Deflation Cure Sickens Dollar
James Grant, 05.12.03, 12:00 AM ET
>>America's own Seinos are pleased that the Fed stands ready to sit on the Treasury yield curve. However, they can't be as pleased as the world's gold bulls, of which I am one. By vowing to meet deflation with inflation, the Fed is only doing what it has mainly done since its inception.<<
The Federal Reserve is acting as if the U.S. were facing Japan-style deflation. With the CPI up 3%, the real problem is in the other direction.
Now hear Goichi Seino: "Bonds are the only option." The bonds in question are Japanese governments, and their yield to a ten-year maturity is all of 0.7%. Seino is a professional investor, employed by Yasuda Capital Management Co. in Tokyo. What's wrong with him?
A better question is: What is wrong with all of us? Government bond yields are low the world over. In Japan they have never been lower. Yet Seino is bullish on bonds. Many are.
Seino is a type. He, like many, is bearish on the Japanese economy, bearish on the Japanese stock market and bearish on the ability of the Bank of Japan to engineer rising prices. He believes that prices will fall--the value of money will appreciate--and that the government is powerless to stop it.
There are Seinos in other countries, too. Taxed with the fact that U.S. Treasurys, at prevailing low yields, offer little potential for gain and much for loss, Americans point to the Japanese experience. One year ago the Japanese ten-year yielded 1.4%. It seemed low, but it went lower. They can't imagine that yields will go back up, either in Japan or the U.S.
If Seino is guilty of building a forecast on an extrapolation, he is only doing what others do. Theorists say that markets discount the future, but what people know is the past. For a bond bull, that knowledge is sweet. The arithmetic is as you remember it: As bond yields fall, bond prices rise. In Japan the yield doesn't have very much further to fall.
If it were to be sawed in half, to 0.35%, the price of the bond would rally from a little over par to 1031/2. And if the yield were halved again, to 0.17%, the price would rise to the heights of 1051/4.
Seino knows how meager are the possible capital gains. But because Japanese prices are broadly falling, the purchasing power of the yen is rising. If the Japanese price level fell by 2%, the bondholder would be 2% better off. If, in addition, interest rates fell, there would be a small capital gain. And, come what may, there would be that rich and dependable stream of coupon income: 70 whole basis points a year.
To Alan Greenspan, Seino is the personification of trouble. He is the kind of person who doesn't consume (he's waiting for lower prices), doesn't invest (except in government bonds) and doesn't respond to the stimulus of conventional monetary policy.
In the U.S., where the Consumer Price Index is 3% higher than it was a year ago, there is no deflation. But there are plenty of deflationary symptoms, and the Federal Reserve Board is worried about a visitation of the real thing. It has cut the funds rate a dozen times since January 2001, yet the economy and the market still run hot and cold. It has only 125 basis points left to cut. What would it do if, at 0%, Wall Street still had the dwindles?
Greenspan has been telling us what he would do. For months his deputies and he have vowed to whip deflation, even before it materializes. They have described the dollar--their dollar and ours--as a piece of paper of no intrinsic value that can be produced "at essentially no cost." They have pledged that, if need be, they will push down not only the funds rate but also longer-dated Treasury yields. In so many words, they have threatened to manipulate the length and breadth of the Treasury yield curve.
What would this mean in practice? Lower government yields and more credit creation to start with. By pegging the ten-year note at, say, 2.5%, the Fed would have to buy all securities offered at 2.5% or higher. The Fed, of course, is no ordinary acquirer. It creates the dollars it spends. For all intents and purposes, it waves a magic wand.
"Such actions have precedent," Greenspan told a New York audience in December, referring to the 2.5% cap imposed by the Fed on long-dated Treasurys between 1942 and 1951. What he did not explain is how that wartime expedient would work in today's world of free international capital flows and a chronic U.S. payments deficit. Nor did he speculate on how such a radical shift in monetary policy would sit with foreign dollar holders.
America's own Seinos are pleased that the Fed stands ready to sit on the Treasury yield curve. However, they can't be as pleased as the world's gold bulls, of which I am one. By vowing to meet deflation with inflation, the Fed is only doing what it has mainly done since its inception.
Precious-metals funds, including First Eagle Gold Fund and Tocqueville Gold Fund, would provide protection in case the Fed waved its wand a little too hard.
James Grant is the editor of Grant's Interest Rate Observer. Visit his homepage at www.forbes.com/grant.
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