Dollar and Yen Monetary Follies Jude Wanniski and David Gitlitz October 12, 1998

The two most important monetary authorities in the world, the U.S. Federal Reserve and the Bank of Japan, continue to impose enormous costs on the world financial system because of their stubborn belief that lower interest rates represent "easy money." The Japanese central bank last month had lowered its overnight interest rate to 0.25% from 0.5% in one more attempt to encourage lending and borrowing in order to pull its economy out of a recession caused by its own deflation and that of the Federal Reserve. In what must be the ultimate example of this folly, the BoJ last week sent convulsions through world markets by shutting off liquidity to its banking system in order to hit its new 0.25% target as it edged closer to zero. The abrupt curtailment after the bank had been supplying a surplus reserve cushion ranging from ¥800 billion to ¥1.2 trillion per day sent the yen into a steep climb against the dollar, to ¥117 from ¥135 a week earlier, slaughtering players short the yen and wounding players long the U.S. Treasury 30-year bond, where the yield leaped above 5.1%. If there were any doubt the exchange rate swing was caused by Japan, the yen gold price tumbled 14%, to ¥35000/oz. from ¥41000 (when it should be closer to ¥45000), even as the dollar appreciated to $297 gold from $300.

As usual, neither the financial press nor U.S. Treasury experts can deal with the most elementary use of gold or atry commodity price as a means of judging the source of the forex spasm. In other words, the yen price tumbled on the tea, sugar, zinc and international potato-chip market, not because the Japanese people suddenly decided to stop buying tea, sugar, zinc and potato chips, but because Japan's central bank was starving the markets of yen liquidity. It is the repeat of the process we observed in the spring of 1995 when the yen gold price was pulled to a low of ¥32000/oz. in an earlier episode of manic monetary deflation, the BoJ being led by the arcana of its operating procedures. In this case, the bank last Wednesday night cut the flow to ¥300 billion from its much higher average in previous sessions — and when the overnight rate remained stuck below target at 0.2%, the technicians completely shut off the surplus flow. Not a word about this in Barron's or today's WSJournal.

What happened next? The high rollers in New York who had seen a surefire bet, borrowing yen at teeny interest rates and buying U.S. Treasury bonds at high rates, felt the earth open up under their feet. They not only had to buy yen in a drumtight market, but had to liquidate their Treasury positions to do so. They essentially had been unwinding their positions in orderly fashion since late August, when the government had begun to complain about the yen's "excessive weakness" against the dollar — the exchange rate then being above ¥140. The bravest of the players stayed in as long as they could eke out a daily profit. Panic set in last week when they saw the BoJ closing off new liquidity. In four hours, the dollar went to ¥125 from more than ¥130, running down to ¥120 when the trading passed from Tokyo to New York and London. Reflecting the intellectual vacuum at Treasury, President Clinton hailed the yen strength as a boon to U.S. exports. To Japan? Is a basket case going to buy our exports?

Now what? The New York Times Sunday urged monetary ease "until low commodity prices begin to move up decisively." Hurray for the Times!! When will the lightbulb go on in Alan Greenspan's head. Neither the Fed nor the BoJ can end the monetary deflation without adding surplus reserves to drive $gold above $325 and ¥gold above ¥44000. At those targets, the dollar would be at ¥135. Even with no lightbulb at the Fed, we should at least expect the yen/gold price to creep toward ¥40000 and the dollar/yen rate to 130, as the deflation is murder on Japanese banks at this level. We also think the Treasury long bond should recoup a bit. But without leadership in the world anywhere it counts, our best guess is for more volatility.