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In 2001 the Bank of Japan, after years of
prodding by people pointing out that the bank's
"zero-interest-rate" policy wasn't working, adopted what it called
"quantitative easing." This was a policy of direct expansion of the
monetary base, which in practice became a bank reserves target. The BOJ was
not nearly aggressive enough, and the whole project was compromised by
pressure on Japan not to let the yen fall, for the tired old competitive
reasons that drove Japan into deflation in the first place. But
"quantitative easing" was ultimately successful, resulting in the
reflationary recovery being enjoyed today. If they hadn't been such a bunch
of foot-draggers, Japan could have enjoyed today's reflationary recovery back
in 1999 or so -- or 1993!
I was watching Larry Kudlow
on CNBC yesterday, and he was doing his best to start the discussion I
mentioned two weeks ago, namely that of the Fed abandoning its interest rate
target policy in favor of one of direct monetary
base adjustment with a goal of raising the dollar's value, notably against
gold. Kudlow was also prompting the Fed to express
its "manhood" (???) by raising its interest rate target further,
which I thought was interesting since Kudlow was a
"no more hikes" guy about one year and 150bps ago.
The fact is the Fed did raise its rate target
last week, and will likely do so again in August. I personally do not think
that 25 bps in August or even 50 bps will make all that much difference to
the declining dollar, just as the previous seventeen rate hikes have not
exactly stopped gold in its tracks. The Fed would succeed in blowing up the
economy however, although the economy is ready for a recession in any case
due to the totally unsustainable housing boom and related lending/spending.
About a trillion dollars worth of adjustable-rate mortgages are due to adjust
in 2007, and we can imagine what that would be like if the Fed is around 6%.
Add 200bps to LIBOR for a typical ARM, and you get 8%, plus amortization of
2% or so, for a total payment of 10% of outstanding mortgage value per year.
A more "manly" approach, such as a surprise 50bps target hike,
would also threaten to shake a variety of levered players out of the boat, as
was the case in 1994 when a surprisingly hawkish Fed resulted in the
bankruptcy of Orange County and some very wild bond market moves. Plus, the
stock market would be most unhappy.
What would a move toward direct monetary
adjustment entail? We can call this "quantitative tightening." In
Mexico it was called the corto
("short"). In Mexico, it amounted to a policy of leaving the money
market a little "short" of money each day. Certainly the first
result of such a policy would be that short-term interest rates would float,
which would strike many people as rather shocking as they have gotten used to
the idea of an interest rate target. The longer-maturity bonds would be more
stable than the short end, which is something of an inversion of today's
situation. In practice, short-term lending rates are not all that important
as long as one-year or longer maturities are relatively stable. This
"floating" of the short end could easily be on the order of +-50bps
per day, maybe more, which would not be that important economically but it
would confuse people who are fixated on 25bps changes that take place every
six weeks.
The purpose of "quantitative
tightening" would be to move the dollar's value back toward the $350/oz.
of gold average of the 1980s and 1990s. To do this the Fed would gradually
shrink the monetary base (or reduce its rate of growth) by selling assets
from its balance sheet. This would tend to put upward pressure on short-term
interest rates in the immediate term, perhaps as much as 100 or 200 bps.
However, the longer maturities would likely stay roughly where they are. In
cases where monetary inflation is well recognized and interest rates are
already rather high, the result of such "quantitative tightening"
(as was the case in Mexico) would be a decline in longer-maturity interest
rates, followed by a decline in short rates as well, accompanied by a strong
currency.
Having longer maturities "stay roughly
where they are" and the short end bouncing around -- while the Fed
experiments with some new system that it would be virtually incapable of
explaining to journalists -- doesn't exactly sound like an improvement to
most people, which is why I doubt the Fed is ready for such a change in its
operating framework at this time. (Journalists never figured out how "quantitative
easing" worked in Japan, nor the corto
in Mexico.) The people at the Fed basically do not know what they are doing,
and you need to know what you are doing to guide the implementation of a new
policy that is not, at this time, being clamored for
by the masses. The Fed is run "on the applause meter," as Bill
Fleckenstein likes to say, and right now it gets the most applause by not
rocking the boat, being "vigilant" on inflation (whatever this
means), and suggesting that it is not going to do anything rash that would
cripple today's healthy-seeming economy.
While my "quantitative tightening"
scenario would likely lead to higher short-term interest rates for at least a
little while (or maybe it wouldn't in practice, it's hard to tell), the end result
would be a stronger dollar, lower interest rates, less inflation and a
healthier economy. In other words, it would work, because it is not focused
on "raising rates" but on reducing base money supply and raising
the value of the currency. What is not likely to work (as we will eventually
discover), is "raising rates" within today's interest
rate-targeting framework. "Raising rates" does not "combat
inflation," at least not in any reliable fashion, because it does not directly
and reliably affect base money supply or the value of the currency. Inflation
is caused by the "dollar going to $0.50," and is solved by the
"dollar going from $0.50 back to $1.00." The mainstream approach to
the present situation would be to "raise rates" with the
expectation that this would lead to less inflation in the future, but it
wouldn't work, even if the rate raisers do discover their manhood in the
process. I suspect we'll see the dollar gradually slip lower, and then slip
lower not so gradually toward the end of the year, and the Fed "raising
rates" in a rather panicked fashion sometime around the first half of
2007. At that point, we might be able to say that "quantitative
tightening" would not only just allow interest rates to stay where
they are (not exactly the most convincing sales pitch), but to reduce
inflation and interest rates significantly, which would generate the applause
that would register high enough on the Fed's applause meter that they might
actually do something.
Just my guess.
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street
Journal Asia, the Japan Times, Pravda, and other publications. He has appeared
on financial television in the United States,
Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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