In 1898 Swedish economist Knut Wicksell said there was “no need to waste words proving how important it is that the exchange value of money or, what is the same thing seen from the opposite angle, the general level of commodity prices, remains as stable and constant as possible.” Wicksell’s words merit a mention given the recent commentary about dollar strength.
Measured against the euro and the yen, the dollar has been performing well — it’s at a 2-month high versus the former and a 16-month high versus the latter. But the Wicksellian model tells us that other factors need to be taken into account.
Importantly, Wicksell’s currency-stability approach did not just rely on the value of the home currency (in his case, the Swedish Kronar) against others. Foreign exchange values were but one factor in his price-rule model. Commodity prices and bond yields played an equal role in proving or disproving market signals that indicated currency strength or weakness. Applied to today’s dollar, the Wicksellian model indicates that the greenback may be weaker than advertised.
Though the dollar is certainly strong right now against the euro and the yen, all three currencies have been weakening versus gold. Current dollar strength is presently a function of the fact that the euro and yen have been falling at a higher rate than the dollar. Indeed, while the dollar price of gold has risen 8 percent over the last 2 months, it has risen over 9 percent in euros. Over the last 16 months, the yen price of gold has risen 22 percent versus 18 percent in dollars.
The above also holds true against a broad basket of commodities. In recent months the dollar price of the Journal of Commerce (JOC) index is up 5 percent, while the weaker euro and yen over the same timeframe have both seen gains of 8 percent.
U.S. Treasuries seemingly contradict commodity-based evidence of dollar weakness. Since 2001, the dollar price of the JOC index has risen 37 percent amidst a 12 percent fall in the yield of the 10-Year Treasury note. The latter market indicator might be saying that the inflation outlook is less dire than the JOC would suggest, or that Federal Reserve attempts to arrest inflation are credible.
Manuel H. Johnson, a former Fed vice chairman under Alan Greenspan, and author of Monetary Policy, A Market Price Approach, is the modern authority on the Wicksellian price rule. According to Johnson, the combination of rising commodity prices and falling yields isn’t necessarily an indicator of a too-tight or too-loose Fed. More information is required.
Johnson does, however, note that “market prices are influenced by both inflationary expectations and expectations of future policy action.” By definition, market prices are also influenced by past policy action. The seemingly low level of Treasury yields relative to commodity prices arguably incorporates market awareness of the monetary deflation that began in the latter part of 1996, and that finally ended in late 2001. Conversely, long-term yields took a long time to adjust to falling commodity prices in the 1980s. Fed policy in the 1970s was presumably a factor.
Regarding non-market inflationary gauges, Ludwig Von Mises said figures like the Consumer Price Index (CPI) “are at best rather crude and inaccurate illustrations of changes which have occurred.” Japan’s CPI index only started to register its monetary deflation six years after it began. In the U.S., the CPI picked up on our own monetary deflation in 2001, just as the deflation was ending.
That the CPI is notoriously lagging explains why a market-based approach to money is so important. As Johnson writes in Monetary Policy, the “procedures embodied in the market price strategy do not try to take advantage of the central banks knowledge (or confidential information) but of the dispersed, decentralized knowledge that no single person or group of people possess.”
In short, money is too important to entrust to government statistics or to the confidential actions of a few wise men. Not only should future Fed chairmen adopt a price-rule model based on market indicators, we should all be made aware of just what indicators they follow.
–John Tamny is a writer in Washington, D.C. He can be contacted at firstname.lastname@example.org.