In 2008, Shades of October 1987
Not long after he took over at the Federal Reserve in 1987, Alan Greenspan was faced with questions about what to do with the Fed funds rate. After polling the various Fed presidents, in September of that year Greenspan found that there was “good growth, high optimism and full employment – all reasons to be leery of inflation.” According to his biography, The Age of Turbulence, the various FOMC members were persuaded “that the Fed would have to raise rates soon.”
In describing the thought processes at work, Greenspan plainly wrote that in order to “subdue inflationary pressures, we were trying to slow the economy by making money more expensive to borrow.” Greenspan’s thinking belies the consensus today suggesting rate increases would aid the dollar. More realistically, the Fed has traditionally hiked rates to reduce dollar demand. From January to mid-October of 1987 the Fed raised it target rate 125 basis points, but the dollar weakened in gold terms from roughly $400/ounce to a high of $481.
Notably, Fed policy was not the only variable at play when it came to our currency. Back in September of 1985, the top treasury officials of the G5 countries met at New York’s Plaza Hotel to realign the major currencies amidst worries, particularly at home, that weak foreign currencies were negatively impacting the ability of U.S. companies to export. The Plaza Accord communiqué specifically stated that “some further orderly appreciation of the main non-dollar currencies against the dollar is desirable.”
By October of 1987 the dollar was weakening, the Greenspan Fed was raising rates, and stocks began to sag. To make matters worse, investors had to contend with a Congress that threatened a combination of harsh protectionist legislation against Japan with new tax laws that would make efficiency-enhancing LBOs more difficult to complete.
All of the above came to a head on October 19, 1987. During a Meet the Press appearance the day before, Treasury Secretary James Baker suggested that the dollar’s fall would not be arrested. The Dow Jones Industrial Average fell 508 points (22.4%) the next day, and as Robert Bartley wrote in The Seven Fat Years, “I think that what the market was saying was that Secretary Baker was toying with the same dollar free-fall Secretary Blumenthal had outlined to President Carter nearly a decade before.” Indeed, with markets fearful of a 1970s inflationary redux, stocks sold off given the negative correlation between inflation and stock/economic performance. The latter in mind, today’s media consensus suggesting Wall Street welcomes cheap and easy money will remain one of those unproven and absurd assumptions.
In response to the crash, Alan Greenspan issued a press release affirming the Fed’s “readiness to serve as a source of liquidity to support the economic and financial system.” Importantly, the subsequent 50-basis point reduction in the Fed funds rate was not a “loosening” of the monetary strings as is so often assumed today. As former Fed Vice Chairman Manuel Johnson wrote with Robert Keleher in Monetary Policy, A Market Price Approach, due to the fall of longer-term Treasury yields on October 19th that shrank the spread between the 10-year and the Fed funds rate, failure on the Fed’s part to reduce its rate would have “constituted a de facto tightening of monetary policy.”
Sure enough, the dollar did not weaken in response to the Fed’s post-crash rate reductions. Far from the monetary “ease” that is frequently used to describe rate reductions today and which presumes devaluation, economist Nathan Lewis noted in Gold: The Once and Future Money that “the dollar wasn’t devalued on Tuesday, October 20, 1987. On the contrary, the dollar went up! After its sickening drop to $481.00/ounce on Monday, the dollar snapped back Tuesday to close London trading at $464.30/ounce.”
Fast forward to today, in some ways there are shades of 1987 in the economic backdrop. China has replaced Japan as the trade miscreant, with anti-China trade legislation ever a threat thanks to a political class eager to be seen doing something for the allegedly down-and-out American worker. And while LBO transactions aren’t threatened by tax changes, those who engage in this kind of activity face the threat of tax increases when it comes to “carried interest” that would reduce the incentives for those in this space to transact at all.
On the monetary front, the dollar has been weakening since 2001 amid varying rate stances from the Federal Reserve. Its fall versus gold began alongside rate cuts, accelerated during 425 basis points of rate increases, and it has continued during the latest round of cuts. Treasury has certainly aided this process in that Secretaries O’Neill and Snow mocked or questioned the importance of a strong dollar, while Secretary Paulson has made plain his desire to see the dollar weaken through his jawboning of China.
And even though the markets have priced in three rate hikes from the Fed beginning in the fall, the dollar has not strengthened as so many assumed it would. Indeed, at $925/ounce gold is once again testing highs experienced earlier in the year. This has occurred amidst a de facto tightening of the kind Johnson referenced judging by a not insubstantial fall in 10-year Treasury yields over the last two weeks.
So while nothing’s ever exact, just as in 1987 we presently have an unseasoned central banker seemingly lost at sea about the true nature of inflation. Much was made of Bernanke’s mention of the dollar a few weeks back, but the main thrust of his “dollar speech” was that rising commodity prices are not a result of monetary mismanagement, but instead a function of too much growth. Like Greenspan in ’87, Bernanke embraces the reprehensible view that growth is inflationary, and that slower growth will reduce commodity prices/inflation.
Bernanke’s lieutenant at the Fed, Donald Kohn seemed to channel his boss in a speech last week. As Bretton Woods Research’s chief economist Paul Hoffmeister wrote in a client report, Kohn’s view is that foreign central banks should seek to weaken their economies in order to fight inflation, or, in Kohn’s own words, in “those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability."
Adding gasoline to the inflationary and market-enervating fire, Treasury Secretary Paulson continues to dance around the dollar subject. He talks up the importance of a strong unit of account, but refuses to engage in any actions that would signal to the markets he’s serious. With Paulson’s ambiguity in mind, investors should hope against a Sunday talk-show appearance where our Treasury Secretary is quizzed on the dollar’s direction.
Whatever the long-term result of all the above, the S&P 500 fell 3.5% last Thursday and Friday in concert with a 4.5 percent surge in the gold price. Feckless dollar policy from Treasury has joined with impressive economic illiteracy at the Fed in ways that have eroded the dollar’s credibility.
Amidst all this uncertainty there’s a rising consensus among strong-dollar types that the path to nirvana is paved with rate increases. History says this would be a bad idea. Rate increases in 1987 did nothing to shore up the dollar’s value, but did make the economic outlook cloudier alongside a falling unit of account that the Treasury countenanced. All we got out of this market and greenback jawboning was a massive stock-market correction.
Ultimately a strong currency is consistent with low, not high rates of interest. If a strong dollar is what we want, and we desperately need just that, the Treasury need only announce a dollar definition in terms of gold with the Fed’s backing. It could do this without any rate machinations from the Fed, though it should be said that actions taken to define the dollar price of gold lower would over time lead to lower rates across the board.
Just as we did in 1987, we need a stronger dollar in 2008. And as we learned in ’87, we don’t today need rate increases to achieve our dollar-price goals.