In an effort to diffuse the issue of protectionism in Congress, the Treasury initiated an accord with four other members of the Group of Five -- Great Britain, West Germany, France and Japan. The essence of the accord was to "push" the value of the dollar lower in the foreign exchange market (FX), and also for the members of the group to undertake policies at home that would stimulate their economies. The accord announced over the past weekend, and when the financial markets opened on Monday, the response of the various markets was dramatic and volatile.

The decline in the value of the dollar from its close on the Friday night before the accord to its opening on Monday morning was the largest decline on record. The Treasury bond market initially jumped up a half point, but then fell about a point. The stock market rallied strongly on the idea that a lower dollar would be good for the U.S. economy. Gold and other precious metals leaped in price. If this accord is adhered to, there could be far-reaching effects in our economy and in all of the markets as well.

For one thing, the Treasury and the Federal Reserve have changed policy, for they formerly would not intervene in the FX market unless an emergency required it. This new policy falls under the purview of the Fed, it takes on a new meaning for interest rates. When the Fed intervenes in the FX market, it sells dollars and buys currencies of the countries whose currencies it wants to appreciate against the dollar. The easiest way to have the dollar move lower is to allow short-term interest rates to decline while intervening when necessary in the FX market. Consequently, for the time being, the Fed will do nothing that would push short-term rates higher. Higher short-term rates would attract foreign investors, who would bid up the cost of dollars to be used in purchasing dollar-denominated assets. In effect, to allow short-term interest rates to increase now would be self-defeating. Stability or lower short rates are necessary.

Long-term rates are another story. Foreign investors purchase our securities for two reasons. First, for the higher real interest rates that are available, and, second, for the possible appreciation that could occur in the dollar. The 5 percent decline in the dollar last Monday was the equivalent, for a foreigner, of a 5 3/4 point price decline in a long U.S. Treasury. If the foreign investor sold his U.S. bonds and repatriated his devalued dollars, he would end up buying less of his own currency, which had appreciated while the dollar declined in value. The question then becomes, if the dollar is going to decline more, will foreign investors gamble on a currency less or will they sell their Treasuries and repatriate their money? Or will they be around for the Treasury's next auction?

In an effort to keep short-term rates from rising now, the Fed's activities of supplying enough reserves to keep short rates low, even though the money supply may explode, becomes inflationary. Inflation is bad for long bonds. Further, if the accord is successful and the dollar declines, in time the price of foreign imports will probably rise, which will allow U.S. producers to raise their prices as well. In short, more inflation, even though our products will have become cheaper for foreigners, which will cause an increase in our exports that will benefit the depressed sectors of our economy.

The bottom line is that a lower dollar will help our economy, will be good for the stock market, and has already caused short-term rates to decline and longer-term rates to rise, producing a much steeper yield curve. That is, you can pick up substantially more yield by going from the 3-month T bill to the 30-year T bond (350 basis points) than was previously possible over most of the past 12 months.

Nevertheless, the key to this new operation is the resolve of all five members of the group in intervening in the FX market and in straightening out their economies at home. For the United States, the failure to resolve the budget problem could blunt the benefits that might come from a successful lowering of the dollar and, in the end, lead to protectionism.