May 21, 2004


Monetary Anchors Aweigh!
In the spring along the shores of Lake Michigan, this old man's fancy turns to sailing. To a sailor, the term "anchors aweigh" means that the anchors have been raised and the boat's movements are no longer constrained. The anchors to the global monetary system were weighed on August 15, 1971, when President Nixon closed the so-called gold window, which thereafter forbade foreign central banks from exchanging their U.S. dollar claims for gold. Prior to August 15, 1971, the U.S. dollar, then was directly anchored to gold; the currencies of other central banks were indirectly anchored to gold by virtue of their agreed upon fixed exchange rates to the U.S. dollar. From 1952:Q1 through 1971:Q2, the total financial assets of the Federal Reserve, in effect, the amount of credit created out of "thin air" by the Fed, grew at a compound annual rate of 2.81%. But starting around 1964, the golden anchor on monetary policy started to "drag." That is, growth in total Fed assets accelerated. Between 1952:Q1 and 1963:Q4, Fed total assets grew at an annualized rate of 1.00%. From 1964:Q1 through 1971:Q2, Fed total assets grew at an annualized rate of 6.09%. The monetary system anchor was no longer holding. Foreign central banks, who were being forced to import U.S. inflation because of fixed exchange rates, tried to "reset" the anchor by demanding gold from the U.S. in exchange for the dollar claims that were building up on their books. Faced with the prospects of paying out gold and restricting Federal Reserve created credit, which would have impeded federal government profligacy, the Nixon administration gave the command to weigh the golden anchors on the global monetary system on August 15, 1971. From 1971:Q3 through 2003:Q4, the total financial assets of the Fed grew at a compound annual rate of 7.02%.

Not surprisingly, inflation was well anchored when monetary policy was too. From 1952:Q1 through 1963:Q4, the U.S. CPI grew at a compound annual rate of only 1.32%. By the way, I do not recall William McChesney Martin, the Fed chairman at that time, sounding the deflation alarm. As the federal government engaged in its guns-and-butter policies of the mid 1960s, a time when the monetary policy anchor began to drag, inflation picked up. Beginning in 1964:Q1 through 1971:Q2, the CPI grew at a compound annual rate of 3.45%. For the entire period, 1952:Q1 through 1971:Q2, the CPI grew at a compound annual rate of 2.21%. Between 1971:Q3, after the golden anchor of monetary policy had been officially weighed, through 2004:Q1, the CPI grew at a compound annual rate of 3.18%. Had not Paul Volcker, Fed chairman between August 1979 and August 1987, deployed a huge "sea anchor," inflation in this period after the golden anchor had been weighed would likely have been considerably higher.

So, after there was no anchor to the monetary system, actual inflation drifted higher. It would not strain credulity to posit that inflation expectations did too. This may explain why the spread between the 10-year Treasury yield and the fed funds rate has drifted wider since the golden anchor was weighed. As shown in the chart below, the median of this spread was 71-1/2 basis points between August 1954 and July 1971. The maximum that this spread reached during this anchored era was 275 basis points. During the period from August 1971 through April 2004, the median of this spread increased to 125 basis points, with a maximum of 385 basis points. As this is being written, the spread is 376 basis points.

So, after there was no anchor to the monetary system, actual inflation drifted higher. It would not strain credulity to posit that inflation expectations did too. This may explain why the spread between the 10-year Treasury yield and the fed funds rate has drifted wider since the golden anchor was weighed. As shown in the chart below, the median of this spread was 71-1/2 basis points between August 1954 and July 1971. The maximum that this spread reached during this anchored era was 275 basis points. During the period from August 1971 through April 2004, the median of this spread increased to 125 basis points, with a maximum of 385 basis points. As this is being written, the spread is 376 basis points.

The winds of inflation are picking up again. We no longer have a permanent anchor that we can depend on to hold us off the shoals. Instead we must depend on the good judgment of Skipper Al to deploy sea anchors of various sizes to save us from disaster. The "passengers" appear to be getting a little nervous, as evidenced by the widening in spread between the Treasury 10-year yield and the fed funds rate by over 100 basis points since March 16. Inflation expectations, as measured by the spread between the nominal yield on a Treasury 10-year security and the real, or inflation-protected, yield on a 10-year Treasury has widened by 43 basis points between March 16 and today.

Today, our federal government is spending like a drunken sailor. If there were some permanent and nondiscretionary anchor on monetary policy, there would be some discipline on government spending. Inflation expectations would be lower. Before he became the Fed skipper, Alan Greenspan used to believe in the anchor of gold. Now he believes it would cramp his style. My advice is to put on your safety harness. It is going to be a wild ride for the next 12 months. My bet is that we will end up on the rocks before Greenspan's replacement takes over the helm. And it is my bet that Greenspan's official watch will not be extended after January 31, 2006, dashing his dreams of being at the wheel longer than any other Fed captain to date.


Paul L. Kasriel, Director of Economic Research (plk1@ntrs.com)

The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.