Readers have taken to throwing brickbats when I post material that suggests that raising interest rates (at least in advanced economies) might not be a good move right now.
We’ve said before that the reason the Fed kept rates too low too long was it looked at inflation as strictly a domestic phenomenon and ignored the inflation-suppressing effects of cheap imports. That process has gone into reverse due to high oil prices and rising import prices. Remember, the reason high interest rates kill inflation is by slowing economic activity. That’s already happening, and I am highly confident things will get worse all by themselves if the Fed and ECB merely stand pat.
The problem is inflation in emerging economies, particularly China. The Chinese stock market (not a perfect indicator, to be sure) says growth is slowing big time. We noted in a post yesterday that there are other indicators, such as significant factory closings, that say Chinese growth may be about to downgear fast. We’ve noted in passing, and reader Independent Accountant noted longer form, that an increase in fuel prices is having the same effect as tariffs. Hello, Smoot Hawley?
And as painful as high oil prices are, if you believe they are the result of supply and demand, a runup this fast is producing considerable demand destruction. We’ve seen it already in the US based on April results, and oil was only $110 to $120 a barrel then. The effect of cuts in fuel subsidies in China and India have only started to work their way through the economy. The blunt instrument of monetary policy is not the answer to high fuel prices.
Note we are not applauding Bernanke’s moves to date. We think he cut too deeply, too quickly, and left the Fed with no maneuvering room. It would be better if the Fed funds rate were, say, 100 basis points higher. But increasing it to that level would wreak so much havoc on banks that you’d get (in the end) such massive fiscal stimulus that it could more than undo whatever benefit there might be via a modest rate increase.
Yes, negative real interest rates normally lead to speculative investment. But pray tell who is getting credit in the US now? Consumers most certainly aren’t, businesses have it tough, the mortgage market depends on Federal guarantees, and by all accounts, the credit markets are having liquidity issues in many sectors. We saw a different version of this phenomenon in the S&L crisis: the prime rate wasn’t all that bad, but it was irrelevant because just about no one could borrow in any meaningful size.
Now if you don’t think the credit crisis has further to run (credit contraction is deflationary), then raising rates is in order. But based on what I see, things are plenty fragile. I’d rather have the central bankers simply sit tight and do nothing for a quarter and try to get a better handle on the fundamentals.
We’ll admit that in a solvency crisis, there is not much a central banker can do. But raising rates now, particularly in pursuit of a dubious notion like inflation targeting, is in its own way as precipitous as Bernanke’s 75 basis point cuts.
First, some comments from Banque AIG market strategist Bernand Conolly (hat tip reader Scott, no online source). The subtext is that he sees no pretty way out of the mess of massive US debt overhang, but efforts to force US rates up now could produce a particularly devastating resolution:
W]hat we are seeing in the world is a breakdown of international economic consensus. In its place is what the literature calls “strategic behaviour”, marked by threat strategies and an underlying feeling of every man for himself….
Our main concern today, though, is with the damage that will be done to the world economic and financial system if the US gives in to threat strategies, whether from the ECB, from europols or from elsewhere in the world. If one looks at the Saudi position, for instance, it is very understandable indeed that the Saudi authorities should be seriously concerned about the erosion of their country’s purchasing-power over rest-of-the-world resources as the dollar has depreciated. But that simply restates the impossibility of achieving a fundamental equilibrium in the US. As we argue in some detail in our note, “Central Banks, Asset Prices, Risk Premia, Money and the Macro Paradigm: Where Does It All Point?” of 19 February 2007, the US current-account deficit has been a Ponzi game: market pricing has implied that holders of claims on the US economy will see the value of those claims (in terms of command over future US resources) go towards zero as time goes towards infinity. There is an agent-principal problem here that relates to the possibility of a self-fulfilling equilibrium with an inefficient outcome: those in charge today of managing their countries’ claims on the US have an incentive not to inflict realised losses on their principals by sparking a dollar rout, even though, in the limit, not bailing of claims on the US now may mean that future generations will find those claims worthless.
But the Saudis, at least, now seem to have understood at least one aspect of the problem. Unfortunately, a combination of Saudi pressure on the US to stem dollar depreciation and europol pressure on the US to try to do that by forcing US rates up could bring disaster. Recall the analysis of the relevant part of our note of 19 February last year. The scale of real effective dollar depreciation required for the US to be able to respect its intertemporal budget constraint without a devastating US
recession was simply not reflected in real-interest-rate differentials. That left two possibilities. One was that the Ponzi game would be allowed to run on indefinitely: the US would not respect its transversality constraint and the rest of the world would not meet its transversality condition. The other was that the US current-account deficit would indeed adjust but, without the support to net exports from a massively-depreciated dollar, that adjustment would take place in conditions of devastating recession. But in that scenario US credits would deteriorate dramatically; yet that, too, was not incorporated in market pricing.
The horrible prospect is that the europols are trying to subject the US to the constraints that EMU has imposed on the euro-area cads. In EMU, currency risk (for individual countries, though not of course for the area as a whole) is transformed into credit risk. But if that happens to the US, via attempts to “stabilise” the dollar, the catastrophic impact on US credits will – given that the dollar has been essentially a credit story in the present decade – lead to very severe downward pressure on the dollar as foreigners are forced to try to bail out of claims on the US. That vicious circle would be broken, no doubt, either by a decision by the US authorities to let the dollar go – in chaotic circumstances recalling the end of the Bretton Woods system but probably with even more profound geopolitical consequences – perhaps after intervention/exchange controls on one side or the other.
Ambrose Evans-Pritchard of the Telegraph is largely on the same page.
Sadly, we are witnessing the sort of strategic errors that turned the recession of 1930 into a global catastrophe.
The European Central Bank is now hell-bent on a course of action that will have a knock-on effect across the world and risk a dangerous implosion of the credit system.
The ECB’s Jean-Claude Trichet told Die Zeit today that “there is a risk of inflation exploding.”
Let me put it differently: there is a grave risk of social and political disorder “exploding” if the logic of his argument is followed to its grim conclusion, that is to say if the ECB charges ahead with a string of rate rises through the autumn after its near certain move to 4.25 per cent on Thursday.
The ECB mantra is that Europe and the world is on the cusp of a wage-price spiral along the lines of the 1970s…By taking this militant 1970s line, he is in effect kicking Bernanke in the teeth. Or put another way, the ECB is trying to pressure America into a tighter monetary stance. Regrettably, this has in part succeeded. The Fed badly needs to cut rates further — probably to 1per cent. It cannot do so because the ECB keeps threatening to pull the plug on the dollar.
This is madness. It is the mirror image of the early 1930s, when the Federal Reserve (cowed by the Chicago liquidationists) precipitated the collapse of 4,000 banks, and transmitted their fervour to rest of the world through the Gold Standard. This time there is no Gold Standard. But the globalised capital and currency markets — egged on by Trichet — are playing much the same role.
Yes, eurozone inflation reached 4 per cent in June. But what on earth does that tell us, unless you are an inflation-target totemist? It takes two years or so for the full effects of monetary policy to work through the economy, and by then Europe will be an entirely different place.
The ECB was too loose in the early part of this decade (in order to help Germany), keeping rates at 2 per cent until December 2005. That is the underlying cause of the rapid credit growth in the eurozone up to the onset of the credit crunch, and a key cause of silly property bubbles in Club Med and Ireland. The ECB was negligent in 2004, 2005, and 2006, (as were the US Federal Reserve and the Bank of England — this is not to absolve Anglo-Saxon central banks at all. They all botched royally.)
We are now in the eye of the post-bubble, debt-deleveraging, deflation storm. The ECB’s rate rise tomorrow will do nothing whatever to deal with the current oil and food spike, which is in any case causing a dramatic squeeze in real wages. It will merely make the downturn worse. I suspect that the ECB will be cutting frantically to undo the damage from its own ideological excesses soon enough, just as the Fed had to do after its fatal rate rise to 5.25 per cent last year…
If the rate rise pushes the euro higher against the dollar, it will merely push oil higher as well — since oil is trading as inverse dollar with seven times leverage. Eurozone “inflation” — that treacherous term — will get worse. Brilliant.
Ben Bernanke — despite his own “helicopter” baggage — has had the courage to ignore the shrieking punditocracy and slash rates by 325 basis points, looking beyond the oil spike to the deflationary risks that lie beyond. This is statesmanship of the first order….
Perhaps Germany now needs higher rates as unemployment tumbles to a 16-year low. It has gained 30 per cent to 40 per cent in unit labour competitiveness against Italy and Spain since the currencies were fixed, and 20 per cent against France.
It is conquering market share across Club Med. As chief supplier to booming Russia, it is enjoying a (positive) asymmetric shock. But Germany is not the euro-zone.
The unspoken truth — and now the source of so much poisonous policy-making — is that Europe signed an implicit political contract with Germany in the 1990s that monetary union should never lead to a recurrence of German inflation. The euro must be as hard as the old D-Mark, and not a Lira-Peseta.
The system is now being bent to comply with this contract. Indeed, one senses that Buba chief Axel Weber has a near maniacal urge to press the point, like Shylock cutting his `Pound of Flesh’, — even if such a course of action has become inherently destructive, especially for Germany’s strategic interests….
As the BIS and others have warned, the eurozone is already in the grip of an incipient credit crunch. Distressed companies are drawing down existing loans from banks because the securitisation market is shut.
The result of monetary overkill is already evident in parts of system. Ireland’s GDP contracted at an annual rate of 1.5 per cent in the first quarter. It will get a lot worse. Investment fell 19.1 per cent. House prices have fallen for fifteen months in a row.
Spain’s house prices have fallen 6.2 per cent since July (4.3 per cent this year alone) according to Facilisimo.com. This hardly surprising. Euribor used to price floating rate mortgages (98 per cent of the total in Spain) has risen 120 basis points since the crunch began.
Unemployment has risen by 425,000 over the last year, a faster rate of increase than during the recession of the early 1990s. Monetary policy has been tightened into a severe downturn.
HSBC expects French house prices to fall 10 per cent over the course of this year and next.
Yes, inflation has run amok in Asia, the Mid-East, and Russia. They will have to slam on the brakes. Some are doing so already. This will hit just as the effects of the ECB’s squeeze bites harder.
It has become fashionable to talk of “global inflation”. There is no such thing. A large number of countries have let their money supplies surge out control by refusing to let their currencies revalue against the dollar. They are now paying the price.
The Western states with collapsing property and asset markets (the Anglo-Saxons, Club Med) or demographic implosions (Germany) have the opposite problem. Confusing one with the other will take us straight into a slump.