Vivek Kaul
Raghuram Rajan before he became the governor of the Reserve Bank of India, wrote a book called Fault Lines. This was one of the first books that offered reasons for the financial crisis and that went beyond the greed of Wall Street.
One of the reasons that Rajan discussed in great detail was income inequality. He argued that this was one of the major reasons behind the financial crisis.
The top 1% of the households accounted for only 7.9% of total American wealth in 1976. This would grow to 23.5% of the income by 2007. This was because the incomes of those in the top echelons was growing at a much faster rate.
The rate of growth of income for the period for those in the top 1% was at 4.4% per year. The remaining 99% grew at 0.6% per year. What is even more interesting is the fact that the difference is even more pronounced in the 1990s and the first decade of the twenty first century.
The incomes of those in the top echelons grew at a much faster rate since the 1990s. Between 1993 and 2000, when the dotcom bull run happened and when Bill Clinton was the President of the United States, the income of the top 1% grew at the rate of 10.3% per year, and for the remaining 99%, it grew at 2.7% per year.
Between 2002 and 2007, when George Bush Jr was the President, the income for the top 1% grew at the rate of 10.1% per year. For the remaining it grew at a minuscule 1.3% per year. In fact, the wealthiest 0.1% of the population accounted for 2.6% of American wealth in 1976. This had gone up to 12.3% in 2007.
But it was not only the CEOs and the super rich who were getting richer. Even those below them were doing quite well for themselves. In 1976, the top 10% of households earned around 33% of the national income, by 2007 this had reached 50% of the national income.
In fact in 1992, before the dotcom bull run started, the top 10% earned around 41% of the national income, by the time it ended, the number was at 47% of the national income. When George Bush took over as President the number was at 45% and by the end of his term in early 2008, it had galloped to 50%.
The rich were getting richer in America. One reason for this was the fact that those at the upper echelons of organisations were making more money than ever before. At a more basic level there was also a huge increase in “college premium”. This meant that people who had a college degree earned much more than those who had stopped studying at the high school level.
The advent of technology had made a lot of low level jobs redundant. Earlier secretaries used to be required to type letters and responses, or to communicate within the various offices and branches of the firm. With the advent of computers and internet, people did their own typing. And that in turn meant lower pays at lower levels.
The solution to this increasing inequality of income to some extent was more and better education. But that is something that would take serious implementation and at the same time results wouldn’t have come overnight. They would take time.
Hence, the American politicians looked elsewhere to deal with this increasing inequality. There solution was to ensure that loans were easily available to people. Rajan explains this in Fault Lines. As he writes “Politicians have therefore looked for other ways to improve the lives of their voters. Since the early 1980s, the most seductive answer has been easier credit. In some ways, it is the path of least resistance…Politicians love to have banks expand housing credit, for all credit achieves many goals at the same time. It pushes up house prices, making households feel wealthier, and allows them to finance more consumption. It creates more profits and jobs in the financial sector as well as in real estate brokerage and housing construction. And everything is safe – as safe as houses – at least for a while.”
This availability of easy money led to a big real estate bubble, which finally morphed itself into the global financial crisis which has been on since late 2008. In the aftermath of the crisis economic growth slowed down. Central banks around the world, led by the Federal Reserve of United States, the American central bank, started to print money.
The idea was to flood the system with money, keep interest rates low and encourage people to borrow, to get the economy up and running again. But that did not happen or at least did not happen at the pace that central banks expected it to.
Low interest rates led to financial firms borrowing and investing money all over the world driving up various financial markets to all time high levels, including the American stock markets. As Gary Dorsch, an investment newsletter, writes in his latest newsletter dated December 4, 2013, “The US-stock market rally is now 57-months old, and over this time period, the S&P-500 index has climbed a “wall of worry,” rising +170% from its March 9th, 2009 low, and hitting an all-time high, above the 1,800-level.”
The idea was that once the stock market started to go up, the wealth effect would come into play i.e. people would feel rich and they would go shop. But as it turned out, the retail investors have stayed away from the market for a large part of the last four and half years and have only now started to come back to the market. As Dorsch puts it “But only this year, did it begin to earn the grudging respect of smaller retail investors. They’ve plowed $175-billion into equity funds so far this year, after withdrawing $750-billion in the previous six years.”
Meanwhile the rich got richer. As Dorsch wrote in a newsletter dated October 3, 2013, “Over the past 1-½ years, the Fed has increased the…money supply by +10% to an all-time high of $12-trillion. In turn, traders have bid-up the combined value of NYSE and Nasdaq listed stocks to a record $22-trillion. That’s great news for the Richest-10% of Americans that own 80% of the shares on the stock exchanges.”
He also adds in his latest newsletter that “US-equity values have increased $14-trillion over the past 57-months. Across the Fortune-500 companies, the average chief executives pockets 204-times as much as that of their rank-and-file workers, that’s disparity is up +20% since 2009. Perversely, the compensation of the S&P-500 chieftains is often linked to the ruthless slashing of jobs and wages in order to increase the companies’ profitability. In theory, that boosts stock prices, and CEO’s collect about 90% of their compensation through the exercise of stock options.”
And this has meant that the rich have got richer, while the average income of the middle class and the poor has been falling, as jobs are being slashed. “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,” writes Dorsch.
Due to this nearly more than 100 million Americans are receiving one or another form of welfare from the government. “According to the latest data from the Census Bureau, the US has already passed the tipping point and is officially a welfare society. Today, more Americans are receiving some form of means tested welfare than those that have full-time jobs. No, that’s not a misprint. At the end of 2011, the last year for which data are available, some 108.6-million Americans received one or more form of welfare. Meanwhile, there were just 101.7-million people with full-time jobs, including both the private and government sectors.The danger is the US has already developed a culture of dependency. No one votes to cut his own welfare benefits,” writes Dorsch.
And this is clearly not a healthy sign. The irony is that the American politicians helped by the Federal Reserve created a real estate bubble to address income inequality. Once that bubble blew up, they started printing money. And that in turn has led to more inequality. The solution has aggravated the problem.
The article originally appeared on www.firstpost.com on December 6, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Money printing
Five years later: It's time Western countries stopped printing money
Vivek Kaul
It was around this time in 2008, that the Federal Reserve of United States, the American central bank, started printing money to buy bonds. This process came to be referred as quantitative easing(QE) and gradually spread to other central banks in the Western world.
When the process was first initiated many writers (including yours truly) said that high inflation was on its way in the United States. Comparisons were made to Zimbabwe which was facing hyperinflation at that point of time.
In July 2008, a few months before the financial crisis broke out, the British newspaper Guardian reported that ordinary hen’s eggs were selling at $50billion each. These were not American dollars, but dollars issued by the Reserve Bank of Zimbabwe. Between August 2007 and June 2008, the money supply in Zimbabwe had gone up 20 million times.
With the money supply increasing by such a huge amount, inflation went through the roof. In early 2008, consumer price inflation was said to be at 2 million percent. By the end of the year it had reached around 230 million percent.
The feeling was that United States was headed towards something similar, though not of a similar proportion. Five years on, people who felt that way, continue to be proven wrong. Inflation levels in the United States and much of the Western world continue to remain very low. The consumer price inflation in the United States was at 1% in October 2013. This is the lowest it has been at since October 2009.
So the question is why is there has been no inflation? As Niels C Jensen writes in The Absolute Return Letter dated November 7, 2013 “The reality is that we have seen plenty of inflation already from QE – just not in the places nearly everyone expected it to show up. Asset price inflation is also inflation, and we have had asset price inflation galore. Many emerging economies have struggled with consumer price inflation in recent times. It looks as if we have been very good at exporting it.”
Countries printed money with the intention of ensuring that there would be enough money going around in the financial system and this would lead to low interest rates.
At lower interest rates people would borrow and spend more, and this in turn would revive economic growth, which had dried up in the aftermath of the financial crisis, which broke out in September 2008, after investment bank Lehman Brothers went bust.
But people had other ideas. They had borrowed and speculated in the real estate market between 2002 and 2008. Once the real estate bubble burst, they were left hanging onto homes, with considerably lower market values. The loans that people had taken still needed to be repaid. Hence, they wanted to repair their individual balance sheets and did not want to take on any more loans. They were more interested in repaying their outstanding loans.
In this scenario, there was little demand for loans from individuals. Financial firms cashed in on this by borrowing money at close to 0% interest rates and investing it in financial and other markets all over the world. And this has led to what economists call asset price inflation, where stock markets and other markets, are at very high levels, even though the underlying fundamentals don’t justify that. The trouble is when these bubbles burst they will create their own set of problems.
There is another reason behind why people are not borrowing even though interest rates are at very low levels. Jensen calls this the impact of the rational expectations hypothesis. As he writes “economic agents (read: consumers and businesses) make rational decisions based on their expectations. So, when the Fed – and other central banks with it – keep ramming home the same message over and over again (and I paraphrase): “Folks, we will keep interest rates low for some considerable time to come”, consumers and businesses only behave rationally when they postpone consumption and investment decisions. They have seen with their own eyes that central bankers have been able to talk interest rates down, so why borrow today if one can borrow more cheaply tomorrow?”
So the longer people postpone their borrowing, the longer government and central banks will have to keep printing money in order to keep interest rates low, in order to entice them to borrow.
In fact, interest rates are so low that banks are also not in the mood to lend. They would rather use the money that they have in proprietary trading activities. This explains to a large extent why financial firms have been borrowing and investing money in financial markets all over the world. While, money printing hasn’t exactly led to what central banks thought it would lead to, it has benefited governments tremendously. This is primarily because money printing has ensured that interest rates continue to remain at low levels and has allowed governments to borrow easily at ridiculously low interest rates.
As William White writes in a research paper titled Ultra Easy Monetary Policy and the Law of Unintended Consequences “Indeed, long term sovereign rates in the US, Germany, Japan and the UK followed policy rates down and are now at unprecedented low levels. However, there can be no guarantee that this state of affairs will continue. One disquieting fact is that these long rates have been trending down, in both nominal and real terms, for almost a decade…Many commentators have thus raised the possibility of a bond market bubble that will inevitably burst.”
This has led to government debts exploding. “Italy’s government debt has jumped from 121% to 132% of GDP over the past two years alone. Spain’s debt-to-GDP has gone from 70% to 94% and Portugal from 108% to 124% over the same period. An interesting brand of austerity I might add! Expanding the government deficits at such speed would have been devastatingly expensive in the current environment without QE,” writes Jensen.
Money printing has been bad for old people. The corpus they had saved for their retirement has hardly been able to generate an income that is good enough to live on. This has impacted people in the United States as well as Europe.
Also, a new stream of research coming out seems to suggest that money printing has an impact on income growth and in turn economic growth. “Charles Gave of GaveKal Research produced a very interesting paper earlier this year, linking the low income growth to QE – another nail in the coffin for economic growth. Charles found that during periods of negative real interest rates (which is a direct follow-on effect from QE), income growth in the U.S. has been low or negative,” writes Jensen.
This is primarily because when interest rates have been low for a very long period of time and are expected to be low for the years to come, there is very little incentive for the private sector to either hire new workers or increase capital spending. And when this happens income growth is more than likely to stagnate. This has an impact on consumer demand, which in turn influences economic growth.
John Mauldin captured this idea beautifully in a recent column where he wrote “The belief is that it is demand that is the issue and that lower rates will stimulate increased demand (consumption), presumably by making loans cheaper for businesses and consumers. More leverage is needed! But current policy apparently fails to grasp that the problem is not the lack of consumption: it is the lack of income.”
Once these factors are taken into account it is easy to suggest that it is time that the Western central banks and governments wound up their money printing plans. It is time for quantitative easing to come to an end. As Jensen puts it “It is time to call it quits. QE proved to be a very effective crisis management tool, but we have probably reached a point where the use can no longer be justified on economic grounds. The obvious problem facing policy makers, though, is that if financial markets are the patient, QE is the drug that keeps the underlying symptoms under control.”
Financial firms have been able to borrow money at close to 0% interest rates and invest it in financial markets all over the world. This is because quantitative easing or money printing has managed to keep interest rates at very low levels. Once money printing is stopped or even slowed, interest rates will start to rise. This will mean that asset bubbles all over the world will start to burst, which will create its own set of problems.
And that is the real problem. The question is who will blink first? The central banks or the financial markets?
The article originally appeared on www.firstpost.comon November 27, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
With the Fed balance sheet at $4 trillion, Indian markets have become ‘more’ bubbly
Vivek Kaul
The Federal Reserve of the United States, the American central bank, has been rapidly expanding its balance sheet since late 2008. As on November 13, 2013, the size of the Fed’s balance sheet was at $3.907 trillion.
Now compare this to the size of the Fed’s balance sheet as on September 10, 2008, when it stood at around $940 billion. The investment bank Lehman Brothers went bust as on September 15, 2008, which led to the start of the current financial crisis.
Since late 2008, the Federal Reserve has been printing dollars. It has been pumping these dollars into the financial system by buying financial securities like American government bonds and mortgage backed securities. Currently, the Fed buys $85 billion worth of financial securities every month.
The securities that the Federal Reserve buys are reflected as assets on its balance sheet. Hence, the balance sheet of the Federal Reserve has increased in size by a whopping 316% in a little over five years. In fact, the balance sheet of the Federal Reserve should touch the size of $4 trillion sometime next month, given that it continues to print dollars and buy financial securities worth $85 billion every month.
At $4 trillion, the Federal Reserve’s balance sheet will be nearly 25.5% of the US gross domestic product of $15.68 trillion in 2012. In fact, if the Federal Reserve continues to print money at the rate it is currently, its balance sheet will cross $5 trillion in a year’s time. These are fairly big numbers that we are talking about.
The idea behind printing money was to ensure that there was enough money going around in the financial system and hence, the interest rates continued to stay low. At low interest rates people were more likely to borrow and spend, and this would help revive business growth and in turn economic growth.
But that hasn’t turned out to be the case and economic growth continues to remain low in United States and much of the Western world. Also, the prevailing belief seems to be that demand can be created by keeping interest rates low for a long period of time.
As investment newsletter writer and hedge fund manager John Mauldin writes in his latest report The Unintended Consequences of ZIRP released on November 16, 2013 “The belief is that it is demand that is the issue and that lower rates will stimulate increased demand (consumption), presumably by making loans cheaper for businesses and consumers. More leverage is needed! Butcurrent policy apparently fails to grasp that the problem is not the lack of consumption: it is thelack of income.”
People borrow and spend money when they feel confident about the future. Right now, they just don’t. A major reason for this is the fact that United States and large parts of Europe are in the midst of what Japanese economist Richard Koo calls a balance sheet recession.
In a balance sheet recession a large portion of the private sector, which includes both individuals and businesses minimise their debt. When a bubble that has been financed by raising more and more debt collapses, the asset prices collapse but the liabilities do not change.
In the American context what this means is that people had taken on huge loans to buy homes in the hope that prices would continue to go up for perpetuity. But that was not to be. Once the bubble burst, the housing prices crashed.
This meant that the asset (i.e. homes) that people had bought by taking on loans, lost value, but the value of the loans continued to remain the same. Hence, people needed to repair their individual balance sheets by increasing savings and paying down debt. This act of deleveraging or reducing debt has brought down aggregate demand and has thrown the economy in a balance sheet recession.
Koo feels this is what has been happening in the United States where people have been paying down their debts, by increasing their savings. In mid 2005, when the housing bubble was at its peak, an average American was saving around 2% of his or her personal disposable income. This has since jumped to nearly 5%. In this scenario, it is unlikely that many people would want to borrow more, even if interest rates continue to remain low.
Individuals may not be borrowing as much as the American government expected them to, institutional investors have more than made up for it. Borrowing dollars at close to zero percent interest rates, they have invested money in financial markets all over the world. The Dow Jones Industrial Average, America’s premier stock market index, crossed a level of 16,000 points for the first time yesterday. The BSE Sensex also continues to trade close to 21,000 points, despite the Indian economy being in a bad shape.
Since the beginning of this year, the foreign institutional investors have invested Rs 71, 308.51 crore, in the Indian stock market. This is a clear impact of the easy money policy being run by the Federal Reserve. During the same period the domestic institutional investors have sold stocks worth Rs 62,573.45 crore. These are clear signs of the stock market being in the midst of a bubble.
The Federal Reserve can keep printing as many dollars as it wants to, given that there is no theoretical limit to it. Also, money printing is not having the kind of impact it was expected to have to create economic growth. At the same time it has led to financial market bubbles all over the world.
As Mauldin puts it “they also know they cannot continue buying $85 billion of assets every month. Their balance sheet is already at $4 trillion and at the current pace will expand by $1 trillion a year. Although I can find no research that establishes a theoretical limit, I do believe the Fed does not want to find that limit by running into a wall. Further, it now appears that they recognize that QE(quantitative easing or the fancy name economists have given to the Federal Reserve printing money) is of limited effectiveness.”
The trouble is that if the Federal Reserve decides to go slow on money printing, there will be a sell off across financial markets all over the world. And that will have fairly negative consequences for the US and large parts of the world.
Also, the Federal Reserve has more or less run out of the tools that it has at its disposal to revive the American economy. As Ray Dalio of Bridgewater pointed out in a recent note. “The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up, in that interest rates are at zero and US asset prices have been driven up to levels that imply very low levels of returns relative to the risk, so there is very little ability to stimulate from here if needed. So the Fedwill either need to accept that outcome, or come up with new ideas to stimulate conditions,” writes Dalio.
The Federal Reserve is in a catch 22 situation right now. Should it continue to print money? Should it go slow? This is a question that Janet Yellen, the Federal Reserve Chairman in waiting, needs to answer.
The article first appeared on www.firstpost.com on November 19, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Why the markets are reading too much into Larry Summers' withdrawal from Fed race
Vivek Kaul
Larry Summers withdrew from the race to become the next Chairman of the Federal Reserve of United States on September 15, 2013. He was believed to be American President Barack Obama’s favourite candidate. (To read why he withdrew from the race click here)
The markets around the world immediately cheered his withdrawal. This happened primarily because Summers was widely seen to be what in central bank speak is termed as a ‘hawk’. A hawk is someone who is likely to raise interest rates and cut down on money supply.
Summers had said in April this year that “QE in my view is less efficacious for the real economy than most people suppose.” QE stands for quantitative easing and refers to the money that the Federal Reserve of United States, the American central bank, has been printing and pumping into the financial system, in the hope of getting the American economy up and running again.
The idea here is that by flooding the financial system with money, the interest rates will continue to remain low, thus encouraging people to borrow and spend more. With people spending more money, businesses will perform better, and the economic growth would come back.
Summers, it is believed, thinks that the government directly spending money through stimulus programmes, would have a greater impact on the economic growth in comparison to the Federal Reserve maintaining low interest rates by printing money and hoping that people borrow and spend more money.
The markets believed that Summers would stop printing money faster than Janet Yellen, the current Vice-Chairwoman of the Federal Reserve, who is now the front runner for the top job at the Federal Reserve.
Currently, the Federal Reserve prints $85 billion every month, which it pumps into the financial system by buying bonds. Ben Bernanke, the current Chairman of the Federal Reserve of United States, has indicated over the last few months that the Federal Reserve will go slow on money printing in the days to come.
This is a big worry for the markets. The idea behind all the money that is being printed has been that at low interest rates people will borrow and spend more money, and thus economic growth will return. But more than that what has happened is that investors have borrowed money available at very low interest rates and invested it in financial and other markets around the world.
This has led to big bubbles in these markets. As economist Bill Bonner writes “Works of art are selling for astronomical prices. High-end palaces and antique cars are setting new records. Is this reckless money hitting the stock market too?” Easy money is showing up in all kinds of places.
If the Federal Reserve goes slow on money printing, interest rates are likely to spike, making it difficult for investors who have enjoyed the benefits of the ‘dollar carry trade’ to continue enjoying it. Summers, the markets had come to believe, was more likely to stop money printing faster than any other candidate. And now that he is out of the race, the era of ‘easy money’ policies is likely to continue for a slightly longer period.
The situation needs a slightly more nuanced reading than this. As Martin Fridson writes on Forbes.com “The main, rather thin basis for portraying Summers as a hawk was a single remark he made in April about the Fed’s quantitative easing (QE) program: “QE in my view is less efficacious for the real economy than most people suppose.” This was not a major, formal policy statement, but a comment within an official summary of Summers’ remarks at a conference.”
Also, the Federal Reserve’s own research has showed as much. More than that even if a economist believes that quantitative easing hasn’t been effective, that doesn’t mean that he also believes that the Federal Reserve should go slow on it.
As Nobel Prize winning economist Paul Krugman writes in a recent column in the New York Times “One answer is the belief that these purchases…are, in the end, not very effective. There’s a fair bit of evidence in support of that belief.” The Federal Reserve puts the money that it prints into the financial system by buying bonds.
Even though, Krugman believes that quantitative easing hasn’t been very effective, he still recommends that it is important to continue with it. “Time for the Fed to take its foot off the gas pedal?” asks Krugman and then goes onto explain why that would not be the right thing to do.
He feels that any suggestion of the Federal Reserve going slow on money printing is going to lead to the long term interest rates in the United States going up. And this can’t be good for the overall American economy, which has just started to show some signs of revival.
Hence, the point here is that even though economists may understand that money printing has not been very effective, at the same time they may not want to go slow on it.
Summers also thinks that government stimulus programmes are likely to be more effective, there was not much that he could do about it. Any extra spending by the American government would mean it would have to borrow more money. This would be a problem given that the government has almost touched its debt limit of $16.7 trillion. As the Reuters reports “The government has been scraping up against its $16.7 trillion debt limit since May but has avoided defaulting on any bills by employing emergency measures to manage its cash, such as suspending investments in pension funds for federal workers.”
And more than that the Republicans don’t seem to be in any mood to let the government increase its spending. As an Associated Press news report points out “What’s more, massive fiscal stimulus is highly unlikely given opposition from congressional Republicans to increased spending.”
Given these reasons it is highly unlikely that Larry Summers would have been able to do anything dramatically different from what the Bernanke led Federal Reserve is currently doing or from what the Yellen led Federal Reserve(which is how it seems like right now) might do in the days to come. As Fridson writes on Forbes.com “My point is rather that the range of policy options will be limited for whoever steps into Ben Bernanke’s shoes. Barack Obama was never going to nominate a Fed chairman who would diverge from the narrow list of realistic choices regarding interest rates.”
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Wall St rules: Why the Fed will continue to print money
Vivek Kaul
Ben Bernanke, the Chairman of the Federal Reserve of United States, the American central bank, announced on June 19, that the Federal Reserve would go slow on money printing in the days to come.
Speaking to the media he said “If the incoming data are broadly consistent with this forecast, the Committee(in reference to the Federal Open Market Committee) currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year…And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”
The Federal Reserve has been printing $85 billion every month and using that money to buy American government bonds and mortgage backed securities. By buying bonds, the Fed has managed to pump the newly printed dollars into the financial system.
The idea was that there would be no shortage of money going around, and as a result interest rates will continue to be low. At low interest rates banks would lend and people would borrow and spend, and that would help in getting economic growth going again.
The trouble is that quantitative easing, as the Federal Reserve’s money printing programme, came to be known as, has turned out to be terribly addictive. And anything that is addictive cannot be so easily withdrawn without negative repercussions.
As Stephen D King writes in When the Money Runs Out “Bringing quantitative easing to an end is hardly straightforward. Imagine, for example, that a central bank decides quantitative easing has become dangerously addictive and indicates to investors not only that programme will be put on hold…but it will come to a decisive end. The likely result is a rise in government bond yields…If, however, the economy is still weak, the rise in bond yields will surely be regarded as a threat to economic recovery.”
This is exactly how things played out before and after Bernanke’s June 19 announcement. With Federal Reserve announcing that it will go slow on money printing in the days to come, investors started selling out on American government bonds.
Interest rates and bond prices are inversely correlated i.e. an increase in interest rates leads to lower bond prices. And given that interest rates are expected to rise with the Federal Reserve going slow on money printing, the bond prices will fall. Hence, investors wanting to protect themselves against losses sold out of these bonds.
When investors sell out on bonds, their prices fall. At the same time the interest that is paid on these bonds by the government continues to remain the same, thus pushing up overall returns for anybody who buys these bonds and stays invested in them till they mature. The returns or yields on the 10 year American treasury bond reached a high of 2.6% on June 25, 2013. A month earlier on May 24, 2013, this return had stood at 2.01%.
An increase in return on government bonds pushes up interest rates on all other loans. This is because lending to the government is deemed to the safest, and hence the return on other loans has to be greater than that. This means a higher interest.
The average interest rate on a 30 year home loan in the United States jumped to 4.46% as on June 27, 2013. It had stood at 3.93% a week earlier.
Higher interest rates can stall the economic recovery process. It’s taken more than four years of money printing by the Federal Reserve to get the American economy up and running again, and a slower growth is something that the Federal Reserve can ill-afford at this point of time. In fact on June 26, 2013, the commerce department of United States, revised the economic growth during the period January-March 2013, to 1.8% from the earlier 2.4%.
These developments led to the Federal Reserve immediately getting into the damage control mode. William C Dudley, president of the Federal Reserve Bank of New York, the most powerful bank among the twelve banks that constitute the Federal Reserve system in United States, said in a speech on June 27, 2013 “Some commentators have interpreted the recent shift in the market-implied path of short-term interest rates as indicating that market participants now expect the first increases in the federal funds rate target to come much earlier than previously thought. Setting aside whether this is the correct interpretation of recent price moves, let me emphasize that such an expectation would be quite out of sync with both FOMC(federal open market committee) statements and the expectations of most FOMC participants.”
What this means in simple English is that the Federal Reserve of United States led by Ben Bernanke, has no immediate plans of going slow on money printing. There will continue to be enough money in the financial system and hence interest rates will continue to be low.
After Dudley’s statement, the return on the 10 year American treasury bond, which acts as a benchmark for interest rates in the United States, fell from 2.6% on June 26, 2013, to around 2.52% as on July 3, 2013. The market did not take remarks made by Dudley (as well as several other Federal Reserve officials) seriously enough. Hence the return on 10 year American treasury bond continues to remain high, leading to higher interest rates on all other kind of loans.
It also implies that the market will not allow the Federal Reserve to go slow on money printing. As King writes “It (i.e. money printing by central banks), is also, unfortunately, highly addictive. If the economy should fail to strengthen, the central bank will be under pressure to deliver more quantitative easing.”
V. Anantha Nageswaran put it aptly in a recent column in the Mint. As he wrote “Financial markets will force the Federal Reserve to delay any attempt to restore monetary conditions to a more normal setting. Further, as and when such attempts get under way, they will be half-hearted and asymmetric as we have seen in the recent past. Since the Federal Reserve has tied the mast of the economic recovery to a recovery in asset prices, any decline in asset prices will unnerve it. Hence, the eventual outcome will be an inflationary bust due to the prevalence of an excessively accommodative monetary policy for an inordinately long period.”
If interest rates do not continue to be low then the recovery in real estate prices, which has been a major reason behind the American economic growth coming back, will be stalled. To ensure that real estate prices continue to go up, the Federal Reserve will have to continue printing money. And this in turn will eventually lead to an inflationary bust.
In fact, Jim Rickards, author of Currency Wars, feels that the Federal Reserve will increase money printing in the days to come. As he recently told www.cnbc.com “They’re not going to taper later this year. They’ll actually going to increase asset purchases because deflation is winning the tug of war between deflation and inflation. Deflation is the Fed’s worst nightmare.” Deflation is the opposite of inflation and refers to a situation where prices are falling.
When prices fall people postpone purchases in the hope of getting a better deal in the future. This has a huge impact on economic growth.
Hence it is more than likely that the Federal Reserve of United States will continue to print money in order to buy bonds to ensure that interest rates continue to remain low. If interest rates go up, the economic growth will be in a jeopardy. As King puts it “The government will then blame the central bank for undermining the nation’s economic health and the central bank’s independence will be under threat. Far better, then, simply to continue with quantitative easing (as money printing is technically referred to as).”
This means that a strong case for staying invested in gold still remains. Rickards expects the price to touch $7000 per ounce (1 troy ounce equals 31.1 grams).
(The article originally appeared on www.firstpost.com)
(Vivek Kaul is a writer. He tweets @kaul_vivek)