Vivek Kaul
Over the last few months, there has been talk about the Federal Reserve of United States, the American central bank, wanting to slowdown its money printing and gradually doing away with it altogether.
Every month the Federal Reserve prints $85 billion and puts that money into the American financial system, by buying bonds of different kinds. The idea is that with enough money floating around in the financial system, the interest rates will continue to remain low.
At lower interest rates people are more likely to borrow and spend more. And this in turn will help economic growth, which has been faltering, in the aftermath of the financial crisis, which started in late 2008.
Some economic growth has returned lately. Recently the GDP growth for the period of three months ending June 30, 2013, was revised to 2.5% from the earlier 1.7%. But even an economic growth of 2.5% is not enough, primarily because the country needs to make up for the slow economic growth that it has experienced over the past few years.
The fear is that with all the money floating around in the financial system, too much money will start chasing too few goods, and finally lead to high inflation. But that hasn’t happened primarily because even at low interest rates, borrowing has been slow. Hence, what economists call the velocity of money (or how fast money changes hands) has been low. Given this, inflation has been low. Consumer price inflation in the United States, for the period of twelve months ending June 2013, stood at 1.3%.
The rate of inflation is well below the inflation target of 2% that the Federal Reserve is comfortable with. So if inflation isn’t really a concern, and the economic growth is still not good enough, why is the Federal Reserve in a hurry to go slow on printing money?
As Gary Dorsch, the Editor – Global Money Trends newsletter, writes in his latest column “The fragile US-economy might find itself sinking into a full blown recession by the first quarter of 2014. However, the Fed’s determination to start scaling down QE-3 is essentially in reaction to the demands of the Bank of International Settlements (BIS), – the central bank of the world – which says it is time to rethink US-monetary policy. The BIS argues that blowing even bigger bubbles in the US-stock market can do more harm to the US-economy than the old enemy of high inflation. Thus, going forward, the costs of continuing with QE now exceed the benefits.”
Quantitative easing or QE is the technical term that economists have come up with for money printing that is happening across different parts of the western world.
What Dorsch has written needs some detailed examination. The argument for keeping the money printing going has been that it has not led to any serious inflation till now, so let us keep it going. While inflation may not have cropped up in everyday life, it has turned up somewhere else. A lot of the money printed by the Federal Reserve has found its way into financial markets around the world, including the American stock market. And this has led to investment bubbles where prices have gone up way over what the fundamentals justify.
The Federal Reserve, meanwhile, has continued with the money printing because it hasn’t shown up in inflation. Central banks work with a certain inflation target in mind. If the inflation is expected to cross that level, then they start taking steps to ensure that interest rates go up.
At 1.3%, inflation in the United States is well below the Federal Reserve’s target of 2%. Some recent analysis coming out suggests that inflation-targeting might be a risky strategy to pursue. Stephen D King, Group Chief Economist of HSBC makes this point in his new book When the Money Runs Out. As he writes “the pursuit of inflation-targetting…may have contributed to the West’s financial downfall.”
King gives the example of United Kingdom to elaborate on his point. As he writes “Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher ‘domestically generated’ inflation. In other words, credit conditions domestically became excessive loose…The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom.”
Hence, the Bank of England, kept interest rates too low for too long because the inflation was low. With interest rates being low banks were falling over one another to lend money to anyone who was willing to borrow. And this gradually led to a fall in lending standards. People who did not have the ability to repay were also being given loans. As King writes “With the UK financial system now awash with liquidity, lending increased rapidly both within the financial system and to other parts of the economy that, frankly, didn’t need any refreshing. In particular, the property sector boomed thanks to an abundance of credit and a gradual reduction in lending standards.”
So the British central bank managed to create a huge real estate bubble, which finally burst, and the after effects are still being felt. And all this happened while the inflation continued to be at a fairly low level.
But this focus on ‘low inflation’ or ‘monetary stability’ as economists like to call it, turned out to be a very narrow policy objective. As Felix Martin writes in his brilliant book Money- The Unauthorised Biography “The single minded pursuit of low and stable inflation not only drew attention away from the other monetary and financial factors that were to bring the global economy to its knees in 2008 – it exacerbated them…Disconcerting signs of impending disaster in the pre-crisis economy – booming housing prices, a drastic underpricing of liquidity in asset markets, the emergence of shadow banking system, the declines in lending standards, bank capital, and the liquidity ratios – were not given the priority they merited, because, unlike low and stable inflation, they were simply not identified as being relevant.”
The US Federal Reserve wants to avoid making the same mistake that led to the dotcom and the real estate bubble and finally a crash. As Dorsch writes “A BIS working paper that traces booming stock markets over the past 110-years, finds that they nearly always sink under their own weight, – and causing lasting damage to the local economy. Asset bubbles often arise when consumer prices are low, which is a problem for central banks who solely target inflation and thereby overlook the risks of bubbles, while appearing to be doing a good job.”
Over the last 25 years, the US Federal Reserve has been known to cut interest rates at the slightest sign of trouble. But only on rare occasions has it raised interest rates to puncture bubbles. Alan Greenspan let the dotcom bubble run full steam. Then he, along with Ben Bernanke, let the real estate bubble run. By the time the Federal Reserve started to raise interest rates it was a case of too little too late.
A similar thing seems to have happened with the current stock market bubble, where the Federal Reserve has printed and pumped money into the market, and managed to keep interest rates low. But this money instead of being borrowed by American consumers has been borrowed by investors and found its way into the stock market.
As Claudio Borio and Philip Lowe wrote in the BIS working paper titled Asset prices, financial and monetary stability: exploring the nexus (the same paper that Dorsch talks about) “lowering rates or providing ample liquidity when problems materialise but not raising rates as imbalances build up, can be rather insidious in the longer run. They promote a form of moral hazard that can sow the seeds of instability and of costly fluctuations in the real economy.”
Guess, the Federal Reserve is finally learning this obvious lesson.
The article originally appeared on www.firstpost.com on September 6, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)