Bonds, What Now? Jude Wanniski February 7, 1994

It wasn't pretty, but it's done. The Federal Reserve move Friday, to raise the federal funds rate to 3.25% from 3% after months of agonizing, obviously displeased the financial markets. Our guess is that the displeasure is directly related to the confusion surrounding the move, and that if Fed Chairman Alan Greenspan can clear up the confusion in his next appearances before the Senate and House Banking Committees, bonds will be back on track. In our report last Thursday, we worried that because Greenspan had not discussed the gold price Monday when he prepared the ground for the Friday decision, 25 basis points "might not do the job." Outgoing Fed Governor Wayne Angell, who did not attend last Friday's meeting, had made this point in his December dissent, when he had urged a rise of 50 basis points accompanied by a clear signal to the markets that the price of gold was the Fed's concern. As the Fed reported Friday:

Mr. Angell also stressed that the committee should focus more directly on forward_looking indicators such as the price of gold and the estimate of the natural rate of interest provided by the rate on five_year Treasury notes. He favored an immediate increase of 50 basis points in the federal funds rate, which would enable the committee to observe how the market adjusted the price of gold to the changed opportunity cost of holding gold. He believed that if bond market participants concluded that the committee was using the price of gold to target the price level, five_year and 10_year interest rates would then be significantly lower than if the committee's tightening was a belated response to a worsening outlook for inflation. He emphasized that the objective of monetary policy clearly should be stable money which produces stable prices and an ongoing optimal and stable economic growth path.

By this approach, the market would be advised that if the price of gold tumbled in response to the 50-point rise, as I think it surely would, the Fed would be under no pressure to raise fed funds further. It could then roll back the increase once the market had been assured of the Fed's intent. There's no secret that Greenspan believes the price of gold is the premiere inflation signal. He said so last August in testimony before the Senate Banking Committee. He had every opportunity to bring it up last week before the JEC, but it was not in his prepared statement and he was not asked about it. In his extraordinary statement last Friday, all the usual questions about the Fed's targets were left unanswered. The Fed statement said in full:

Chairman Alan Greenspan announced today that the Federal Open Market Committee decided to increase slightly the degree of pressure on reserve positions. The action is expected to be associated with a small increase in short_term money market interest rates. The decision was taken to move toward a less accommodative stance in monetary policy in order to sustain and enhance the economic expansion. Chairman Greenspan decided to announce this action immediately so as to avoid any misunderstanding of the Committee's purposes, given the fact that this is the first firming of reserve market conditions by the committee since early 1989.

The use of the term "a less accommodative stance" was a red flag waved at congressional Democrats on the Senate and House banking committees, who have been worried for the past year that Greenspan would not accommodate the fiscal drag implied by this year's federal tax increases. If the economy weakens as a result, they fear they will pay for this tightening in the November elections. What else would Greenspan be "accommodating"?

Where do we go from here? Greenspan had the complete support of the Clinton Administration on Friday's move. Today's reports indicate the White House and Treasury were not only persuaded that the decision was timely, but they may even give him running room this year up to 4% fed funds. Would it do any good to take quarter-point bits up to that level, or would this only cause further confusion? The markets were really told Friday's move was a "preemptive strike" against future inflation. How many more preemptive strikes will be needed before the Greenspan Fed is satisfied? To be sure, the optimum time to "preempt" was last fall, when gold was moving up. Both Angell and Governor Larry Lindsey were dissenting even then. But is it now too late to make amends? Would it be too painful to get gold back to $350? Or will we have to accept the 1995-96 inflation implied by $380 or so?

The more relevant question is how does Greenspan regain the confidence of the bond market? As he clearly didn't succeed in the combination he put together last week, he'll have to try something else. I actually think he has moved the debate a long way in the direction in which he knows it must go. In a political sense, last week was very much a net plus. Greenspan should read the setback in the financial markets as an argument for being more aggressive in bringing the gold signal back to center stage. It's a much more pleasant alternative than trying to signal intent by ratcheting up short rates. If gold is identified as a primary target, the Fed then has to be prepared to ratchet up short rates when the market tests its resolve. That's why it's nice to have that particular price rule codified by law, so the Fed has no choice. When the speculators know the Fed has no choice, there is no reason to speculate. We are still quite a way from getting to that point, which would enable us to refinance the national debt at very lowest interest rates. But, we're closer than we were a week ago.