Ben Bernanke

Of Football Goalkeepers, RBI Governor Subbarao and the Art of Doing Nothing

 

subbarao-rbi-governor

Sometime in August last year I got an email, late in the evening. Before I clicked to open it, I thought it was one of the many spam emails that one gets during the course of any day.

Thankfully, I did click on it and the contents of the email told me that it wasn’t spam. The sender of the email was writing a book and he wanted my permission to refer to an article I had written for the Daily News and Analysis(DNA) in August 2013.

This book, which refers to my DNA article, titled Who Moved My Interest Rate? has recently published. It has been authored by D Subbarao, who was the governor of the Reserve Bank of India between 2008 and 2013, before Raghuram Rajan took over.

On page 140 of the book, governor Subbarao refers to my August 2013 DNA article. The article was titled RBI is behaving like a football goalkeeper. The article was written during the taper tantrum.

On May 22, 2013, Ben Bernanke, the then Chairman of the Federal Reserve of the United States, the American central bank, told the Joint Economic Committee of the American Congress that “if we see continued improvement and we have confidence that that is going to be sustained, then we could in the next few meetings … take a step down in our pace of purchases.”

The Federal Reserve of the United States had been printing dollars every month. It had been pumping those dollars into the financial system by buying financial securities. The idea was to ensure that there was enough money going around in the financial system, so that interest rates remained low.

At lower interest rates, it was hoped that the American consumer would borrow and spend again, and in the process revive the economy. What also happened was that low interest rates allowed financial institutions to borrow dollars and invest them in financial markets all over the world. This became the dollar carry trade.

This led to financial markets rallying all over the world. Bernanke, spoilt the party in May 2013. What he was basically saying was that money printing by the Federal Reserve would come to an end. Of course, this wouldn’t be done all at once and would be done gradually (i.e. tapered) over a period of time. This meant that the dollar carry trade would no longer be viable with an era of easy money coming to an end and the interest rates starting to go up. And as a reaction institutional investors who had borrowed in dollars to invest, started to get money out of financial markets all over the world.

This included India. Foreign investors sold both stocks and bonds. When they did that, they got rupees in exchange. These rupees had to be exchanged for dollars, if the money was to be repatriated back to the United States. This pushed up the demand for the dollar, and the rupee started to lose value against the dollar.

In fact, on May 22, 2013, when Bernanke made his comment one dollar was worth Rs 55.41. By August 7, 2013, when my article appeared in DNA, one dollar was worth Rs 60.78. Of course, the RBI was trying to intervene in the foreign exchange market in order to ensure that rupee doesn’t fall too much.

One of the major reasons for doing the same lay in the fact that those were days of high oil prices. India imports four-fifth of the oil that it consumes. Hence, the oil companies would have to pay more in rupees to buy the dollars that they would have needed to buy oil.

Further, back then the oil companies weren’t allowed to pass on this increase in price of oil to the end consumer by increasing the price of diesel, kerosene and cooking gas (since then diesel has gone out of the list). The government picked up a major part of this tab and in the process the fiscal deficit of the government went up as well. Fiscal deficit is the difference between what a government earns and what it spends.

Getting back to the point. In my DNA article I suggested that the RBI was behaving like a football goal keeper. This analogy came from a research note written by Societe Generale’s Albert Edwards. In this note, Edwards said: “When there are problems, our instinct is not just to stand there but to do something… When a goalkeeper tries to save a penalty, he almost invariably dives either to the right or the left. He will stay in the centre only 6.3% of the time. However, the penalty taker is just as likely (28.7% of the time) to blast the ball straight in front of him as to hit it to the right or left. Thus goalkeepers, to play the percentages, should stay where they are about a third of the time. They would make more saves.”

But they rarely do that. “Because it is more embarrassing to stand there and watch the ball hit the back of the net than to do something (such as dive to the right) and watch the ball hit the back of the net,” wrote Edwards.

The point being that in a moment of crisis it is important to be seen to be doing something. Using this analogy, I had said that the RBI would have been better off just letting the rupee fall and finding its right level. The efforts of the RBI between May and August hadn’t helped much, and the rupee had continued to fall. As I wrote back then: “The RBI is like a football goalkeeper. It knows ‘do nothing’ is the best course, but it can’t just stand pat.”

This is something that Subbarao also suggests in his book. As he writes: “Let me conclude my experiences of steering the rupee in turbulent waters by reiterating a standard dilemma. Given my position that a sharp correction of the exchange rate was programmed and forex intervention by the Reserve Bank would only postpone the inevitable, wouldn’t it have been rational to just stay put till the adjustment had been complete…Sensible maybe, but virtually impossible in the shrill democracies of today.”

To conclude, this is a point that another ex-RBI governor (not Subbarao) made to me once, when he said that in “moment of crisis the central bank can’t be seen to be doing nothing,” even if “do nothing” might be the best strategy to follow.

The column was originally published in Vivek Kaul’s Diary on July 18, 2016

How the Federal Reserve caused the Great Recession


This column is slightly different from the ones I usually write. On most days the idea is to write on something which is currently happening. This column doesn’t fit that formula.

In this column I wanted to write about how our world view plays a huge part in what we think and the decisions that we make, and how those decisions can turn out to be majorly wrong in the long-term, even though when we were making them they seemed to be the perfectly correct thing to do.

The dotcom bubble started to burst in early 2000. Soon after on September 11, 2011, several airliners were hijacked, of which two flew into the iconic World Trade Center in New York and one into Pentagon. The American economy which was going through tough times in the aftermath of the dotcom bubble collapsing, got into even more trouble after 9/11.

Alan Greenspan, who was the Chairman of the Federal Reserve of the United States, at that point of time, recalls in his book The Age of Turbulence that the American economy had been in a minor recession for a period of seven months before September 2001. And in the aftermath of the attacks, the reports and statistics streaming in painted a very worrying picture.

Americans had stopped spending on everything other than the items they would need in case there were more attacks. Sales of grocery items had gone up; so had sales of security devices, insurance, and bottled water. On the flip side, businesses like travel, entertainment, hotels, tourism, and even automobiles were majorly hit.

The American economy is very consumer driven and if consumers stop spending, then the economic growth immediately collapses. This was likely to happen in the months that followed September 2001.

With spending collapsing, there was a danger of the minor recession turning into a major one. To prevent this, Greenspan, as he had in the past, decided to cut interest rates. The federal funds rate, which was at 3.5 percent before the attack, was cut four times and brought down to 1.75 percent by the end of the year, starting with the first rate cut of 50 basis points, or half a percentage point, on September 17, 2001, six days days after the attack. (One basis point is one hundredth of a percentage). The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

Central banks cut interest rates in the hope that consumers would borrow money to spend and businesses would borrow money to expand, and so the economy would grow. As James Rickards writes in The Death of Money—The Coming Collapse of the International Monetary System: “We all asked ourselves how we could help [in the aftermath of the attack]. The only advice we got from Washington was ‘get down to Disney World … take your families and enjoy life’.”

People did borrow and spend, but they went overboard with it. America’s new bubble after dot-com was real estate and it was built on the belief that anyone could make money in real estate. As Stephen D. King puts it in When the Money Runs Out: “The white heat of the 1990s technological revolution was replaced by the stone cold of a housing boom.”

Between January 2001 and mid-2003, the federal funds rate was cut by 550 basis points to one percent. The interest rate stayed at one percent for little over a year.

The Federal Reserve did not want the United States to become another Japan. Japan had been in a low growth environment since the collapse of the stock market and the real estate bubbles, starting in late 1989. Prices had been regularly falling. In an environment of falling prices(or deflation) consumers keep postponing consumption in the hope of getting a better deal in the future. This leads to businesses suffering and the economic growth collapsing.

Ben Bernanke, who would takeover as the Chairman of the Federal Reserve from Alan Greenspan in 2006, joined the Federal Reserve in 2002 as a governor. Bernanke was a scholar on the Great Depression of 1929.

In one of the first speeches that Bernanke made after joining the Federal Reserve he said: “Whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation—a decline in consumer prices of about 1 percent per year—has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors … the consensus view is that deflation has been an important negative factor in the Japanese slump… I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small… So, having said that deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether.”

This fear of not becoming another Japan and at the same time not engineering another Great Depression led to the Federal Reserve keeping interest rates low much longer than it should have. This led to the real estate bubble which would finally start bursting in 2007-2008.

As Barry Eichengreen writes in his brilliant new book Hall of Mirrors—The Great Depression, The Great Recession and The Uses—And Misuses—Of History: “With benefit of hindsight, we can say that the Fed overestimated the risk of deflation and responded too preemptively and aggressively. As a student of Japan and of the Great Depression, Bernanke may have been overly sensitive to the danger of deflation at this point of time. In other words, history may be useful for informing the views of policy makers of how to respond to certain risks, but it may also shape and inform outlooks in ways that heighten other risks”

Bernanke’s world view led to the Federal Reserve keeping interest rates low much longer than it should have. Over and above this, the inflation data that was coming out at that point of time may also have had a role to play. As Eichengreen writes: “Distorted data may have also contributed to the Fed’s exaggerated concern with deflation. Contemporaneous data showed the personal consumption expenditure deflator[the inflation index that the Federal Reserve follows], cleansed of volatile food and fuel prices, falling to less than 1% in 2003, dangerously close to negative territory. Subsequent revisions revealed that inflation in fact had already bottomed out at 1.5% and was now safely on the rise.”

This led to Federal Reserve maintaining low interest rates, when it should have been raising them. In the process, the Fed ended up fuelling the real estate bubble, which finally led to the bankruptcy of Lehman Brothers in September 2008, and the start of the current financial crisis, which was followed by what is now known as the Great Recession.

The column originally appeared on The Daily Reckoning on May 29, 2015

'The Federal Reserve Learnt the Lessons Of The Great Depression'

Prof Randall Kroszner..

R Jagannathan and Vivek Kaul

Randall S Kroszner served as a Governor of the Federal Reserve System from March 2006 until January 2009. During his time as a member of the Federal Reserve Board, he chaired the committee on Supervision and Regulation of Banking Institutions and the committee on Consumer and Community Affairs. Kroszner was a member of the President’s Council of Economic Advisers (CEA) from 2001 to 2003. Currently he is the Norman R Bobins Professor of Economics at the University of Chicago Booth School of Business. He is an expert on international financial crises and the Great Depression. He was recently in India for the opening of The University of Chicago Center in Delhi. In this interview Kroszner tells Forbes India on how the Federal Reserve managed to avoid another Great Depression in 2008 and why it had to let the investment bank Lehman Brothers go bankrupt.

You were a governor at the Federal Reserve between 2006 and early 2009. That must have been a very tough and an exciting time…
Three easy years…(laughs). I am joking.
Can you give us some flavour of how those years were?
It was an incredibly challenging time because the markets were moving so rapidly. The economy was also moving rapidly downward. So we had to take important decisions in real time. We would often get into situations where we would try to survive until Friday and then try to do the resolution by Sunday, before the Asian markets opened. So we had a lot of board meetings late on Fridays, Saturdays and Sundays. And it was a time where having an economic framework was very useful because when you have to make decisions in real time, you need to have a framework to understand what the priorities are.
You and Ben Bernanke are scholars of the Great Depression. How did that help?
A number of us were quite familiar with the economic history. Three out of the five of us on the board had written papers on the Great Depression. And we were all pretty much influenced by Milton Friedman and Anna Scwartz’s magisterial A Monetary History of the United States. Their study squarely put the blame on the inaction of the Federal Reserve, turning a depression into the Great Depression. Those were very important lessons for us and gave us both an economic and historical framework for looking into the kind of price distress we were having at that point of time, so that we could act quickly and boldly to prevent a repeat of the Great Depression.
Did you all really believe that if the fiscal side and the monetary hadn’t acted as they did in 2008, you were really seeing a repeat of the Great Depression?
There was a certainly a risk of that because clearly there was a lot of turmoil in the financial markets. There was a potential for failure of many financial institutions, if the Fed did nothing and did not provide liquidity to the market and some institutions. It was by no means a certainty. Even if the probability was low, it’s a risk that I and other members of the Federal Reserve board were reluctant to take.
In the meetings at the Fed before September 2008 what was the atmosphere like? Did Chairman Bernanke and other governors have a clue of what was to come?
If you see the verbatim transcripts of 2008 many of us including myself were very concerned about the fragility of the market and the economy. We undertook some very bold action in terms of a very rapid interest rate cut. This was at a time when the European central banks were raising interest rates because oil prices were rising throughout 2008. But our forecast was that demand was likely to go down significantly and that the rise in oil prices was just a temporary price shift not suggesting an underlying increase in inflation. And that is why we had interest rates very low during that time period while other central banks were raising interest rates.
Being the Chair of the committee on Supervision and Regulation of Banking Institutionsyou must have been in the room when a decision to let Lehman Brothers go bust would have been made. What was the atmosphere like?
So, there was no meeting where a go/no go was made. It was a series of processes. Remember we were dealing with independent investment banks having significant funding troubles and having great concerns about their ability to survive. And so we were exploring whether there could be merger partners for organisations like Merrill Lynch and Lehman Brothers. Bank of America decided to buy Merrill Lynch. There were others who were looking at Lehman Brothers and we thought that we would be finding a merger partner. But it then emerged over that weekend[the weekend of September 13-14, 2008] that a merger partner was not available for Lehman Brothers. The market had known that they were in trouble for a while. And Lehman Brothers had not been willing to merge with a number of other institutions that had proposed merger over the summer. Hence, it was in an effectively weak capital position. Its business model was imploding and so, the Fed was not able to do a capital infusion.
Why was that the case?
The Fed can only lend against good collateral to a solvent organisation. It was very difficult to make an assessment at that time. There was a merger partner avaialble for Merrill Lynch and Bank of America could provide capital infusion and support. Morgan Stanley and Goldman Sachs had sufficient capital and sufficiently functional business models, that we felt comfortable granting them bank charters on an emergency basis. But Lehman Brothers did not have that wherewithal.
But two days later Federal Reserve stepped into rescue AIG. How do you explain that?
Well remember that the Fed could lend against good collateral. The problematic part of AIG was the financial products subsidiary of the holding company. But AIG had other operations in many states and in many countries that were not associated with the challenges that were there in the financial products division. And also AIG had sufficient collateral to be able to post against the loan.
You are also a scholar of the Great Depression. What were the mistakes made during the Great Depression that haven’t been made during the period of what is now called the Great Recession?
As you know a number of us including Bernanke, myself and one of the other governors, were students of the Great Depression and had done work on it. Milton Friedman and Anna Scwartz’s in their magisterial book on the monetary history of the United States had said that depression of the late twenties and early thirties was turned into the Great Depression precisely because the Fed did not act. The Fed stood by as the money supply collapsed, and as deflation came in. The prices fell by a third, GDP fell by 30%, and unemployment went up to 20%, and there was no action.
And that was the lesson?
Yes. That was a very important lesson for those of us who had studied the Great Depression, to make sure that we did not make that mistake of inaction because the central bank can prevent deflation. Broadly, we certainly learned the lessons of the Great Depression at the Fed, to make sure that we didn’t make the same mistakes. We didn’t just sit ideally and allow the price level to fall significantly and allow the GDP to contract. Honestly, we were able to avoid a significant to recession. It is really something very different from what happened in the 1930s.
You also managed to avoid a deflation…
Deflation can be very destructive as we saw in the thirties. Even a mild deflation can be very problematic as we have seen over the last fifteen years in Japan. It was the strong commitment on the part those of us who studied the 1930s as supposed to the others, to make sure to not allow a state of inaction, where a central bank did not act as the lender of the last resort, which is actually what it was created to do. Further, central banks around the world have to be vigilant against the threat of deflation.
International financial crises is an area of your expertise. Why are economists unable to spot bubbles. Your colleague and Nobel laureate Eugene Fama has even gone to the extent of saying that “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”
It is easy ex-post to say that aha that price did not make any sense or it was clear that price would be coming down. But when in you are real time it is very difficult to be able to tell whether there is some sort of dislocation of the market or a fundamental change. We had the same challenge after the Asian, Russian and the Latin American crisis in the 1990s. The World Bank, IMF and many economists looked for indicators, so called red flags, which you could look at and tell when the economy is is getting overheated. They tried to figure out which are the indicators that can tell us that credit growth is too fast, or that there is a “bubble” in a particular sector. Despite a lot of work by a lot of very smart people on the policy side and the academic side, we really haven’t come up with a simple set of indicators or any indicator where you can have confidence and say just look at x, y and z, and you know that there is some sort of dislocation here, that is going to be reversed.
In a recent interview you said that the Fed’s approach to communication has changed through the years. Could you elaborate on that?
The communication has become more complete and more transparent and also the words have changed over time. They are sometimes called forward guidance. They are sometimes called open mouth operations because its talking about what kind of purchases and sales that the open market operations are going to do. In my last meeting at the Federal Open Market Committee(FOMC) we brought interest rates to approximately zero and said that we would keep them there for an extended period of time. That gradually changed into a particular date, and Fed would describe dates like 2014/2015. That changed to a description of 6.5% unemployment threshold. And most recently the Fed has said that it would not be focusing on a particular unemployment threshold.
What is the aim here?
I think all of the statements are trying to get at the same thing. It’s different words in different circumstances, around the same idea about the desire of the Fed to provide liquidity support to monetary accommodation to make sure that the economy fully recovers before it decides to take the punchbowl away. In these uncharted waters, giving a little bit more guidance about what the Federal Reserve thinks about policy making and how is it going to react to data is helpful because the past behaviour may not be that useful because we haven’t had these kinds of circumstances before.
In a recent interview when you were asked that when do you think the time will come when the Federal Reserve will start to raise interest rates, you had replied “I do think it will come sometime in my lifetime”. Does that mean the era of low interest rates in the US is here to stay? That was a bit of flip comment. I hope you understand that it was not meant seriously. We have had low interest rates for five to six years now. There is a hope that the economy will be strong enough sometime in 2015, and rates will be able to go up. You can see from most recent FOMC documents all of the FOMC members believe that the interest rates will be higher by the end of 2015 than they are now. And that sounds to me as reasonable.
A lot of gold bulls have been thinking that some point gold should have some role in money making. Do you see gold ever having any kind of role in monetary policy in future?
It’s narrow to pull this in any particular commodity because then the value of the currency will rise and fall depending on the vagaries of the particular market. So, like a flood in a mine in South Africa will have a big impact. And that is like putting too many eggs into one basket. The least you would want is a broader commodity based basket that would be well diversified and would be able to withstand these kind of shocks. So certainly thinking about alternative benchmarks for units of account are worthwhile to do. But I wouldn’t want to put all of my eggs in one particular commodity basket, particularly a market like gold which is a very small one. Small shocks like a flood in a mine in South Africa could have a big impact on money supply. Hence, it doesn’t seem like a very stable system.
The near zero interest rates and the QEs have had a bigger impact on the assets markets than the credit markets and the real economy. Would you say it is building up some problem?
It is important that the Fed is aware about this and is looking into this. Jeremy Stein one of the governors of the Fed has been at the forefront trying to think about what indicators to look at, indicators that might raise red flags. Jeremy as well as his staff are thinking very carefully about that. Monitoring this very very closely is very important and I know that the Fed is. To be able to predict which markets will have a dislocation, it is impossible to do that. No one has that kind of foresight. But I do think there is much more focus on that today than there was in the past.
In another five six months it will be six years since the Lehman Brothers went bust. How long do you think the easy money policies will continue?
As Chairman of the Federal Reserve, Ben Bernanke had said, whatever it takes, a corollary of that is as long as it takes. We have had a slow recovery than anyone had hoped for and that has been true not only in the US but many other countries as well. Some countries like India and some emerging markets that had done very well in the late 2000s have seen a significant fall in growth more recently. As the FOMC and Janet Yellen have said they are now on a path of tapering. It is very important to draw the distinction between tapering and tightening. The Fed had made a commitment to buy $85 billion worth of additional assets every month and that added nearly $1 trillion to the balance sheet every year. And with tapering now it is going to reduce the pace of that increase. So, it is not a tightening it just reducing the pace of additional accommodation. The additional accommodation is likely to wind down by the fourth quarter of this year and then depending on economic conditions, around six to nine months after that, the Fed might actually begin the process of tightening. But this is sort of a very gentle lengthy process. This is not a sudden shift of policy.

The interview originally appeared in the Forbes India magazine dated Jun 27, 2014

 

Why no one is afraid of tapering any more

 yellen_janet_040512_8x10Vivek Kaul  
The only economic theory that works all the time is that no economic theory works all the time.
Since May 2013, analysts, economists and journalists have fettered over what will happen once the Federal Reserve of the United States, the American central bank, starts to taper.
The Federal Reserve had been printing $85 billion every month to buy bonds. By buying bonds, the Federal Reserve pumped money into the financial system. This was done so as to ensure that there was enough money going around in the financial system leading to low long term interest rates.
Since December 2013, the Federal Reserve has been cutting down on the amount of money that it has been printing to buy bonds. This cut down in the total amount of bonds being bought by the Federal Reserve by printing money, is referred to as tapering.
In a statement released yesterday (i.e. March 19, 2014) the Federal Open Market Committee (FOMC) said that henceforth it would buy bonds worth only $55 billion, every month. At the current pace it is expected that the Federal Reserve will stop printing money to buy bonds by October 2014.
When Ben Bernanke, who was the Chairman of the Federal Reserve till February 3, 2014, had first suggested tapering in May 2013, it spooked financial markets all over the world very badly. Institutional investors had borrowed money at low interest rates prevailing in the United States and invested that money in financial markets all over the world.
This trade referred to as the dollar carry trade wouldn’t be viable any more, if the Federal Reserve started to taper. Tapering would ensure that the amount of money floating around in the financial system would come down and hence, interest rates would start to go up.
And once interest rates started to go up, the dollar carry trade wouldn’t work, that was the fear among institutional investors. This would lead to them selling out of financial markets all over the world and taking their money back to the United States.
In the Indian context it would have meant the foreign institutional investors exiting both the Indian stock and bond market. As they would have converted their rupees into dollars, there would have been pressure on the rupee, and the currency would have depreciated against the dollar.
In fact, between the end of May 2013, when Bernanke suggested tapering for the first time, and August 2013, the rupee fell from 55.5 to a dollar to close to 69 to a dollar. A lot of money was withdrawn from the Indian bond market by foreign institutional investors. Also, between June and August September 2013, the foreign institutional investors sold out stocks worth Rs 19,310.36 crore from the Indian stock market.
But after yesterday’s decision by the FOMC to cut down on bond purchases by $10 billion to $55 billion, the financial markets around the world have barely reacted.
The S&P 500, one of the premier stock market indices in the United States, fell by around 0.61% yesterday. Closer to home, the BSE Sensex, has barely reacted. As I write this it has fallen by around 28 points from yesterday’s closing level and is currently quoting at 21,804.8 points.
So, what has changed between May 2013 and March 2014? Since December 2012, the Federal Reserve had been following the Evans rule (named after Charles Evans, who is the president of the Federal Reserve Bank of Chicago). As per this rule, the Federal Reserve will keep interest rates low till the rate of unemployment fell below 6.5% or the rate of inflation went above 2.5%.
The rate of unemployment in the United States has been falling for a while and currently stands at 6.7%, very close to the 6.5% mandated by the Evans rule. The trouble here is that the unemployment number has not been falling because more people are finding jobs. It has simply been falling because more people have been dropping out of the workforce. The unemployment rate does not take into account people who have dropped out of the workforce. It only takes into account people who are still in the workforce and are not able to find jobs.
In December 2013, nearly 3,47,000 workers left the labour force because they could not find jobs, and hence, were no longer counted as unemployed. This took the number of Americans not working to a record 102 million. As Peter Ferrara puts it on Forbes.com“In fact, all of the decline in the U3 headline unemployment rate since President Obama entered office has been due to workers leaving the work force, and therefore no longer counted as unemployed, rather than to new jobs created…Those 102 million Americans are the human face of an employment-population ratio stuck at a pitiful 58.6%. In fact, more than 100 million Americans were not working in Obama’s workers’ paradise for all of 2013 and 2012.” Interestingly, the labour force participation rate, which is a measure of the proportion of working age population in the labour force, has slipped to 62.8%. This is the lowest since February 1978.
In it’s latest policy statement issued yesterday, the Federal Reserve seems to have junked the Evans rule. As the statement said “In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.” Federal funds rate is the interest rate that banks charge each other to borrow funds overnight, in order to maintain their reserve requirement at the Federal Reserve. This interest rate acts as a benchmark for business and consumer loans.
What this means is that instead of just looking at the rate of unemployment and the rate of inflation, the Federal Reserve will take a look at other factors as well, before deciding to raise the Federal funds rate. What this tells the financial markets all over the world is that the Federal Reserve will continue to ensure low interest rates in the United States, in the time to come, even though it will most likely stop printing money to buy bonds by October 2014.
In fact, in the press conference that followed the FOMC meeting, Janet Yellen, the Chairperson of the Federal Reserve was asked how long did she think would be the gap between the end of bond buying and the Federal Reserve starting to raise interest rates. “It’s hard to define but, you know, probably means something on the order of around six months,” replied Yellen.
This spooked the financial markets briefly because it meant that the Federal Reserve would start raising interest rates by around April next year. But Yellen quickly clarified that any decision to raise interest rates would depend “on what conditions are like”.
So what this means is that the Federal Reserve will ensure that interest rates in the United States continue to stay low. Hence, the dollar carry trade will continue, much to the relief of global institutional investors.
Peter Schiff the Chief Executive of Euro Pacific Capital explained the situation best when he said “The Fed will keep manufacturing excuses as to why rates can’t be raised. Whether it’s a cold winter or a hot summer, a geopolitical crisis, or an unexpected sell-off in stocks or real estate, the Fed will always find a convenient excuse to postpone tightening. That’s because it has built an economy completely dependent on zero percent interest rates. Even the smallest rate shock could be enough to push us into recession. The Fed knows that, and it is hoping to keep the ugly truth hidden.”
To cut a long story short, the easy money party will continue.
The article originally appeared on www.FirstBiz.com on March 20, 2014, with a different headline
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why the Federal Reserve will be back to full money printing soon

helicash Vivek Kaul 
The Federal Reserve of United States led by Chairman Ben Bernanke has decided to start tapering or go slow on its money printing operations in the days to come.
Currently the Fed prints $85 billion every month. Of this $40 billion are used to buy mortgage backed securities and $45 billion are used to buy American government bonds. Come January and the Fed will ‘taper’ these purchases by $5 billion each. It will buy mortgage backed securities worth $35 billion and $40 billion worth American government bonds, every month. The American central bank hopes to end money printing to buy bonds by sometime late next year.
The Federal Reserve started its third round of money printing(technically referred to as Quantitative Easing(QE)- 3) in September 2012. The idea, as before, was to print money and pump it into the financial system, by buying bonds. This would ensure that there would be enough money going around in the financial system, thus keeping interest rates low and encouraging people to borrow and spend money.
This spending would help businesses and in turn lead to economic growth. With businesses doing well, they would recruit more and thus the job market would improve. Higher spending would also hopefully lead to some inflation. And some inflation would ensure that people buy things now rather than postpone their consumption.
Unlike the previous rounds of money printing, the Federal Reserve had kept QE 3 more open ended. As the Federal Open Market Comittee(FOMC) of the Fed had said in a statement issued on September 13, 2012 “ If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”
Now what did this mean in simple English? Neil Irwin translates the above statement in The Alchemists – Inside the Secret World of Central Bankers “We’ll keep pushing money into the system until the job market really starts to improve or inflation starts to become a problem. And we will act on whatever scale we need until we achieve that goal. We’re not going to take the foot off the gas, that is, until some time after the car has reached cruising speed. Markets had been eagerly speculating about the possibility of QE3. Instead, they got something bigger: QE infinity.”
In a statement issued on December 13, 2012, it further clarified that it was targeting an unemployment level of 6.5%, in a period of one to two years. And the hint was that once the level is achieved, the Federal Reserve would start going slow on money printing.
The unemployment rate for November 2013 came in at 7% as employers added nearly 203,000 workers during the course of the month. This is the lowest the unemployment level has been for a while, after achieving a high of 10% in October 2009. The Federal Reserve’s forecast for 2014 is that the rate of unemployment would be anywhere between 6.3 to 6.6%. Given this, it was about time that the Federal Reserve started to go slow on money printing.
History has shown us that continued money printing over a period of time inevitably leads to high inflation and the destruction of the financial system. Hence, going slow on money printing “seems” like a sensible thing to do. But there are several twists in the tail.
The unemployment rate of 7% in November 2013, does not take into account Americans who have dropped out of the workforce, because they could not find a job for a substantial period of time. It also does not take into account people who are working part time even though they have the education and experience to work full time.
Once these factors are taken into account the rate of unemployment shoots up to 13.2%. The labour participation ratio has been shrinking since the start of the finanical crisis. In 2007, 66% of Americans had a job or were looking for one. The number has since shrunk to around 63%. To cut a long story short, all is not well on the employment front.
What about inflation? The measure of inflation that the Federal Reserve likes to look at is the core personal consumption expenditure (CPE). The CPE has been constantly falling since the beginning of 2013. At the beginning of the year it stood at 2%. Since then the number has constantly been falling and for October 2013 stood at 1.11%, having fallen from 1.22% a month earlier. This is well below the Federal Reserve’s target level of 2%. In 2014, the Federal Reserve expects this to be around 1.4-1.6%. And only in 2015 does the Fed expect it touch the target of 2%.
The point is that the Federal Reserve hasn’t been able to create inflation even after all the money that it has printed over the last few years, to keep interest rates low. A possible explanation for this could be the fact that the disposable income has been falling leading to a section of people spending less, and hence, lower inflation. As Gary Dorsch, editor of Global Money Trends newsletter points out in his latest newsletter “For Middle America, real disposable income has declined. The Median household income fell to $51,404 in Feb ‘13, or -5.6% lower than in June ‘09, the month the recovery technically began. The average income of the poorest 20% of households fell -8% to levels last seen in the Reagan era.”
Given this, instead of the inflation going up, it has been falling. The benign inflation might very well be on its way to become a dangerous deflation, feels CLSA strategist Russell Napier.
Deflation is the opposite of inflation, a scenario where prices of goods and services start to fall. And since prices are falling, people postpone their consumption in the hope of getting a better deal at a lower price. This has a huge impact on businesses and hence, the broader economy, with economic growth slowing down.
Deflation also kills stock markets. As Napier wrote in a recent note “Inflation has fallen to 1.1% in the USA and 0.7% in the Eurozone and we are now perilously close to deflation…Investors are cheering the direct impact of QE on their equity valuations, but ignoring its failure to produce sufficient nominal-GDP growth to reduce debt…When US inflation fell below 1% in 1998, 2001-02 and 2008-09, equity investors saw major losses. If a similar deflation shock hits us now, those losses will be exacerbated, since the available monetary responses are much more limited than they were in the past…We are on the eve of a deflationary shock which will likely reduce equity valuations from very high to very low levels.”
Albert Edwards of Societe Generale in a research note dated December 11, 2013, provides further information on why all is not well with the US economy. As he writes “So far, S&P 500 companies have issued negative guidance 103 times and positive guidance only 9 times. The resulting 11.4 negative to positive guidance ratio is the most negative on record by a wide margin. The highest N/P ratio prior to this quarter was Q1 2001, at 6.8…The margin cycle is turning down, profit forecasts over the next few weeks will be eviscerated. To me, this is consistent with recession.”
What these numbers tell us is that all is not well with the American economy. Over the last few years it has become very clear that the only tool that central banks have had to tackle low growth is to print more money.
Given this, it is more than likely that the Federal Reserve will go back to printing as much as it is currently doing or even more, in the days to come. The FOMC has kept this option open. As it said in a statement “However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchase.”
In simple English, what this means is that if the need be we will go back to doing what we were. As The Economist magazine puts it “It is entirely possible that the tapering decision will prove premature. The Fed terminated two previous rounds of QE, only to restart them when the economy faltered and deflation fears flared. The FOMC’s forecasts have repeatedly proved too optimistic. Two years ago it thought GDP would grow 3.2% in 2013; a year ago, that had dropped to 2.6%, and it now looks to come in around 2.2%..”
We haven’t seen the end of the era of easy money as yet. There is more to come.
The article originally appeared on www.firstpost.com on December 19, 2013.
(Vivek Kaul is a writer. He tweets @kaul_vivek)