Wednesday, August 10, 2011

Deflationary Monetary Policy

“The first requirement is that the monetary authority should guide it-self by magnitudes that it can control, not by ones that it cannot control. If, as the authority has often done, it takes interest rates or the current unemployment percentage as the immediate criterion of policy, it will be like a space vehicle that has taken a fix on the wrong star. No matter how sensitive and sophisticated its guiding apparatus, the space vehicle will go astray. And so will the monetary authority.”
-The Role of Monetary Policy by Milton Friedman

On Sunday I outlined a game plan for the week with expectations of increasing volatility. Needless to say the first two days have far exceeded my imagination. While most investors watched in disbelief on Monday as markets sank over 6 percent, yesterday’s nearly 9 percent reversal from overnight lows was even more remarkable. For those unaware, after China reported higher than expected inflation, S&P futures tumbled from 1111 to 1077. By the market open, futures had roared back to 1138. After stumbling near flat, the market surged another 30-plus points. Following the Federal Reserve’s statement, trading ranges expanded dramatically with the market initially selling off nearly 50 points before rallying back 75 to ultimately close almost 5 percent higher. Volatility certainly appeared heightened by the Fed meeting and their semi-policy change is worth further consideration.

Over the past several days, an increasing number of investors and economists have been calling for the Fed to enact QE3. When the Fed initially decided to apply quantitative easing (QE), market liquidity had dried up and financial institutions were witnessing modern day bank runs. QE was an effective means for exchanging liquid assets (Federal Reserve notes) in return for illiquid (generally devalued) securities. Responding to a liquidity crisis, QE was well directed and ultimately successful.

Last summer the economic recovery showed deterioration and stock markets sold off substantially. Renewed Fed intervention involved another round of quantitative easing aimed at reducing interest rates and increasing asset values. If successful, these measures would generate increasing consumption and debt while lowering savings. This policy was ill-advised as the economy no longer suffered from a liquidity crisis, but rather a balance sheet recession in which excessive private debt decreases aggregate demand.

Beyond being misguided, QE2 was also poorly understood by much of the general public. Common conception is that quantitative easing is inflationary money printing. However, as noted earlier, quantitative easing (as practiced) is strictly an asset swap between the Federal Reserve and banks. Operationally, QE2 simply involved the Fed exchanging interest-bearing Federal Reserve notes for treasury notes. Net financial assets were not actually increased during this process. Quantitative easing therefore involves no money printing, simply swapping assets.

Misunderstanding the Fed’s policy as inflationary, markets sold dollars and bid up asset prices. Unfortunately for the Fed, markets viciously bid up prices of real assets including food and energy. With many households still over-burdened by debt and high unemployment restraining income growth, these increasing costs actually reduced demand for other goods. This recognition is likely why the Fed correctly believes higher inflation will be temporary. Reviewing recent GDP and unemployment data, it’s patently false that QE2 had a significant, if any, positive economic impact.

An obvious follow up question, why are people demanding QE3? One argument claims that dollar devaluation increases exports and as a byproduct, economic growth. Ludwig von Mises and Frédéric Bastiat (among others) clearly disproved this notion decades ago, but I’ll save that topic for another day. Others hold out hope that wealth effects create far larger multipliers than most economic research shows. Another group believes simply doing something is better than nothing. In spite of requests, the Fed thankfully did not proceed with QE3 (at least not yet).

So what did the Fed do? Well, in some ways nothing and in some ways everything. From their statement:

The committee currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013”

Although not explicitly stating interest rates will remain “exceptionally” low through mid-2013, markets reacted as such. In Treasury Yields Low for Good Reason, I noted that “interest rates are a function of the expected rates over that time period.” Hence shifting expectations for 0 percent rates through 2013 sent treasury yields plunging, with 10-year notes briefly touching an all-time low of nearly 2 percent. Longer-term inflation expectations also moved higher, devaluing the dollar and creating a surge in equity markets. Impressively, without committing to actual policy change, the Fed effectively generated the impact of QE (at least for a day) with some wisely chosen words.

This post began with equally wise words from Milton Friedman, chosen specifically from his paper, The Role of Monetary Policy, which outlines my greatest fear of the new Fed policy. Friedman posits that monetary policy is unable to control real interest rates, apart from short periods, which remain relatively stable over longer time horizons. Since economic capital is only produced if expected returns are positive, real interest rates must be positive in the long-run. Monetary policy, as determined by the Fed, sets nominal interest rates. Friedman’s theory implies that long-term nominal interest rates are equivalent to long-run real interest rates plus inflation. Therefore a “monetary authority could assure low nominal rates of interest--but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy.”

In 1996 the Bank of Japan (BOJ) lowered benchmark interest rates to 0.5 percent, attempting to jump start economic growth stunted by debt deleveraging. Over 15 years later the benchmark interest rate sits at 0 percent, having never exceeded 0.5 percent during that span. Given Friedman’s framework, if long-run real interest rates are around 1 percent, then maintaining an effectively 0 percent nominal interest rate requires Japan to experience small, consistent deflation. Japan’s economic record the past decade displays confirming evidence of this assumption.

During the financial crises of 2008, the Fed lowered its benchmark interest rate practically to 0. Although initially expected to be temporary, yesterday’s projection portends retaining a lower bound rate policy for at least 5 years. If structural changes are not made, a weak economy could keep Fed rate hikes on hold far longer. As Friedman theorized and Japan bore witness, maintaining low nominal interest rates is ultimately deflationary.

What I find most discouraging is that the names of Keynes, Hayek and Friedman are highly revered today, yet much of their work and philosophy appears to have been lost in translation. Monetary policy today focuses on both fronts Friedman argued would lead the “space vehicle...astray.” Avoiding an outcome similar to Japan requires policy makers to recall the great economic minds of the 20th century. As the philosopher George Santayana said, "those who cannot remember the past are condemned to fulfill it."

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