Best of the Week
Most Popular
1.Ukraine Preface, the Emerging Dynamics Of Petro-Yuan Standard - Jim_Willie_CB
2. Speculations Reversed - Gold Price Stealth Rally 2014 - Peter_Schiff
3.Bubbleberg News Drivel Masquerading as Financial Reporting - David A. Stockman
4.Nationwide UK House Prices 9.5% Inflation, Housing Market on Steroids, Help to Buy Anniversary - Nadeem_Walayat
5.How to Profit from Palladium Huge Price Surge… - Peter Krauth
6.UK Home Solar Panel Installations Good or Bad for House Buying and Selling? - Nadeem_Walayat
7.Global Gold Manipulation Update - MAP Wave Analysis - Marc_Horn
8.Ukraine Capital Controls and 200% Inflation But Still In Better Shape Than US! - Jeff_Berwick
9.The Rise of a Euro-Chino-Russian Superpower - Stephan Bogner
10.Across Europe Secession Movements Intensify - BATR
Last 72 Hrs
Silver, Gold, and What Could Go Wrong - 15th Apr 14
How I Intend to Survive the Meltdown of America - 15th Apr 14
France Wakes Up To The Multicultural Multi-Threat - 15th Apr 14
The Real Purpose Of QE - It’s Not Employment - 15th Apr 14
Peak Coal - 15th Apr 14
Flash Crash, Rigged Markets - What’s the Frequency Zenith? - 15th Apr 14
Forecasting U.S. GDP Growth: A Look at WSJ Economists’ Collective Crystal Ball - 15th Apr 14
Stock Market - Is Something Nasty About to Happen? - 15th Apr 14
How to Trade Your Way To Freedom - 15th Apr 14
Understanding (and Ignoring) the Media Bandwagon Against Gold - 15th Apr 14
When Stock Market Bubble Crashes, Take Refuge in Gold Stocks - 15th Apr 14
Bitcoin Price Strong Appreciation to Be Followed by Declines? - 14th Apr 14
Greece, Turkey, We're Shuffling The Cards on Our Europe Investing Play - 14th Apr 14
Silver Price Ultimate Rally: When Paper Assets Collapse - 14th Apr 14
Get Your Share of an Extra Trillion Euros Money Printing - 14th Apr 14
Fourth Reversals in The Gold and Silver Charts - 14th Apr 14
Stock Market Nearing Rally in a Downtrend - 14th Apr 14
London House Prices Bubble, Debt Slavery, Crimea 2.0 - Russia Ukraine Annexation - 14th Apr 14
Four Horsemen - Top Economists Explain the Source of Our Economic Crisis - Video - 13th Apr 14
Peak Oil And Global Warming – A Question Of Culture - 13th Apr 14
The Global Banking Game Is Rigged, and the FDIC Is Suing - 13th Apr 14
College Degree Earnings Propaganda - 13th Apr 14 - Andrew Syrios
Stock Market Potential Diagonal Triangle Pattern Forming - 12th Apr 14
Ukraine Crisis – Military Flash Drive Thinking - 12th Apr 14
Gold And Silver – 2014 Coud Be A Yawner; Be Prepared For A Surprise - 12th Apr 14
Gold Preparing to Launch as U.S. Dollar Drops to Key Support - 12th Apr 14
Manipulated Stocks Markets And The Empty Bag - 12th Apr 14
Stock Market - It’s Not Time to Panic… It’s Time to Buy - 12th Apr 14
Doctor Doom on the Fiat Money Empire Coming Financial Crisis - 12th Apr 14
Sheffield, Rotherham Roma Benefits Plague, Ch5 Documentary Gypsies on Benefits & Proud - 11th Apr 14
This Bitcoin Price Rally Might Be a Fake One - 11th Apr 14
GDX Gold Stocks Benchmark - 11th Apr 14
Silver Price Finally Outperforms – How Bullish Is That? - 11th Apr 14
Limits to Employment Participation, and Societal Change - 11th Apr 14
US Moves To Restrict Travelers Taking International Flights - 11th Apr 14
Bill Gross to El-Erian: 'Come on, Mohamed, Tell Us Why' You Resigned PIMCO - 11th Apr 14
British Pound GBP/USD - Double Top or Further Rally? - 11th Apr 14
Don't Miss the Boat on Big Biotech Catalysts: Keith Markey - 11th Apr 14
Russia Invaded Crimea and These US Energy Companies Made a Killing - 11th Apr 14

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

Bernanke's Credible Irresponsibility: The Logic Behind Cheap Money

Interest-Rates / US Interest Rates Jun 10, 2011 - 02:09 PM GMT

By: Ben_Traynor

Interest-Rates

Best Financial Markets Analysis ArticleDoes Ben Bernanke want us to trust him? Maybe not…

IN THE murky realm of economic policy, things are not always what they seem.


"When it becomes serious, you have to lie," Luxembourg's prime minister and chairman of the Eurogroup of finance ministers Jean-Claude Juncker 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 last 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:

  • 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.
  • 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:

  • 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.

By Ben Traynor
BullionVault.com

Gold price chart, no delay   |   Buy gold online at live prices

Editor of Gold News, the analysis and investment research site from world-leading gold ownership service BullionVault, Ben Traynor was formerly editor of the Fleet Street Letter, the UK's longest-running investment letter. A Cambridge economics graduate, he is a professional writer and editor with a specialist interest in monetary economics.

(c) BullionVault 2011

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it.


© 2005-2014 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Free Report - Financial Markets 2014