If anything was clear last week, it was that the U.S. economy, inflation, the energy problems and the fate of the dollar overseas were all linked inextricably.
As the world tried to evaluate the implicationsof President Carter's energy speech and the results of the Cabinet shakeup, the various markets began to tabulate the feelings of the public on these matters.
The key in this expression of sentiment was the foreign exchange market in which the dollar continued its downturn. From July 2 toJuly 19, the dollar had depreciated 3 percent against the Swiss and German currencies.
Ominous was an Organization of Petroleum Exporting Countries statement at their last meeting that if the dollar depreciated against the Continental currencies by more than 5 percent, OPEC would meet again to move the price of oil higher.
Also important was Middle East oil-producing country's sales of dollars and purchases of British pounds.
The meaning for buyers of fixed-income securities is simply this: The Fed has been forced into a corner.
Now with our economy slowing, the Fed should be easing credit and lowering interest rates. But the ever-present fear of the declining dollar caused by inflation prohibits it from loosening the credit reins. Instead, the Fed has had to do the opposite, to raise the discount rate.
The peoples and countries who hold out dollars want to see the U.S. maintain a strong currency by combating inflation. To do this effectively, interest rates must be raised and growth in the monetary aggregates slowed.
The question becomes, do we tighten credit and raise interest rates, thereby jeopardizing our slowing economy for international reasons or do we ease credit and lower rates out of concern for our economy?
As the dollar declined earlier last week, the bond markets sold off anywhere from 1 to 1 1/2 points. Several unsuccessful new-issue syndicates broke and finally sold at lower prices.
Then, on Friday, the Federal Reserve acted to aid the dollar by raising the discount rate (what memeber banks must pay to borrow from the Fed) to the highest level ever, 10 percent. Minutes later, the news was released that the gross national product (the market value of goods and services produced) had suffered a steep decline during the second quarter.
Both actions were considered bullish by the bond markets, and prices rose anywhere from one half point to a point. As the day wore on, the Fed permitted the federal funds rate (what members charge each other for lending their free reserves) to rise in the vicinity of 10 5/8 percent.It was a clear sign of tightening, and the market retreated from its highs.
The Fed has decided to defend the dollar in spite of a weakening economy. Until a clearer picture emerges as to the extent of the Fed's tightening, short-term liquid investments are preferrable.
In the next two weeks, the Treasury will offer $10 billion in notes and bonds, so the market isn't going to run away. The Treasury will offer a 2-year note on Tuesday in minimum denominations of $5,000. Tenders may be entered at the Treasury here or any of the Federal Reserve banks on their branches. A price guesstimate would be 9.20 percent to 9.30 percent.