In recent years, economists have hotly debated the potentially catastrophic consequences for the U.S. of a Japanese and Chinese retreat from the U.S. bond market. So in February, 2005, then-Federal Reserve Chairman Alan Greenspan surprised a lot of people when, addressing the U.S. Senate Finance Committee, he opined that the fallout from such an event would be minimal. "We've looked into that question and I think that we've concluded that the effect of foreign purchases of U.S. Treasury instruments has lowered long-term interest rates a modest amount. And therefore, if they were to choose to stop buying or to sell, it would raise interest rates, but again, by a modest amount," Greenspan said.
This view was a complete departure from the conventional wisdom that a foreign pullout from the U.S. bond market would send U.S. interest rates spiking skyward. (It's worth noting that current Fed Chairman Ben Bernanke shares Greenspan's view.)
How the View Came About
Last week, I had the opportunity to listen to a former Fed official who provided the background behind this change of view at the Fed. He explained that the change in thinking came about after Fed economists analyzed the impact of massive foreign-exchange intervention carried out by Japan between 2003 and March, 2004. The official noted that the Bank of Japan sold 30 trillion yen (equivalent to $285 billion) to keep the Japanese currency from appreciating and used the dollars it obtained to buy U.S. Treasury bonds.
If foreign government purchases of U.S. Treasuries did have a significant impact on U.S. interest rates, rates should have fallen when Japan started buying dollar bonds. Similarly, they should have risen when the purchases stopped. But in this case, the Bank of Japan's purchases had almost no impact on the U.S. Treasury market. This led the Fed to the view that the global bond market is now so deep and so liquid, that even interventions of this magnitude have negligible effect.
But the above event alone is insufficient to prove that a stoppage or reversal of foreign fund inflows would not have a major impact on the dollar or U.S. interest rates. The fact that Japanese government had to purchase 30 trillion yen worth of dollars in order to prevent the yen from appreciating means that the private sector was selling 30 trillion yen worth of dollars for yen during the same period. Had the Japanese government ignored this outflow from the dollar and into the yen, the result very likely would have been a steep fall in the dollar and a sharp rise in U.S. interest rates. In other words, it was only because Japanese authorities moved in a direction opposite to that of private capital flows that U.S. rates did not rise.
The Fiasco of Spring 1987
But the question remains what would happen if foreign central banks decide to shift assets out of the dollar and into other currencies on their own (as opposed to moving to neutralize the effects of private flows, as the Bank of Japan was doing in 2003-04). Based on the above, the obvious answer is that both the dollar and U.S. interest rates would be adversely affected if their dollar sales are not offset by aggressive dollar buying from the private sector.
If private investors discovered that financial authorities in Japan and China were bailing out of the dollar, they would probably rush to dump their own dollar holdings as well. After all, private-sector investors well know that it is Japan's and China's central banks that have propped up the dollar in spite of the fact that the U.S. has been running such a large current account deficit. The likely end result of a Japanese and Chinese retreat, therefore, would be skyrocketing U.S. interest rates.
Japanese investors actually rushed out of the dollar once before, in late March, 1987, four months before Alan Greenspan was appointed Fed chairman. At that time, the dollar abruptly fell below the psychologically important 150-yen level for the first time. Japanese investors, who had been assured by the Louvre Accord only a month earlier that the dollar would not fall below 150 yen, panicked and pulled out of the U.S. market. As a result, the yield on benchmark 30-year U.S. Treasuries surged 150 basis points in just six weeks.
This spike in U.S. rates coincided with a plunge in the dollar from 150 yen to 137 yen, offering clear evidence that a move by foreign investors to shun the dollar can have a substantial impact on long-term interest rates in the U.S.
Lessons Erased from Memory
Then-Fed Chairman Paul Volcker quickly seized on the gravity of the situation and worked frantically with the U.S. Treasury and Japanese counterparts to stem the dollar's decline. Ultimately, the effort succeeded, and the dollar once again climbed toward the 150-yen mark, while the benchmark long-term yield slipped from 9% to 8%. At the time I was in daily telephone contact with the forex desk of the New York Fed, my previous employer. And I know from firsthand experience that U.S. authorities were fully aware of the importance of Japanese investors in the U.S. market and were desperately collecting information about their behavior.
Twenty years have passed since this incident. And when the subject came up in a conversation during a visit to Washington last year, none of the U.S. officials I spoke with remembered it. In other words, the lessons it taught us have been completely wiped from U.S. institutional memory.
Many people are of the opinion that something that hasn't happened for 20 years is unlikely to happen again. Still, the U.S. current account deficit as a percentage of gross domestic product is already nearly twice what it was in 1987, while Japan's current account surplus has reached levels comparable to those of 1987.
These two factors could contribute to dollar selling and yen strength, respectively. While another March, 1987-style collapse in the dollar may not happen anytime soon, the fact that countries are beginning to worry about inflation and mini-bubbles is indeed reminiscent of conditions in 1987 and we need to tread carefully.