Playing Chicken with Currencies

A catch-up game in which all sides could be losers

Volck' er i za' tion, n. 1: a process of money management whereby interest rates are kept high at a time of deepening recession; 2: a reliance on tight monetary policy in order to protect the value of the dollar abroad and quell inflation at home.

That wry description of the policy of the Federal Reserve Board's new chairman is already making the rounds in Washington. Though he has headed the U.S.'s central bank for a little more than seven weeks, tall, taciturn Paul A. Volcker has lost no time in establishing himself as a staunch inflation fighter, dollar defender and hard-liner on interest rates. Since he took charge on Aug. 6, the key rates used to manipulate credit policy have shot up dramatically. The Fed last week raised the discount rate, which is the interest it charges on money that it lends to member banks, by a half-point, to 11%, a record high. Several major banks then boosted their prime rate by a quarter-point, to 13 1/4%, also a record. That was the sixth jump in the prime since the end of July, when it stood at 11 3/4%.

One anomaly, however, is the fact that despite the heights that interest rates have reached, there has been no shortage of cash for borrowers. Indeed, the money supply grew at a fast annual rate of close to 13% in the past two months. Though Volcker feels that the growth should be curbed, the spread of such financial innovations as credit cards and savings certificates tied to Treasury bill rates have lessened the Fed's ability to control the nation's money stock.

The Fed's latest discount rate increase prompted a rare rebellion among its seven governors. Three of them opposed the move, saying it would seriously worsen the slowdown in the economy. There are signs that the recession will be deeper and longer than was predicted only three months ago. So some economists dispute Volcker's assertion that "what basically is good for the dollar is good for the economy at home." They are fearful that in his zeal to raise interest rates to buttress the buck abroad, he will worsen the Interest rates have been rising through the industrialized world since July, as governments try to curb inflation. But the U.S. has been playing catch-up with European and Japanese rates. At present, U.S. interest levels are no higher than existing U.S. inflation rates; thus there is scant reason for money traders to buy dollar-denominated short-term securities, since they earn nothing. Other currencies are a better buy. For example, even though the West German prime rate of 7.75% is more than five percentage points lower than the U.S. prime, West German inflation is about one-third that of the U.S., so traders sell dollars to buy marks and other currencies where they can earn a real return. This weakens the dollar. But if the Fed were to push U.S. interest rates another one-half of 1%, to 1% above the rate of inflation, it might lure some money back into greenbacks.

House Banking Committee Chairman Henry Reuss charges that the U.S. is being "forced into supertight monetary excesses" by its trading partners. The force cited most is the West German Bundesbank, which tends to steer European monetary policy. Last week Volcker and Treasury Secretary G. William Miller returned emptyhanded from a Paris meeting of finance ministers and central bankers from Britain, the U.S., West Germany, France and Japan. The Americans tried but failed to persuade the others to slow down an international "chicken game," in which countries seem almost to dare each other to imperil their own economies by raising their interest rates to protect their currencies.

The others at the meeting said that higher interest is needed to combat an inflation rate averaging 11.8% among 24 non-Communist industrialized nations.

But Reuss and some U.S. economists fear that the Bundesbank has been raising West German interest to keep the mark strong against the dollar. Reason: the mark's appreciation lowers Germany's oil bill, which must be paid in dollars. The Europeans and the Japanese all depend heavily on imports; these would become more expensive, and inflation would worsen, if the value of their currencies were to drop. For somewhat the same reasons, the U.S. wants a stronger dollar.

Interest rates abroad probably will continue to rise for a time because inflation will worsen when the industrialized nations feel the full impact of this year's oil price increases, the effects of excessive money-supply growth in the U.S., West Germany, Britain, Japan and Italy, and the results of a round of wage settlements coming this fall and winter. For the U.S. this could mean further dollar deterioration. But "keeping up with the monetary Joneses," as Henry Reuss puts it, and letting domestic interest rates rise might turn a soft landing into a sharp decline.

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