Volcker's October Deflation
Jude Wanniski
November 2, 1983

Executive Summary: For more than a year, the price of gold had remained above $400, usually in the vicinity of $425. In October, the price plunged below $400, ending the month 10 percent below $425 as Fed Chairman Paul Volcker renewed vigorous pleas for fiscal belt tightening and worries about inflation. Most of the indices of commodity prices have been falling since August, suggesting that renewed deflation is the problem and the Fed's current errors threaten completion of the recovery. Vice Chairman Preston Martin leans toward monetary ease. Volcker, at an October 26 dinner with the author, gives the impression that he appreciates the implications of falling gold and commodity prices for international banking and the Third World debt crisis, but worries about rising wages and consumer prices. Economic growth, not the IMF, can solve the problem, but the October deflation revives talk of an '84 recession instead. Not much chance of that, but a stalled recovery will hurt the GOP and weaken the mandate for Reagan's second term.

Volcker's October Deflation

On Wednesday evening, October 26, I had dinner with Paul Volcker in Washington. I'd had a brief visit two days earlier with the Fed's Vice Chairman, Preston Martin. While it would be improper to quote them directly, especially since the conversations were informal, frequently light-hearted, and thus subject to more than the usual amount of misinterpretation, my general impressions can be appropriately reported. As it is, these two very powerful men, whose utterances can rock the already turbulent financial markets, are generally guarded in their comments, revealing as little as possible that could cause difficulty if quoted out of context. General impressions may even be more useful than bits and pieces of conversation.

The brief session with Preston Martin provided a pleasant surprise. We talked at a cocktail party given.for him in Manhattan by co-hosts Lewis Lehrman and Walter Wriston, an odd couple if there ever was one, at least on monetary policy Lehrman a hard-money, fixed-exchange rate advocate, Wriston a fan of Milton Friedman and floating dollars. Martin made a few remarks to the gathering of about 50 bankers, brokers and big-hitters. The surprise was that he clearly aligned himself with the advocates of economic growth, leaned in the direction of monetary ease at the moment given the decline in sensitive commodity prices, including gold. And, he even sprinkled his remarks with a little gold dust, when discussing the Fed's "groping" toward a better monetary system. At the same time, he seemed careful not to undercut Chairman Paul or to leave much room for speculation that there is internal conflict. But with Volcker publicly waving the austerity banner lately, it was cheering to see Martin at least get a hand on the banner of growth.

I conveyed this impression to Volcker when we dined at the Four Seasons in Washington D.C. (Volcker, eyeing the menu and lofty prices, feigned a move to the door with a remark that he should quickly get back to the Fed and tighten up, insofar as he is following a price rule these days.)

The meeting with Volcker was not encouraging, but perhaps not as discouraging as his performance of the previous weeks. At least he endured my critique and analysis for two and a half hours, and one always hopes for marginal influences. In October, Volcker had testified before House and Senate committees, spoken to the Business Council in Hot Springs and the American Bankers Association in Honolulu. Everywhere there were unusually vigorous pleas for fiscal belt-tightening and worries about renewed inflation. In these public appearances he gave no sign of recognition that the financial markets are not worried about inflation at all. Rather, the markets are certainly aware of the deflationary implications of the decline in sensitive commodity prices, and Volcker's remarks about inflation are interpreted as a sign that he intends to squeeze even more.

At dinner, he seemed genuinely persuaded that Wall Street doesn't fear deflation at all, and that the decline in the price of gold below $400 has no especially important meaning at the moment because it is not, in his view, part of a general price decline. In fact, he insisted that commodity prices were higher as we spoke than they had been a month earlier. I thought him wrong, but there was no ready way to settle this point and the difference on this point of fact helped frustrate discussion on whether the Fed can or can't risk a period of monetary ease.

Volcker, though, was in error, at least as of the moment he spoke. The Dow Jones Commodity Futures Index had declined 5.4 percent in the previous month; the DJ Spot Index was down 4.1 percent. Both were also down in the month before that. He particularly cited the rising price of lumber, although the price of lumber has been tumbling with reports of weakness in housing starts. At least one index, though, showed an upward blip for a few weeks in October, and this could have influenced his thinking; the Commodity Research Bureau index of industrials has been flat since August, with ups and downs in between. The Economist's industrial index, somewhat similar but reflecting different weights, like the Dow has been falling since August. Whatever the reason for Volcker's error in recollecting information of price movements, he did show fresh interest in watching commodity futures and gold prices in the next several weeks and for any correlations in the financial markets. At least part of our discrepancy on price trends results from the fact that he focuses on the spot market instead of the futures.

This goes to the heart of the debate on monetary policy. I argued again that gold, the most monetary of all commodities, is the most sensitive indicator of incipient inflations or deflations. An index of spot commodity prices in any case is a poor guide to current monetary policy because it represents a collection of prices that embody past monetary policies. That is, the Fed's shift a year ago to an easier stance was first reflected by a rise in gold's price from the $325 to $425 level. The spot price of plywood took a much longer time to rise because plywood had to await the real economic activity that the stock market and bond market foresaw. For Volcker to look at spot markets and worry about inflation can only lead him to undermine the real economic activity that the Fed's previous easing produced.

This is why an index of future commodity prices will give Volcker more reliable information on whether the Fed at the moment is being "too tight" or "too easy." Generally the spot and futures markets move in tandem, but there are times when they do not, and at such times it seems obvious that the futures market is more heavily weighted with information on current monetary policy than is the spot market.

The gold price is the only commodity price where the spot market and futures market are virtually the same at all times. That is, the future gold price a year out is the spot price plus the interest foregone in holding gold. There may be some trivial impact on the gold price in the futures market because of speculations involving gold production or events in the jewelry market. But this is insignificant when compared to the differences in spot and futures prices in all other commodities.

Today's monetary policy at the Fed, for example, has a much smaller impact on the price of copper or soybeans or plywood a year out. The futures prices of these commodities are not simply the spot prices plus the interest foregone in holding them. Much heavier weights are given expectations about the weather, business cycles, and even the impact that tax and spending policies will have on the industries that make most use of these commodities.

That is to say: Even if Volcker saw the index of commodity futures prices rising (which he did not) and the price of gold falling, he errs by letting the index tell him more than gold about whether his monetary policy is currently inflationary or deflationary. If he wants market feedback about the Fed's policies, he should not expect it from signals that are clouded by the weather, business cycles or tax policies.

Volcker does not entirely appreciate these arguments. They are only one set of many that come to his attention. But he's not insensitive to them, either. He'd rather not have the price of gold fall below $400 and he'd rather not have it rise above $450. But now that the $400 level has been breached after more than a year at around $425, he's obviously under no great hurry to react. And when I complain about this, he deflects the criticism light-heartedly by insisting he thought he only had to keep gold in the "vicinity" of $400. But the markets can't be happy with a gold vicinity. If the Fed is willing to see gold at $390, it's probably willing to see it at $380, or $350, I said. The cost of this vicinity has already been high, in the financial markets, and the cost will be high in the real economy too, as the world economy is forced to adjust to this latest deflation.

If gold had been at $425 for a brief time, there would be fewer problems with this sudden decline of more than 10 percent. But for more than a year the U.S. economy has been reviving and expanding at the equilibrium level that $425 gold signals. The longer gold stays at the $370 or $380 level, the more Volcker will be forced to notice continued declines in the commodity futures and spot markets. But by that time, we'll all be worrying about recession again. We would expect a break in the price of oil, for example, with unpleasant implications for the Sun Belt, oil patch economies.

In pulling other prices in its train, gold exerts its heaviest pressure on U.S. taxpayers when it is falling. A 10 percent decline in the gold price raises the burden of federal debt by 10 percent, the equivalent of $100 billion these days. The Third World debt that Volcker and other central bankers anguish about, a debt of several hundred billions, also increases by 10 percent because it is denominated in dollars. Third World citizens are even less able to handle this extra burden than are U.S. taxpayers, which is why Volcker and the rest of the banking community are anxious to have U.S. taxpayers cough up another $8.4 billion to the International Monetary Fund.

The IMF replenishment legislation now before Congress, due for a critical vote in the House around Thanksgiving, is a key element in the policy process we have to watch. Volcker's lobbying activity on its behalf has been nothing short of feverish. But the big banks and the Eastern Establishment in general have been feverish, too, selling President Reagan and his administration on the fearful consequences of not bailing out the Third Worlders and big banks via the IMF.

The worst-case scenario is that if the IMF doesn't have the resources to patch together refinancing packages for the Brazils and Argentinas, these big debtor nations will default or even repudiate their debt, the Chase Manhattans and Citibanks will go bankrupt, there will be a run on the banks everywhere, and the Federal Deposit Insurance Corporation will go bankrupt. Holy Smokes!

The trouble with this worst-case scenario is that Volcker would be forced to bring the Fed in at some point, with no choice but to bail out the FDIC. The result: Inflation, first characterized by a rise in the price of gold, happily ending the deflation.

Rep. Jack Kemp of New York, the ranking Republican on the House subcommittee that oversees IMF appropriations, has irritated President Reagan and upset the White House in general because of his opposition to the IMF replenishment. The bill squeaked through the House last spring by only six votes, with a majority of Republicans following Kemp's lead in opposition. On final passage, the administration does not now have the votes.

Kemp has advised the White House and Treasury that he would now not only vote for the bill but also bring at least 25 Republicans with him from the "nay" column to the "yea" column. This 50-vote swing would guarantee the bill's passage. Kemp's condition is that the administration guarantee the dollar value of its international gold reserves at a price between $410 and $440. Treasury Secretary Donald Regan, who at least has the Kemp offer in his pocket, would be required to buy gold when the spot price hit $410 and sell it when it hit $440. Of course, he'd have to have the cooperation of Paul Volcker, who would have to get out of the vicinity of $375 gold and into a higher band.

Kemp's offer no doubt seems unreasonable around the White House. Most people probably don't see a connection. But the Kemp position is a perfectly sound one. The banks are in trouble because of the absence of a reliable monetary standard. By targeting monetary aggregates in 1979-80 instead of gold, Volcker and the Fed created bank reserves while gold's price doubled to $650 from $325. The banks lent with abandon at high interest rates, especially to Third World countries that could see profits in soaring commodity prices. The Fed's subsequent deflation trapped dollar debtors around the world. The IMF winds up in the role of "enforcer" for the international loan sharks.

What would happen if Kemp's offer were accepted? The current deflation would be ended, along with the threat of a deeper deflation that still hangs over the markets. At least the price of gold would have to come up by $35, and in cooperating with the move, Volcker would have to create bank reserves sufficiently accommodative to keep Donald Regan from having to buy up all the world's gold stocks.

In other words, as long as Regan must actually hand out dollars for gold at $410, adding to our hoard at Fort Knox, the deflation continues. Only when the Fed takes $410 as the signal to ease, adding to bank reserves, thereby pulling down the federal funds rate, will the deflation end. Back at around $425 gold, the relief at the big banks would be significant. The stock markets and bond markets would boom. Commodity futures would turn up, increasing the value to the banks of Third World debt. And the decline in interest rates would enable Brazil and Argentina to refinance painlessly.

We are now on the same path we were on during the summer of 1982, with the price of gold falling and pulling in its train the other sensitive commodity and industrial prices. Volcker kept the squeeze on until the threatened bankruptcy of Mexico forced him to end the deflation by creating bank reserves in the Mexican bailout. We're now being needlessly put through the same torture. As in the worst-case scenario, at some point the Fed will be forced to intervene and thereby end the crisis that it has been creating.

Successful passage of the IMF bill would not do much to alleviate the foreign-debt headaches. The $8.4 billion involved is a relatively tiny amount of money when set against the several hundred billions that continue to compound at double-digit interest rates. A 10 percent deflation increases the burden of Brazil's debt alone by more than $8 billion, which is why the debt negotiations seem to have been getting less and less promising in the last month, as the deflation has intensified. Debtor nations will get to the point where they just don't care, a point that is reached quicker in a deflation.

My impression is that Volcker makes all these connections, more or less, at least more so than anyone else in officialdom that I talk to these days. But there's so much confusion among orthodox economists about the nature of the problem that Volcker's not sure enough about anything to be more than a passive player right now. The safest place for the chief monetary authority is in the role of fiscal critic, harping at Congress to lower federal deficits by cutting spending or raising taxes. As long as the monetary aggregates are on target, he has enough orthodox opinion behind him to keep life from becoming miserable with criticism.

He also worries far more than he should about things he has no direct control over. The consumer price index, for example, is the worst possible guide to Fed policy, because it represents the cumulative errors made by the monetary authorities over a long period of time, years, with residual influences lasting decades. There is simply no way for Volcker to keep the CPI from rising for another several years, unless he is prepared to force cumulative deflationary errors on the economy so that he could average out some rising prices with some falling prices. The cost of this kind of victory over inflation would be exorbitant and really not possible; at some pain threshold the government would always be forced to intervene with inflationary bailouts of some sort. If he could be sure of several years of only four or five percent inflation in the CPI, at $400 or so gold, he wouldn't be concerned. It's the fear that bigger numbers would show up quickly that keeps him leaning with a deflationary bias.

Just when Republicans are feeling secure with the leading indicators and the economic recovery, even starting to count their political chickens in 1984, October's sudden whiff of deflation has revived talk of an '84 recession. Had Volcker been willing to experiment with monetary ease at the $400 gold level, as I'd hoped, there's no doubt in my mind that Wall Street would have applauded with enthusiasm. We could then have been talking of completing the recovery and prolonging an economic boom in 1984. But that chance is lost and it seems likely Volcker will not initiate change in the absence of political pressure.

It will have to come from the younger, less secure elements in the Republican Party, probably the younger House Republicans. These now worry that the White House will want to play a pat hand in 1984 with the cards dealt out so far, with the assumption that Reagan can win with what he's accomplished and that new plays are risky. Elsenhower's soporific 1956 re-election over Adlai Stevenson comes to mind. Reagan can surely beat Mondale & Co. in the same fashion, but there would be no clear mandate, no landslide, Democratic gains in the Senate, and four years of treading water inconclusively.

This, not a 1984 recession, is the riskiness of current economic policy. Monetary and fiscal policy would have to be much worse to halt the recovery and throw it into reverse continued deflation in November, for example. The President has been quick on the trigger in shooting down Senator Dole's tax balloons, and Volcker's monetary errors have thus far been minor. But the economic boom that Ronald Reagan should be enjoying in 1984 the kind that brings landslides to a President and his Party hasn't been prepared and isn't in sight.

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