Volcker’s policy success

Source: The Privateer

When the US Fed under Paul Volcker stopped “targeting interest rates” in late 1979, they stopped trying to hold US interest rates below levels set by the markets. The result, of course, was that US interest rates SOARED. They soared because there was now no impediment which prevented them from reflecting both the risk of a depreciating currency and the risk of the debtor reneging in part or in whole on the debt. Until late in 1980, these risks were also reflected in the $US “price” of Gold which soared to $US 850 in January of that year and had a secondary rally to $US 720 in September. But while all this was happening, the US Dollar had stopped falling in the international currency markets simply because high US interest rates were compensating US Dollar and $US-denominated debt paper holders for their risk.

At the time when this was happening, US Treasury funded debts were hovering just below the $US 1 TRILLION level. Interest payments could still be met, albeit with some difficulty. But as these high interest rates persisted, the global attitude towards the US Dollar changed profoundly. All of a sudden, it was possible to earn a very good rate of return on US Dollar investments. Even better, US Treasury debt paper was selling at rock bottom prices on the secondary markets and had been falling for a decade. With the Dollar now stabilised and indeed starting to go up on the currency markets, everyone knew that US rates would start heading down at some point and when they did, the prices of Treasury paper on the secondary markets would soar. The world was enticed back into US paper with a rush, starting in 1982.

On the surface, this looks like the “classic” means by which a chronic balance of payments deficit is resolved. But it was not. There was still no “final means of payment”. The entire financial world still relied totally on the “full faith and credit” of the US Government.

Of course, ending interest rate targeting allowed for the explosion of bond markets in the US; which came back to bite us later.

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