Economic Outlook: the Bond Market

The M1 obsession.
By Jonathan Rowe
May/June 1984
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Economics is, above all else, a puzzling study . . . as evidenced by the fact that men and women who number among the world's acknowledged "experts" in this subject can be counted on to hold contradictory positions at any given time. For that reason, it's good to go "back to basics" occasionally, and take a look at the forces that influence our economy. In that spirit, MOTHER EARTH NEWS is pleased to be able to present this excerpt from "The Cult of M1" by Jonathan Rowe, adapted with permission from The Washington Monthly (November, 1983). 

We can't understand the monetary dances of the last few years without going back to where we started: the network of banks and investment houses that buy and sell government—and to a lesser extent, corporate—bonds.

The bond market is not a place, like the stock exchange. Rather, it's a telephonic clique. At the hub are 40 or so firms, ranging from the biggest New York banks to those mysterious investment houses like Salomon Brothers which seem to produce Republican economic advisers the way Darien produces debs. Through a gentlemanly process that is more like a club initiation than the granting of a license, the Federal Reserve selects these firms as the exclusive conduits for the “Open Market Operations” by which it buys and sells government bonds and tries to control the amount of spending money in the economy. Buy or sell, there is generally a profit for the bond house; and since all bond trading averages $50 billion a day, the profits can be substantial.

Two points will help us understand the psyche of this strange market. First, bondholders regard inflation the way a movie-magazine heartthrob regards age: It's a wipeout. Bonds yield a fixed return, which inflation only diminishes. Hence, given a choice between growth, which can mean inflation, and stagnation, which (to a bondholder, at least) is less risky, the bondholder will generally choose the latter. Second, and equally important, bond traders make money, not by clipping coupons, but by making trades. They are thus inclined to seize upon news that will make other bondholders feel dissettled, and just about anything will do. Merely by worrying aloud—in a speech in South Africa, no less—about the possibility of strong economic activity (good is bad, remember?) dour bond oracle Henry Kaufman of Salomon Brothers can almost single-handedly send the market downward, as he did back in August. But when it comes to jitter potential, nobody holds a candle to Federal Reserve Board Chairman Paul Volcker. The biggest game in the bond market has been what they call there “playing the M's.”

Paul Volcker's conversion to monetarism may have been of dubious benefit to the country, but in the bond houses on Wall Street it was an utter boon. The weekly M1 figure became the key to the mysteries, and hence a source of continual worry, a 24-hour roulette wheel at which the action never stops. [EDITOR'S NOTE: Put simply, M1 refers to the “spending money” active in the economy.] Last August 19, for example, bond prices rose almost two points after the Fed disclosed what appeared to be a $500 million drop in M1. On July 27, the Fed had reported that M1 had grown by $1.2 billion, moving banks to raise the prime rate by half a percent.

It used to be that the stock and bond markets were like the opposite ends of a seesaw, but now the stock dealers are worrying as much about the money numbers as are their counterparts in bonds. The M1 fetish is so intense that it has given rise to what Albert Sommers, chief economist of the Conference Board, calls a “cottage industry” of consultants, who provide the Wall Street equivalent of tip sheets on the Fed's forthcoming M1 figure. The tipsters aren't always awfully accurate. But, hey, if it gets people stirred up, it has to be worth something, right?

The deficiencies of the Fed's weekly reports are legendary. For example, the reports aren't even for the current week, but rather for the week that ended nine days before . . . but the weekly numbers are not for utility but for action. Edward E. Yardeni, chief economist at Prudential Bache Securities, put it politely when he told Business Week that the numbers “reflect the market's expectation on the directions of interest rates and Fed policy.” Translation: They are a great occasion for dissettlement. As credit columnist Michael Quint put it in the New York Times, “The first concern of traders is outguessing the market minute by minute, not with analyzing the true worth of new economic data.” Forget the old distinctions between perceptions and reality. The obsession with M1 becomes the reality.

This became painfully clear early in 1981, when the bond traders misread Volcker's signals, and thinking he had loosened up on the money supply, they traded interest rates down. Everything was fine until April, when the Fed released the minutes from the Open Market Committee at which the actual decisions had been made. Lo, far from loosening the money supply, Volcker had tightened it. The response, according to the old Washington Star, was a “minicrash.” Bond prices fell, and interest rates jumped a full percent.

Most bond traders are understandably defensive about their M1 obsession. “If it's the market reaction then it can't be excessive,” bristled Steve Blitz of Salomon Brothers. Others are more skeptical. “A private game in the financial community” is what the Conference Board's Sommers calls it. Economist Alan Blinder of Princeton gets heated on the subject. “It's as though a bunch of high rollers went and played the tables in Las Vegas, and it was widely reported in the press.”

Would that it were so. The real danger of this M1 crapshoot, however, is that the connections to the productive economy can be all too real and perverse. It jerks interest rates up and down, and stock and bond prices along with them. The resulting nervousness moves lenders to tack on what they call a “risk premium,” in effect an extra interest charge to take account of uncertainty about the future. What is even worse is that the mentality of these M1 crapshooters has become a touchstone in the highest reaches of economic policy. When Paul Volcker's renomination as chairman of the Fed was still an open question last spring, the press saw the issue almost exclusively from the standpoint of these financial markets. “Volcker has the total confidence of the financial community,” columnist Hobart Rowen wrote in the Post, in a comment typical of the respectable press; and what was most extraordinary is that nobody else's confidence seemed to matter.

“The bond market scenario has become everybody's thinking,” observes House Banking Committee staffer Richard Medley, one of the more thoughtful observers on Capitol Hill. That includes the man who has most to say at this moment about our economic fortunes, Mr. Volcker himself. Last May, the Open Market Committee decided—in secret, as it always does—to tighten the money supply so as to slow down the economic recovery. The minutes of that meeting reveal that Mr. Volcker and his majority felt that tightening the money supply would have a “favorable effect . . . on market perceptions about monetary policy and the outlook for containing inflation.” This was at a time when unemployment was still hovering close to 10 percent and a quarter of our productive capacity was going unused, but it is bond traders and not producers who matter these days. A few months before, at a hearing of the Congressional Joint Economic Committee, Senator Ted Kennedy charged Mr. Volcker with pursuing a monetary policy that was “completely contrary” to the goal of economic recovery. Mr. Volcker responded that, personally, he felt there was “room for interest rates to come down.” However, he added, “we have a hypersensitive audience.” Volcker seems to be as concerned with providing statistical placebos for the money markets as he is with producing sufficient dollars for our economy. Could it be that he knows better, but feels a little trapped?

“The credit markets are in control. They have taken charge of policy,” Prudential Bache's Yardeni told me, not bragging, simply stating a fact. This, Brooks Adams would have understood. [EDITOR'S NOTE: Brooks, grandson of John Quincy Adams, wrote Laws of Civilization and Decay, which—among other things—noted the correlation between the rise to power of bankers and the decline of past civilizations.] What might have surprised him, however, is how little the rest of us seem to mind. After all, there may be over 10 million unemployed, but there are now over 12 million money market accounts, and that doesn't even include the new Money Market Deposit Accounts at the banks. We are no longer farmers who go hat in hand to the banker in the spring. We are now on the receiving end. Since 1960 our income has increased six times over, but our interest income has increased 15 times. We are getting twice the interest we received as recently as 1978. “When banking was deregulated,” the Banking Committee's Medley says, “many people didn't think through the profound implications.” This deregulation, combined with Volcker's tight money policies, has helped to turn us into a nation of bankers. In Brooks Adams's phrase, we prefer increasingly that coin rise relative to goods, and that includes even our corporations, the capital investment of which may be down since 1979, but which are getting 60 percent more interest income than they did that year. And if you want to know why a latter-day Jackson or Bryan has not appeared to stir us from this troubled land, part of the answer is here. We are busy, thank you, opening a new money market account at the bank.


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