite. But it means monetary policy must shift into a longer-run strategy, moving away from a "what do we do today" approach. Having the President put monetary reform on the agenda in his State of the Union address could be the backdrop for other transition moves that could chip away at interest rates around the world.
One idea being urged on the Administration is to take some of the anti-inflation burden off Volcker's monetary shoulders by backstopping him with Treasury's gold stocks. That is, Volcker's fear of an easing of interest rates leading to a surge in inflationary expectations — and a further runup of gold's price — would be removed entirely if Treasury pledged to sell gold from its vast hoard to keep gold from rising above $375 or $400. In other words, if in cutting the discount rate the Fed finds it has erred in creating surplus liquidity, bidding up gold and other prices, Treasury would step in to mop up the surplus with unsterilized gold sales. With the Fed and Treasury coordinating, they could plumb for the lowest interest rates currently consistent with stable price levels.
Columbia University's Robert Mundell has passed this recommendation to both Fed and Treasury policymakers. He believes that until the Treasury and the other world central banks mobilize the 1.1 billion ounces of gold in their monetary reserves, intervening to stabilize the value of this enormous inventory, the gold price can throw off false signals in the short run. This is because expectations in the relatively thin private gold market can produce volatile swings. And this can lead to the kind of paradox that confounds Volcker: Expecting a Fed easing, the private markets bid up gold; fearing the rise in gold, he then can't ease. By combining Fed buying and selling of bonds with Treasury interventions in the gold market, the paradox is solved and interest rates can be cut with confidence. Will it happen? Sooner or later it has to happen; Jim Baker and Richard Darman know they'll have to get their feet wet in the gold reserves if there's going to be reform.
There are serious arguments being made by Lewis Lehrman that a gold price of $350 is too low by at least $50, given the depths of deflationary pressures in the economy. Alan Reynolds tends to agree that in the absence of Mundellian gold sales at $375, which would have positive effects on expectations and interest rates in themselves, the gold price should be higher.
But the probing for an optimal price is just that. We must wait to see what response there is in the oil and commodity markets to the recent easing of monetary policy (or expectations of an easier monetary policy) that pulled gold up to $350. Lehrman insists this easing isn't sufficient to pull prices up enough to relieve the embattled oil and farm producers. He will probably have an important ally in Wayne Angell, when he is confirmed as a Fed governor. In his January 23 confirmation hearings at Senate Banking, Angell revealed both passion and persuasiveness in arguing against the deflationary policies that have ravaged the farm communities he knows so well. Indeed, farm prices fell another 3.1% in January. If gold is at $375 and farm commodity futures aren't rising, Angell will not want to slow down, and may be able to rally the others.
This is all end-game maneuvering, however. The gold price is now an accepted object of scrutiny in the setting of monetary policy. Volcker, as the lone bulwark against inflation, cites it now that it suits his purposes. The President's appointees, as a bulwark against deflation, use it for theirs. We're close to a political equilibrium in any case.
It will no doubt take some additional groundwork by Treasury before the gold reserves are deployed, even in modest fashion. The Paris meeting of finance ministers in April is a milestone, the Tokyo economic summit in May another. In these few months probabilities are that whatever the Fed does on the symbolic discount rate, it will continue to shave the more important federal funds rate by eighths and sixteenths and watch the effect on the bond and commodity markets.
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There's mass confusion on Wall Street, we find, over the simultaneous fall in oil and rise in gold. This is another element complicating monetary policy. What's happening?
We must remember that although gold and oil inevitably correlate as closely as apples and oranges, the gold market is much more fluid than the oil market because of Saudi Arabia and OPEC. The gold price quadrupled from August 1971 to the summer of 1973, reacting to the blatantly inflationary monetary policies of the Nixon Treasury and Arthur Burns' Federal Reserve. The world oil price rose only a bit, though, because OPEC expanded production rather than raise prices. Commodity prices other than oil soared in this inflation, well before OPEC got tired of accepting devalued dollars and demanded a fourfold increase in oil. In this two year period, investment patterns were grossly distorted in the United States because of the relative cheapness of oil; when oil leaped suddenly there were painful readjustments. If there had been no OPEC, the price of oil would have climbed apace with gold, with few of the relative price distortions.
In the last deflationary years an opposite mirror-image scenario has unfolded. As the Fed deflated from 1980, pulling the gold price down from $625, the commodities in the most fluid markets following in train, the oil price remained relatively high because of Saudi Arabia. The Saudis had built up a huge financial cushion in the last half of the 1970s. Now it could feed off those assets during the deflation, cutting production steadily instead of holding it steady and letting prices fall. The biggest losers, as a result, were producers of other commodities, U.S. farmers in particular. Their output prices fell but their input prices did not: Their cost of capital remained high because of the Fed's monetary deflation; their cost of energy, including fertilizer, stayed up because of OPEC.
In his Polyconomics essay of November 2, 1984, Alan Reynolds wrote that if gold remained at (then) $340, "oil would fall to about $22 and other commodity prices would continue their. . . decline." Subsequently, the gold price dipped to as low as $280 and really spent most of 1985 below $325. In the regressions he ran, a $20 oil price would not be out of line, which is where it tumbled when Sheikh Yamani and the Saudis decided to throw in the towel and go for market share. The Saudi government has seen a good part of its financial cushion evaporate these last two years and is now facing a $15 billion internal budget deficit. With production cut below 2 mbd, they really had no choice.
The William Safire column in The New York Times of January 26, argues that the Saudis had "declared economic war on most of the rest of the world" by "flooding the market" with cheap oil in order to persuade the non-OPEC members to unflood the market in order to send prices back up. To foil the Saudis, Safire says, "The President should impose a $12-a-barrel oil import fee." This nonsensical proposal sounds like Safire's old friends in the Nixon Administration, George Shultz and Herb Stein, who no doubt think this would both strike a blow for Israel and raise billions for Gramm-Rudman.
Such a move is of course the same as if the Saudis could raise the price of oil to the U.S. by $12 a barrel, letting the rest of the world pay the lower number. All U.S. energy intensive industry would slide into recession and the U.S. budget deficit would climb, not fall.
It would be nice if the oil price could stay at $15 or $18 without dire consequences for friendly energy producers —Canadians, Mexicans, Texans, etc. and their bankers. But for the price to sink that low and stay there, the Fed has to raise interest rates to offset the increased demand for oil inventories that builds up at those levels. That is, it has to deflate again, driving down the gold price, doing through monetary policy what Safire and his friends would like to do through taxation. This is not going to happen.
The oil price tumbled, remember, just as the Fed moved to a slightly easier monetary policy that allowed gold to rise by $25, shaving about an eighth of a point off its fed funds target range. Where the Fed had been keeping fed funds above 8% for the last quarter of 1985, it now keeps it between 7 ¾ and 7 7/8 %. Alan Reynolds now writes:
Oil is thus belatedly reacting to earlier deflationary pressures, which have been ameliorated for dollar debtors, yet shifted to other countries. I do not expect that an oil price below $20 can be sustained unless the dollar again rises in terms of gold and other commodities. It becomes too attractive for speculators to stockpile oil for a capital gain when its price gets too low relative to alternative inventory investments (like gold). But renewed downward pressure on gold and other dollar commodity prices is possible if foreign interest rates are reduced without a matching move by the Fed. In that case, the dollar would go back up and other commodities would do what oil is doing. It may not be a coincidence that the second round of G-5 was followed by the oil price collapse.
The G-5 meeting in London on the weekend of January 18-19 was supposed to lead to a coordinated interest rate decline, which would have bolstered oil prices. But when West German Economics Minister Martin Bangemann let the cat out of the bag, talking to reporters in Washington after a meeting with Jim Baker, the opponents of monetary ease were forewarned. The Germans, who are dominant in the European Common Market, are wary of any monetary agreements that would put them in the back seat to the U.S. again. We can easily imagine Secretary of State Shultz, an ardent foe of monetary reform, sowing doubts about Baker among the Europeans, especially the Germans. Other U.S. monetarists raised a hue and cry about the imminent return of inflation, with the lead story in The Wall Street Journal on January 17 amounting to a monetarist editorial on the matter. Market expectations of an easing sent gold briefly to $379, and this was enough to spook Volcker. The meeting ended inconclusively.
In the few weeks since G-5 the only important development was Japan's decision to cut its discount rate to 4 ½ to 5%, where it had sat for three years. The financial press, which is having a very hard time figuring all this out, reported how happy everyone seemed to be with the Bank of Tokyo's decision, because this might enable the U.S. to follow. Hardly anyone seems to remember that after the G-5 meeting September 22, at the Plaza Hotel, Japan was applauded for tightening monetary policy in order to get dollar down and the yen up.
Volcker, we know, was not at all happy with Japan's monetary squeeze after the Plaza meeting, ostensibly because he understood it would only weaken the Japanese economy and contribute to the recession developing in the Pacific rim. More to the point, Volcker knew these events were nudging him toward a monetary easing he wants to avoid. Japan's discount rate cut, which arrested the yen's appreciation against the dollar, was more to his liking because it relieved, for now, the exchange rate pressure on him to ease — exactly the opposite of the conventional analysis.
The fiscal and regulatory issues that impinge on monetary policy are also worth noting. In Volcker's mind, interest rates can come down without the gold price rising if the demand for credit would fall. His interest in Gramm-Rudman on this account is obvious: If the government borrows $50 billion less in the credit markets, there's that much less "crowding out." This is a form of credit allocation, with less worthy borrowers (those on whom the borrowed public monies are spent) cut out, and worthy borrowers put back at the head of the credit line. Volcker's foray against "junk bonds" was of a piece with this strategy. He believes borrowing for mergers and acquisitions is less worthy than borrowing for new plant and equipment; Boone Pickens is kicked off the credit line and there's presumably more credit, at lower interest rates, for the good guys at the Business Roundtable.
These "crowding out" ideas are as obsolete as Henry Kaufman, who not only shares them, but who believes the Fed should solely concern itself with credit volume in making monetary policy. As Alan Reynolds argued in his January 30 paper: "Gramm-Rudman: Trivia Pursuit," its provisions will at best leave monetary policy and interest rates constant, and at worst —with tax increases or diversion from tax reform — make things tougher for Volcker. A tax increase especially discourages suppliers of credit (producers of goods) and puts upward pressure on interest rates. The junk bond rule similarly reduces credit demands the way Volcker and Kaufman imagine, but we suspect it reduces the potential supply of new credit even more by blocking the corporate efficiencies that Pickens & Co. can clearly see.
But these are minor skirmishes, becoming even less worrisome as time passes. There won't be a tax increase in 1986, Senator Packwood of Senate Finance said on January 26, unless revenue projections decline in the August revisions. On January 30, the Congressional Budget Office revised its projections upward, astonishing the Beltway Boys who had counted on a $200 billion deficit to force a tax hike down the President's throat. CBO sees $178 billion in fiscal '87, and as the economy expands again, here and abroad, that number is likely to be down again in the August revisions.
After a five month stretch of "shooting the rapids," the President is out of white water with clear sailing ahead. The economy is climbing back onto a higher expansion track, tax reform looks better all the time, and now international monetary reform moves onto the agenda. But these always seem to be the times for an unexpected bolt from the blue, the space shuttle reminds us, so we keep our guard up.
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