Tag: interest rates

China: Hot Money In, Now Out

For some years, hot money flowed in, adding massively to China’s foreign reserve stockpile. Speculators borrowed cheaply in U.S. dollars and bought yuan-denominated assets in anticipation of an ever-appreciating yuan. Well, this carry trade has shifted into reverse, with $91 billion in net outflows in the last quarter of 2014. And with that, the ever-appreciating yuan story has come to a close, too. Indeed, the yuan has lost 1.8% against the greenback since the New Year.

A clear picture of the drag that the hot money outflows are putting on China is shown by inspecting the annual growth rate in the People’s Republic of China’s net foreign assets. With the reserve of the carry trade, the slowdown in net foreign assets growth has been pronounced.   

This, in turn, has reduced the foreign asset component of the growth in China’s money supply, putting a squeeze on the economy’s fuel supply. Indeed, China’s money growth rate has fallen well below its trend rate since mid-2012.

In an attempt to reverse the slump in China’s money supply growth, the People’s Bank has just reduced its benchmark interest rates for the second time in three months. A wise move.

The Fed Should Quit Making Interest-Rate Promises

If there’s anything we ought to have learned from the recent boom and bust, it’s that a Fed commitment to keep interest rates low for any considerable length of time, like the one Greenspan’s Fed made in 2003, is extremely unwise. 

The problem isn’t simply that interest rates should be higher, or that the Fed should have a different plan for how it will adjust them in the future.  It’s that the Fed shouldn’t be making promises about future interest rates at all, because it can’t predict whether a rate chosen today will be consistent with stability in six months, or in one month, or even in a week.

Instead of making promises about future interest rates, the Fed should promise to change its interest rate target whenever doing so will serve to maintain a reasonable level of nominal spending or nominal gross domestic product, which is the best way to avoid causing either a boom or a bust.

The Federal Reserve vs. Small Business

Given all the attention that the Federal Reserve has garnered for its monetary “stimulus” programs, it’s perplexing to many that the U.S. has been mired in a credit crunch. After all, conventional wisdom tells us that the Fed’s policies, which have lowered interest rates to almost zero, should have stimulated the creation of credit. This has not been the case, and I’m not surprised.

As it turns out, the Fed’s “stimulus” policies are actually exacerbating the credit crunch. Since credit is a source of working capital for businesses, a credit crunch acts like a supply constraint on the economy. This has been the case particularly for smaller firms in the U.S. economy, known as small and medium enterprises (“SMEs”).

To understand the problem, we must delve into the plumbing of the financial system, specifically the loan markets. Retail bank lending involves making risky forward commitments, such as extending a line of credit to a corporate client, for example. The willingness of a bank to make such forward commitments depends, to a large extent, on a well-functioning interbank market – a market operating with positive interest rates and without counterparty risks.

With the availability of such a market, banks can lend to their clients with confidence because they can cover their commitments by bidding for funds in the wholesale interbank market.

At present, however, the interbank lending market is not functioning as it should. Indeed, one of the major problems facing the interbank market is the so-called zero-interest-rate trap. In a world in which the risk-free Fed funds rate is close to zero, there is virtually no yield be found on the interbank market.

In consequence, banks with excess reserves are reluctant to part with them for virtually no yield in the interbank market. As a result, thanks to the Fed’s zero-interest-rate policies, the interbank market has dried up (see the accompanying chart).


Without the security provided by a reliable interbank lending market, banks have been unwilling to scale up or even retain their forward loan commitments. This was verified in a recent article in Central Banking Journal by Stanford Economist Prof. Ronald McKinnon – appropriately titled “Fed ‘stimulus’ chokes indirect finance to SMEs.” The result, as Prof. McKinnon puts it, has been “constipation in domestic financial intermediation” – in other words, a credit crunch.

When banks put the brakes on lending, it is small and medium enterprises that are the hardest hit. Whereas large corporate firms can raise funds directly from the market, SMEs are often primarily reliant on bank lending for working capital. The current drought in the interbank market, and associated credit crunch, has thus left many SMEs without a consistent source of funding.

As it turns out, these “small” businesses make up a big chunk of the U.S. economy – 49.2% of private sector employment and 46% of private-sector GDP. Indeed, the untold story is that the zero-interest-rate trap has left SMEs in a financial straightjacket.

In short, the Fed’s zero interest-rate policy has exacerbated a credit crunch that has been holding back the economy. The only way out of this trap is for the Fed to abandon the conventional wisdom that zero-interest-rates stimulate the creation of credit. Suppose the Fed were to raise the Fed funds rate to, say, two percent. This would loosen the screws on interbank lending, and credit would begin to flow more readily to small and medium enterprises.

Bernanke’s Anti-Stimulus

One of the direct results of the Federal Reserve’s zero interest rate policies has been a massive reduction in interest income going to households. Since 2008, household interest income has fallen by about $400 billion annually. That’s $400 billion each year that families have not had to spend.

Now of course you can also argue that families interest expenses have also fallen, and that would be true, but that just serves to illustrate that much of monetary policy is not about creating wealth, but re-distributing it. Since interest payments are one’s person expense and another’s income, Fed driven changes in the interest rate should not increase household income in the aggregate.

As interest income/expense is not the only item on the household balance sheet, the Fed does try to make us feel richer via changes in asset prices. The problem, however, is that the change in many asset prices can also have little more than distributional effects. If owners feel richer because their house prices have gone up, or not fallen as much as they would have otherwise, then renters are poorer as they need to save more to by the same house. The same holds for commodity prices. Monetary driven increases in the price of food might be great for farmers, or speculators, but it makes households poorer by the same amount it increases the wealth of commodity holders. If the Fed truly wished to help our economy get back to “normal” then it would allow the free choices of individual borrowers and savers to determine the interest rate. It would also end its implicit practice of picking winners and losers in our economy. Unlike Fed driven changes in asset prices and interest payments, voluntary exchange between savers and borrowers increases the welfare of all parties involved.

Ricardo Paging Alan Blinder

I almost hesitate to suggest that anyone actually read Alan Blinder’s defense of Keynesian economics in today’s Wall Street Journal, except that the piece lays out clearly in my mind why Blinder is so wrong.  The only part you really need to read is:

In sum, you may view any particular public-spending program as wasteful, inefficient, leading to “big government” or objectionable on some other grounds. But if it’s not financed with higher taxes, and if it doesn’t drive up interest rates, it’s hard to see how it can destroy jobs.

So in Blinder’s world, deficits are explicitly not future taxes, despite what I believe is a fairly strong consensus among economists that some form of Ricardian equivalence holds (see John Seater’s literature review and conclusion, “despite its nearly certain invalidity as a literal description of the role of public debt in the economy, Ricardian equivalence holds as a close approximation.”).  Perhaps Blinder is blind to the fact that deficits are so much a part of the public debate today because households absolutely see those deficits as future taxes.

I also think Blinder misses that fact that crowding out can occur without raising interest rates.  As Cato scholar Steve Hanke points out, the Fed’s current policies have basically killed the interbank lending market, which has encouraged banks to load up on Treasuries and Agencies, rather than lend to the productive elements of the economy.  While I sadly don’t expect most mainstream macroeconomists to focus on the link between the banking sector and the macroeconomy, Blinder has no excuse; he served on the Fed board.

As I have argued elsewhere, banks are indeed lending, but to the government, not the private sector.  The simplistic notion that crowding out can only occur via higher interest rates, as if price is ever the only margin along which a decision is made, has done serious harm to macroeconomics.  But then if macroeconomists actually understood the mechanics of financial markets, then we might not be in this mess in the first place.

Dilma Announces Spending Cuts in Brazil

The new Brazilian government of President Dilma Rousseff has announced spending cuts of 50 billion reais (approximately $30 billion) this year. This amounts to approximately 1.3% of the country’s estimated GDP for 2011. Despite good intentions, that is still a very timid effort in curbing the size of government in Brazil: Total government spending (including state and local levels) runs at almost 40% of GDP.

Perhaps the timidity of the proposal is explained by the fact that curbing the size of government is not the motivation for the spending cuts. Nor is it to avoid a looming fiscal crisis. Brazil’s estimated budget deficit for 2010 was 2.3% of GDP; not good, but still a far cry from the fiscal woes of Europe or the U.S.

Dilma’s reason for cutting spending lies in the helplessness of Brazil’s Central Bank in containing the rise of the real without harming the economy. The real has appreciated against the dollar by 38% in the last two years (thanks in large part to Ben Bernanke’s policies at the Fed).  Efforts to contain this appreciation by intervening in the foreign exchange market and building up reserves led to a rise in inflation, which closed at 5.9% last year. The Central Bank has raised interest rates in order to curb inflation, but at 11.25% they are already too high and constitute a heavy burden on Brazil’s productive sector. Moreover, high interest rates are a magnet for foreign money seeking high returns, which drives up the value of the real even further.

Cutting government spending wouldn’t seem like the favored policy alternative of a left-wing technocrat such as Dilma Rousseff. However, it is the best way to bring down interest rates and control inflation under the present circumstances. It remains to be seen if the cuts do the trick, but they are certainly a positive sign from Brazil’s new president.

Do Inflation Expectations Drive Consumption?

After proponents of the Federal Reserve’s second round of quantitative easing (QE2) abandoned the argument that QE2 would spur growth by bringing down interest rates (only after rates increased), the new defense became “we intended for rates to go up all along, as a result of increased inflation expectations.”  Since few would argue for increased inflation, or expectations of such, as an end in itself, the claim was that increases in inflation expectations would drive households to consume more, which would in turn causes businesses to hire more, bringing down the unemployment rate.  But does this chain of reasoning withstand empirical scrutiny?

It turns out looking at the historical data on inflation expectations, as collected at the University of Michigan, that inflation expectations and household savings rates (the inverse of consumption rates) are positively correlated.  Now of course correlation doesn’t mean causality,but what the data suggest is that instead of consuming more when inflation expectations increase, households have actually saved more.  This positive correlation also holds for the second half of the data series, so it’s not simply the result of a downward trend in either inflation or savings.

To review, the latest argument for QE2:  increase inflation expectations, which is assumed to increase consumption, which is hoped to increase employment.  The problem I’ve had all along with this position is that the only thing we know for certain is the first part, QE2 would increase inflation expectations.  The hope that it would increase consumption and hence employment was just that:  hope.  Given the disconnect we’ve seen between consumption and unemployment over the past 18 months, the third link in that chain is also a weak one.   So what do we have at the end of the day:  certain costs with fairly speculative and uncertain benefits.  And here I was thinking that reckless speculation was the sole province of the private sector.