The "Irresponsible" Logic Behind The Fed's Cheap Money

Does the Federal Reserve want us to trust it? Maybe not...

IN THE world of economic policy, things are not always what they seem, writes Ben Traynor at BullionVault.

"When it becomes serious, you have to lie," Jean-Claude Juncker, Luxembourg's prime minister and chairman of the Eurozone finance ministers reminded us a few weeks back.

So when Ben Bernanke tells us the Federal Reserve must be "vigilant in preserving its hard-won credibility for maintaining price stability", as he did on Tuesday, should we believe him?

Or is it just a feint? Is the Fed in fact perfectly happy to see its credibility ebb away, to the point – if we haven't reached it already – that no one at all believes it is serious about keeping a lid on inflation?

The question is not as far-fetched as you might think. Indeed, there is a body of economic theory that actively encourages "irresponsible" monetary policy.

The year is 1998. The US economy is growing, consumers are spending, and Washington is far more concerned with blue dresses and "improper relationships" than it is with federal debt limits or unemployment. 

But over in Japan, things are very different. Japan's economy has stalled. Growth has been stagnant for almost a decade. The Bank of Japan, in an effort to get things moving, has slashed interest rates to near-zero. It hasn't worked.

In May of that year economist Paul Krugman – who would later find fame and adulation as the New York Times' Conscience of a Liberal – offers a diagnosis. Japan is in a liquidity trap.

The liquidity trap, in economic theory, is a situation in which monetary policy is incapable of further stimulating the economy. Even an interest rate of zero, where the cost of borrowing money is essentially free (and the reward for saving nil) fails to encourage more spending or investment.

In his paper, Krugman offered two explanations for why a liquidity trap might occur:

1. The Deflation Explanation If prices are falling, then while the nominal rate of interest may be zero, the real rate, adjusted for changes in prices, would still be positive. In other words, saving cash for no nominal return would still leave you more spending power in future, because prices will be lower.
2. The Falling Incomes Explanation If incomes are falling – for example because of recession – then people will save now in order to have something to spend later. Similarly, businesses are unlikely to invest in new stock or greater productive capacity if their potential customers are getting poorer.

Note that what's important isn't just what is happening to prices and incomes right now, but what people expect will happen in future. This is why central bankers talk so much about credibility. They (attempt to) control inflation by influencing inflation expectations. If no one believes they'll achieve their targets, this is much harder.

To get consumers spending and businesses investing, then, it is not enough to cut interest rates to zero. Expectations need to be changed too.

The solution Krugman offered for Japan in 1998 can be summed up in a single word: inflation.

"The way to make monetary policy effective," he wrote, "is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs." [Italics Krugman's].

In other words, if people believe prices will keep rising, there is no incentive to hang on to cash. Consumers may as well spend, and businesses may as well invest, since their money will be worth less tomorrow.

Maybe this is how western central bankers justify to themselves the ultra-low interest rates we see today. In their minds, so successful have they been at portraying themselves as tough on inflation, extraordinary measures are required to undo the "hard won credibility" they believe they have.   

Perhaps too this was part of the logic behind quantitative easing – to convince us all that prices were rising, so we may as well hit the shops pronto.

There's just one niggling problem with this policy prescription...

It didn't work in Japan. And it hasn't worked in the West either...

Nevertheless, that's no reason to think central banks will give up now. After all, Japan's official policy rate has stayed below 1% since 1995...and last year the Bank of Japan lowered it to less than 0.1%.

Various statements by Bernanke suggest the Fed too is in no hurry to reverse its cheap money policy, and will wait for the economy to make the first move:

• "As the economy recovers, banks should find more opportunities to lend out their reserves," he wrote in the Wall Street Journal in July 2009.
• A few months later, in February 2010, Bernanke told Congress that an exit from the Fed's "accommodative policy stance" would "depend on economic and financial developments".
• And now we have Tuesday's speech, in which the Fed chairman shared the latest diagnosis that although the economy "is moving in the right direction", production remains well below potential so "accommodative monetary policies are still needed". 

Then we have this post on the New York Fed's blog, lamenting "The Mistake of 1937" – when inflation fears led to the Fed abandoning the loose monetary policy that had prevailed since 1933.

Sure, the Fed may hold back on a third round of QE, at least for a while. Bernanke may even do a Jean-Claude Trichet, and raise rates a mere quarter-percent – as the European Central Bank did in April – so he can trumpet his "vigilance" on inflation.

Here at BullionVault we see little likelihood the Fed will significantly changing course any time soon. Returns on cash – after inflation – will remain negative until...well, until everything's fine, basically.

A bet on real interest rates turning positive is, in effect, a bet that the US economy will right itself. That it will generate sustained growth even though its budget deficit is officially forecast to be nearly 10% of GDP this year...even though national debt about to breach its statutory limit...and even though the government will, sooner or later, have to make some drastic spending cuts.

Anyone taking that bet will find no shortage of encouragement, especially from policymakers, who will continue to insist things are "heading in the right direction", and who will talk a good game on price stability. 

To take inspiration from Jean-Claude Juncker, though, when it becomes really serious, you have to see through the lies.