Why Federal Reserve ‘really’ wants to go slow on money printing

ben bernankeVivek 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) 
 

Not instant coffee

ARTS RAJAN
Vivek Kaul
 
Raghuram Govind Rajan will take over as the governor of the Reserve Bank of India(RBI) on September 4, 2013. There are great expectations from him to turnaround the faltering Indian economy. His appointment has been welcomed by the media, business leaders as well as politicians. It is one of those rare occasions where almost everyone seems to be happy about the appointment.
But will Rajan be able to deliver? Will he able to control inflation, stop the rupee from falling further against the dollar and at same time engineer economic growth, as he is expected to. Or to ask a more pointed question, can any central banker really make a huge difference?
Before I get around to answering that question, let me deviate a little.
Inflation targeting has been a favourite policy of central banks all over the world. This strategy essentially involves a central bank estimating and projecting an inflation target and then using interest rates and other monetary tools to steer the economy towards the projected inflation target.
But recent analysis suggests that inflation targeting might have been one of the major reasons behind the current financial crisis. 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.”
He gives the example of United Kingdom to make his point. “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.”
In simple English what this basically means is that the Bank of England, the British central bank, kept interest rates too low for a very long time, so that people borrowed and spent money. This was done in the hope that prices would rise and the inflation target would thus be met.
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.”
The Western central banks were focussed on just maintaining the inflation target that they had set. In fact, the ‘inflation only’ focus was a result of how economic theory had evolved over the years. As Felix Martin writes in the fascinating book Money – The Unauthorised Biography “The sole monetary ill that had been permitted into the New Keynesian theory was high or volatile inflation, which was deemed to retard the growth of GDP. The appropriate policy objective, therefore, was low and stable inflation, or ‘monetary stability’…On such grounds, the Bank of England was granted its independence and given a mandate to target inflation in 1997, and the European Central Bank was founded as an independent, inflation-targeting central bank in 1998.”
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 Martin writes “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.”
And this ‘lack of focus’ led to a big real estate bubbles in large parts of the Western world, which was followed by biggest ‘macroeconomic’ crash in history.
Since then, central banks around the world have tried to concentrate on factors other than inflation as well. But it is not easy for a central bank, if I might use that phrase, to be all over the place.
Raghuram Rajan understands this very well. As he wrote in a 2008 article (along with Eswar Prasad) “The RBI already has a medium-term inflation objective of 5 per cent…But the central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act.”
Focus on multiple things makes the RBI run the risk of not doing any of them well. “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well,” wrote Rajan and Prasad.
Hence it made sense for the RBI to concentrate on one thing instead of being all over the place. As Rajan wrote in the 2008 Report of the Committeeon Financial Sector Reforms “ The RBI can best serve the cause of growth by focusing on controlling inflation, and intervening in currency markets only to limit excessive volatility. This focus can also best serve the cause of inclusion because the poorer sections are least hedged against inflation.”
Rajan might have revised his beliefs in the last five years. But as we have seen over the period, the strategy of central banks being all over the place hasn’t really worked either. Given this, we shouldn’t have very high expectations from what Rajan will be able to do as the governor of the RBI, even though he maybe the best man for the job.
To conclude, it is worth remembering what Sunil Gavaskar said in 1994, after he was appointed the manager of a floundering Indian cricket team. “Results can’t be produced overnight. I’m not instant coffee,” said the cricket legend.
Rajan probably realises this more than anyone else. As he wrote recently in his globally syndicated column “The bottom line is that if there is one myth that recent developments have exploded it is probably the one that sees central bankers as technocrats, hovering independently over the politics and ideologies of their time. Their feet, too, have touched the ground.” 

 
This article originally appeared in the Wealth Insight Magazine for September 2013
 
(Vivek Kaul is the author of the soon to be published Easy Money. He tweets @kaul_vivek)
 
 
 

Yesterday, once more! Western central banks are fuelling real estate bubbles again

bubble


Vivek Kaul
 

A major reason behind the financial crisis that started in late 2008 was the fact that the Western countries had built many more homes than were required to house their populations. Once the home prices started crashing what followed was an economic catastrophe from which the world is still trying to come out.
Ironically the solution that central banks came up with for mitigating the negative effects of the financial crisis was to get home prices up and running again. This was done by printing money and pumping it into the financial system and ensure that the interest rates remain at very low levels. The hope was that at low interest rates people will borrow money and buy homes. 
Initially people stayed away but gradually they seem to be getting back to borrowing and home prices in Western countries are up and running again. 
As Albert Edwards of Societe Generale writes in a report titled 
If UK Chancellor George Osborne is a moron, Fitch’s Charlene Chu is a heroine “Young people today haven’t got a chance of buying a house at a reasonable price, even with rock bottom interest rates. The Nationwide Building Society data shows that the average first time buyer in London is paying over 50% of their take home pay in mortgage payments – and that is when interest rates are close to zero!…The OECD has recently identified UK house prices as between 20-30% too high (depending on whether you compare prices with rents or incomes – link). To be sure the UK is nowhere near the most expensive, with some of the usual suspects such as Canada, Australia and New Zealand even worse.”
Home prices in the United States have also been rising steadily since the beginning of 2012. The S&P Case-Shiller 20-City Home Price Index has risen by 13.4% since the beginning of 2012. Even with this price rise, home prices in the United States are still 25% lower than the peak they achieved in April 2006. 
Real estate prices in Western countries should not be rising at such high rates. They have huge amounts of land to build all the homes that they need. Hence, real estate prices in a country like America, which is not really short of land have rarely risen at a very fast pace. Housing prices in America had remained flat for a large part of the 20th century. Prices rose on an average at the rate of 0.4% per year (adjusted for inflation) for the period between 1890 and 2004. In fact in many parts of the country the pries had actually gone down.
For smaller countries like the United Kingdom land may be an issue, but the population density is not very high. The United Kingdom has around 255 people living per square kilometre. In comparison, Japan has 337 people living per square kilometre and India has 367. So there is enough land going around given the population. 
But more than these reasons the biggest reason why home prices should not be rising at the rates that they are is simply because the home ownership rates in these countries are very high. In June 2004, at the peak of the real estate boom, 69.2% of US households owned their own homes, up from 64% in 1995. Home ownership in the United Kingdom peaked in 2001 at 69%. Since then home ownership rates have fallen. In the United States, it has fallen to around 65%. In the United Kingdom it is at 64%. 
Even with the falling home ownership rates a major part of the population in these countries owns the homes that they stay in. The falling home ownership rate in the aftermath of the financial crisis only means one thing and that is that there were many more homes built than required. And a lot of homes were bought not to live in, but for speculation. 
The governments and central banks are now trying to get the speculation going again. In the United States this is important because home equity loans were responsible for a lot of consumption. Home equity is the difference between the market price of a house and the home loan outstanding on it. Banks give a loan on this home equity. 
Charles R Morris writing in 
The Trillion Dollar Meltdown: Easy Money, High Rollers, And the Great Credit Crash explains this phenomenon: “Consumer spending jumped from a 1990s average of about 67% of GDP to 72% of GDP in early 2007. As Martin Feldstein, a former chairman of the Council of Economic Advisers, has pointed out, that increase was financed primarily by the withdrawal of $9 trillion in home equity.”
Feldstein’s study was carried out for the period between 1997 and 2006. A study carried out by Alan Greenspan estimated that in the 2000s, home equity withdrawals financed 3% of all personal consumption. But this was a low estimate. Home equity supplied more than 6% of the disposable personal income of Americans between 2000-2007, another study pointed out. In fact, by the first quarter of 2006, home equity extraction made up for nearly 10% of disposable personal income of Americans. 
And all this consumption in turn created economic growth. If home prices keep going up, more home equity will be created and people can borrow against that. Also as home prices go up, people feel wealthier and tend to spend more, which helps economic growth. 
Governments are trying to encourage banks to give out loans so that people can buy homes. George Osborne, the British chancellor of the exchequer (the Indian equivalent of the finance minister) has come up with a “help to buy” scheme. In this the government will guarantee up to 20% of the home loan to encourage lending to borrowers with small savings. As Edwards writes “This means that if a borrower defaults on a loan, the taxpayer will be liable for a proportion of the losses.”
Criticism for this scheme has come in from various fronts. Andrew Bridgen, senior economist for Fathom Consulting, a forecasting firm run by former Bank of England economists, said: “Help to Buy is a reckless scheme that uses public money to incentivise the banks to lend precisely to those individuals who should not be offered credit. Had we been asked to design a policy that would guarantee maximum damage to the UK’s long-term growth prospects and its fragile credit rating, this would be it.” (As Edwards quotes in his report)
This is precisely what happened in the United States as well in the run up to the financial crisis, wher
e the government nudged banks and other financial institutions to lend to people who were in no position to repay the loan.
Central banks can afford to keep interest rates low primarily because of the policy of inflation targeting that they follow. There mandate is to maintain the rate of inflation at a certain rate and do everything required for that. Increasing real estate prices do not get captured in the rate of consumer price inflation, which central banks tend to use for inflation targeting. 
In fact inflation targeting was one of the reasons behind the global real estate bubble of the 2000s. As Stephen D King writes in 
When Money Runs Out – The End of Western Affluence “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…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.” 
The same thing seems to be happening right now. With inflation rates too low the central banks have been maintaining low interest rates, so that people consume more and that in turn hopefully creates some inflation. But that in turn means doing the same things that led to the financial crisis. 
Governments and central banks pushing up real estate prices does help in the short term and translates into some sort of economic growth. But it does have serious long term repercussions as we have seen over the last few years. As Edwards writes “What makes me genuinely 
really angry is that burdening our children with more debt (on top of their student loans) to buy ridiculously expensive houses is seen as a solution to the problem of excessively expensive housing…First time buyers need cheaper homes not greater availably of debt to inflate house prices even further. This is madness.”
To conclude, let me quote economist Robert J Shiller from 
The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It “The idea that public policy should be aimed at…preventing a collapse in home prices from ever happening, is an error of the first magnitude. In the short run a sudden drop in home prices may indeed disrupt the economy, producing undesirable systemic effects. But, in the long run, the home-price drops are clearly a good thing.” 

The article originally appeared on www.firstpost.com on July 10, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)