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May
xt
1978
Money Stocksand ExchangeRates
I
Strong cross currents have developed
in recent economic data. On the one
hand, the U.s. inflation problem has
worsened, with the consumer index
rising at a 9.3-percent annual rate in
the first quarter of the year - almost
twice the rate recorded during the
second half of last year. On the other
hand, both the stock market and
the foreign-exchange market
strengthened considerably during
April, with U.s. stock averages rising
about 8 percent and the dollardeutschemark exchange rate rising
about 21/2percent. These apparent
contradictions may perhaps be reconciled, however, within the context of
a monetary theory of exchange rates.
According to this theory, a sustained
and systematic acceleration of money
growth leads over time to a rise
in inflation expectations. The theory
may be illustrated with reference
to the activities of the three major trading nations - the U.S., West Germany
and Japan. Over the last three years,
the u.s. concentrated on curbing its
serious unemployment problem, while
Germany and Japan concentrated on
anti-inflation measures. These
contrasting policy actions could be
seen in an acceleration of money
growth in this country and a deceleration of money growth in Germany and
Japan.
Money and prices
Between the third quarter of 1976 and
the third quarter of 1977, for example,
the year-over-year growth of the M2
money supply increased from 9 to 11
percent in the U.s., but decreased
from 11 to 9 percent in Germany and
from 15 to 11 percent in Japan. Over
that same time-span, the year-overyear increase in wholesale prices increased from 4 to 6 percent in the U.s.,
but decreased from 7 to a minus 1
percent in Germany and from 7 to 1
percent in Japan. Consequently, inflation expectations tended to rise in the
U.s. but to decline in Germany and
Japan.
International investors wishing to pre- ,
serve the real value of their portfolios
responded to this widening jnflationexpectations gap by shifting their
assets out of dollars and into
deutschemarks and' yen. Their actions
consequently reduced the value of
U.s. securities, as they sold off some of
their dollar-denominated assets. ThE;ir
actions also tended to depreciate the
dollar relative to the D. M. and yen, as
these dollar assetswere converted into
D. M. assets and yen assets. And again,
their actions tended to raise the value
of German and Japanese securities
due to increased demand.
These expectations-fed portfolio
shifts could lead to movements in the
dollar's exchange value which would
be disproportionate to actual differences.in inflation rates. This would
happen whenever investors expected
the inflation gap to widen over the period in which they were planning to
hold their securities. Thus, they would
sell dollars not only on the basis of the
current inflation rate, but also on the
basis of the expected inflation rate
(continued on page 2)
1k\CD)If
Opinions expressed in this newsletter do not
necessarily reflect the views of the management oJ the
Reserve Ba.nk of San Francisco, nor of the Board
Reser\/e S)/sterfl.
of Governors of the
over the next several years. This
would make the dollar undervalued in
terms of current purchasing power
against the D. M. and yen, but not undervalued in terms of expectedpurchasing power in future periods.
The monetary analysis would attach
only secondary importance to real factors in the determination of exchange
rates. For example, massive oil imports
would affect the international value of
the dollar, only to the extent that the
oil-exporting countries stopped investing in dollar assets because of an
upward revision in their inflation expectations regarding the dollar. Again,
rising non-oil trade deficits would tend
to be a result rather than a cause of
dollar weakness; a faster growth of
U.s.imports over exports would re-,
flect a relatively more stimulative U.s.
policy, and hence a relatively faster
rate of growth of income and output
in this country.
Shift in policy?
At this stage, we may be witnessing a
shift in policy, and thus a shift in policy
in the three major trading countries. The Germans and the
Japanese have effectively achieved
their goals of eliminating domestic inflation. In late 1977 and early 1978, as
noted above, both countries recorded slight declines in wholesale prices in
relation to year-ago levels. Meanwhile, the U.s.has effectively achieved
its goal of full employment. Over a
2
strong three-year-Iong business expansion, the U.s.has created almost 10
million new jobs - about as many as in
the eight preceding years put together. The number of jobless now account for about 6 percent of the labor
force, but this apparently reflects effective full employment, given a
changing labor-force structure and
other factors which tend to boost the
reported jobless figures.
We might thus expect the Germans
and Japanese to begin more stimulativepolicies, and the U.s.to focus
more on, its inflation problem. In the
Japanese case, there is little evidence
of such a shift, but the U.s.and German data suggest that we may be witnessing policy shifts in those two
'countries. u.s.M2 growth, on a yearover-year basis, has decelerated from
11 to 8 percent over the past two
quarters. In'contrast, German M2
growth reached a low point of 8
percent in the second quarter of 1977,
but then rose to 10 percent in the first
quarter of this year.
These developments, if continued,
could eventually cause a narrowing of
the inflation-rate gap between the
two countries. To the extent that investors forecast future inflation on the
basis of current money growth, inflation expectationsmay already have
been affected. Such a shift in expectations, by inducing a shift in desired
portfolios away from D. M. assets and
toward dollar assets, could help ac-
CClTangc
Rate
840
count for the recent Wall Street rally
and the concurrent turnaround in the
foreign-exchange market.
.
During April, the German stock-market index fell from 800 to 769, while
the U.s. (Dow Jones) index rose from
769 to 837. At the same time, the dollar
rose about 2 V2percent relative to the
D. M., from 2.019 to 2.073 D. M. (see
chart). These movements stood out
strikingly in contrast to the trends of
the December-March period. In that
earlier period, investors reduced their
demand for U.s. assets, depressing
the U.s. stock market; they then converted their proceeds into D. M., depressing the dollar-D. M. exchange
rate; and then they purchased German stocks, leading to a small rise in
those stock values.
Japanese statistics would show somewhat similar results. The latest data
show no change in a relatively restrictive monetary policy, and hence no
shift in inflation expectations. International investors thus have exhibited no
desire to shift their portfolios out of
yen. As a result, the Japanese stock
market has continued to rise over the
past four months - although at a decelerated pace - and the exchange
rate has stabilized at around ¥225 per
dollar in April after falling in previous
months.
U.S.policy and inflation
Why did the dollar-D. M. portfolio
shift occur in April and not at some oth-
3
'2.20
er
Perhaps because investors
perceived a shift in economic priorities
on the part of the U.s. Administration.
Previously, the reduction of unemployment had appeared to be the major
target of policy, but the fight against inflation took center stage during April,
as reflected in the strong statements
made by both President Carter and
Federal Reserve Chairman Miller. This
development, along with the observed deceleration in money growth,
could convince investors of the reality
of the policy turnaround, and thus lead
them to expect future developments
along the same line.
None of this lessensthe severity of this
country's current inflation problem.
The monetary data suggest, however,
that the U.s. inflation will not worsen in
1979, and that the gap between U.s.
and German inflation rates will then begin to narrow. The crucial point is that,
given the increased sensitivity of market participants to inflation - both actual and expected - monetary policy is
likely- to become more influential than
ever before. Investors throughout the
world now appear to base their inflation forecasts not only on actual inflation, but also on observed moneysupply trends. In the present context,
this suggests that if the major trading
nations continue with their present
policies, conditions will be set for an
improved U.s. inflation performance
and for a permanent recovery in the
value of the dollar.
Michael Keran
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BANKINGOATA-TWElfTH fEDERALRESERVE
DISTRICT
(Dollar amountsin millions)
Selected Assets and Liabilities
large Commercial Banks
Amount
Outstanding
Change
from
Changefrom
year ago
Dollar
Percent
5/3/78
4126178
Loans(gross,adjusted)and investments*
Loans(gross,adjusted)- total
Securityloans
Commercialand industrial
Realestate
Consumerinstalment
U.s.Treasurysecurities
Other securities
Deposits(lesscashitems)- total*
Demand deposits(adjusted)
U.s.Government deposits
Time deposits- total*
Statesand political subdivisions
Savingsdeposits
Other time depositst
LargenegotiableCD's
110,779
88,036
1,999
27,165
29,410
15,547
8,335
14,408
106,538
28,643
725
75,419
7,251
31,475
34,003
15,762
+
+
+
+
Weekly Averages
of Daily Figures
Week ended
Week ended
5/3178
4/26/78
+
+
+
+
+
+
-
+
+
892
667
102
171
177
61
313
88
71
1,019
257
910
158
4
738
751
+ 14,950
+ 14,334 .
249
+
+ 3,315 .
+ 6,336
+ 2,921
433
+ 1,049
+ 12,723
+ 2,504
170
+
+ 9,987
+ 1,600
- 631
+ 8,123
+ 6,746
15.60
19.45
+ 14.23
+ . 13.90
+ 27.46
+ 23.13
- 4.94
+ 7.85
+ 13.56
+ 9.58
+ 30.63
+ 15.26
+ 28.31
- 1.97
+ 31.39
+ 74.82
+
+
Comparable
year-agoperiod
Member Bank Reserve Position
ExcessReserves(+)/Deficiency(-)
Borrowings
Net free(+)/Net borrowed (-)
+
22
66
44
58
51
109
+
+
19
3
16
Federal Funds-Seven Large Banks
InterbankFederalfund transactions
Net purchases(+)/Net sales(-)
Transactionswith u.s.security dealers
Net loans(+)/Net borrowings (-)
+
1,695
+
1,532
63
+
76
248
+
214
*Indudes items not shown separately.tlndividuals, partnershipsand corporations.
Editorial comments may be addressed to the editor (William Burke) or to the author ..•.
Information on this and other publications can be obtained by calling or writing the Public Information
Section, Federal Reserve Bank of SanFrancisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184.
@FedFRASER