Greenspan Surprise: No Solution Jude Wanniski October 16, 1998

The Fed’s oddly-timed quarter-point reduction in the funds rate to 5% and the news that eight of the twelve Fed districts had petitioned for a cut in the discount rate was justifiably welcomed by Wall Street. As long as the Fed continues to target the real economy, it might as well get the interest-rate target right, and a 5% overnight rate is a more reasonable target when the 30-year bond is essentially at that rate. As we suspected, though, the market was given no reason to believe the Fed is interested in raising commodity prices to end the monetary deflation which is the source of the global financial turbulence. The rate cut will increase demand for liquidity and the Fed will supply only that amount, which will do nothing to lift commodity prices. We were only slightly encouraged by the Fed’s stated reason for the cut. Despite its Keynesian coloration and concern for weakening aggregate demand, it expressed some financial anxieties about increased risks to lenders. This invited speculation that Greenspan sees something really ugly that no one else sees, unless he can keep the stock market jacked up with “easy money.” It more likely reflects Greenspan’s general doubts about his policy tract, but until he squarely faces up to the commodity deflation, it will continue to hound the financial markets and the world economy.

Note that Mexico’s Bolsa did not join in the general euphoria. Brazil’s Bovespa, which ran up 6.7% on the Fed rate cut, has begun to have second thoughts today, especially after investors read the page one leader in the WSJournal, which seems to suggest a devaluation of the real is on the way despite Brazil’s insistence it will maintain its dollar peg. With no relief for commodity producers unless Greenspan tells the markets his aim is to increase commodity prices, Mexico and Brazil will remain under pressure and so will the U.S. economy. Brazil has become vulnerable because its government is making the same mistake Greenspan makes, in confusing high interest rates with tight money. The overnight rate in Brazil at 50% in defense of the real is causing more problems than the dollar commodity deflation. To halt the outflow of reserves, the central bank should simply ignore the overnight rate and sell real-dominated assets to make the currency scarce, an option never even mentioned in the WSJ assessment. International currency speculators have spotted this intellectual weakness in Sao Paolo and are exploiting it in the same way they dynamited the Mexican peso four years ago.

Greenspan has to be pushed to a commodity target, but there is simply no pressure on him to do so. The Fed Chairman respects the WSJ editorial opinion, but editor Robert L. Bartley seems satisfied with gold at $300, even though the deflation it has caused is responsible for the GOP Congress caving in to demands for another $18 billion for the IMF and several billion more in farm subsidies. When capitalism fails, people turn to socialism. Yes, Jack Kemp continues to potshot the Fed and urge gold targeting at $325, but he’s not going to get any attention unless he decides to make a serious presidential run -- a decision he says he will not make until after the November 3 elections. Unless there is something scary coming down the road that Greenspan knows about and realizes can’t be fixed unless he changes targets -- as Paul Volcker did in 1982 -- we might as well settle back and wait for the elections too.