Best of the Week
Most Popular
1.Will UK Interest Rate Rises Crash House Prices? - Nadeem_Walayat
2.Full on Crash Alert for Major World Stock Markets... - Clive_Maund
3.Gold And Silver Market Bottoming? Big Rally Imminent? Reality Check Says NO - Michael_Noonan
4.The Coming Silver Price Rally Will Outperform All Previous Ones - Hubert_Moolman
5.The Trigger For The Upcoming Stock Crash - Harry_Dent
6.Imploding Department Store Results - James_Quinn
7.Dr. Copper is Speaking, are you Listening? ... - Rambus_Chartology
8.Pandemonium in the Stock Market, Dow falls 1,000 points in a week - EWI
9.Asia's Whirling Dervish of Devaluations Has Encircled China's Exports - Keith_Hilden
10.China Weakens the Yuan; Rattles Global Stock and Financial Markets - Gary_Dorsch
Last 5 days
Sturgeon Plays Politics with Syrian Refugee's, Solution Settle Migrants in Hungary and Poland - 5th Sept 15
Jeremy Corbyn’s “Quantitative Easing for People”: UK Labour Frontrunner’s Controversial Proposal - 4th Sept 15
Stock Market Third Wave - Elliott Waves Point to Market Probabilities - 4th Sept 15
Another Hysterically False BLS US Unemployment Report - 4th Sept 15
Bill Gross: Jobs Report Means ‘Fifty-Fifty’ Chance of Fed Sept Interest Rate Move - 4th Sept 15
Will The Government Confiscate Your Gold? - 4th Sept 15
Gold-Silver Ratio in Gear - 4th Sept 15
The Real Threat from China's Stock Market Crash - 4th Sept 15
The Stocks Bear Market Everyone Saw Coming - 4th Sept 15
Why September’s Stock Market Volatility Is a Huge Opportunity for Options Traders - 4th Sept 15
What IF Gold is Just in a Great Big Bull Consolidation Pattern ? - 4th Sept 15
This Stock Market VIX Chart Should Blow Your Mind - 3rd Sept 15
Eurodystopia: A Future Divided - 3rd Sept 15
Stock Market Prepares for the Next Decline - 3rd Sept 15
Europe Rethinks the Schengen Agreement - 3rd Sept 15
BP Oil Company Moves past Mistakes But Still Feeling Price Pinch - 3rd Sept 15
EU Migration Crisis and Population Density, Why Cameron is Right, England Really is Full - 3rd Sept 15
Stock Market Return to Crisis: Things Keep Getting Worse - 3rd Sept 15
Dow Theory Stock Market Sell Signal Examined - 3rd Sept 15
How OPEC’s Attempt to Save Face Affects the Crude Oil Market - 3rd Sept 15
Crude Oil Price Forecast 2015 and 2016 - Video - 3rd Sept 15
The Real Threat from China’s Stock Market Crash - 2nd Sept 15
How Our “Mixed Economy” Created These Mixed-Up Markets - 2nd Sept 15
'Gravity' Is Returning to Stocks and Bond Markets - 2nd Sept 15
OPEC Divorce And Self-Destruction Thanks To Saudi Crude Oil Strategy? - 1st Sept 15
The Beginning Of A New Financial / Stock Market Cycle - 1st Sept 15
Three Things Every Master Trader Knows About Trading Options - 1st Sept 15
Chinese Yuan Revolution? - 1st Sept 15
Take Advantage of Record-High Auto Sales… Before This Bubble Bursts - 1st Sept 15
Pondering Hitler's Legacy - 1st Sept 15
Mainstream Media Goes Berserk - 1st Sept 15
Your Decisive Stock Market Plan to Follow Whilst Most Investors Shiver With Fear - 1st Sept 15
Are There Stock and Financial Markets Investing Opportunities For The Remainder Of 2015 - 1st Sept 15
Crude Oil Price Forecast 2015 and 2016 - 1st Sept 15
REPO Window Hidden $Trillion QE Monthly Volume - 31st Aug 15
Silver and Warnings From Exponential Markets - 31st Aug 15
Stock Market Calls Fed’s Bluff - 31st Aug 15
Why Some ETFs Led the Stock Markets Down Last Week - 31st Aug 15
Stock Market Collapse - Take The Opportunity To Bail Before It’s Too Late! - 31st Aug 15
The Most Important Market Chart on The Planet - 31st Aug 15
Stock Market 50% Retracement - 31st Aug 15
Stock Market Crash Red Alert for 2nd Downwave... - 31st Aug 15
Independant Scotland 1 Year on, UK Civil War If the SNP Fanatics Had Succeeded - 30th Aug 15
Gold’s 7 Point Broadening Top - 30th Aug 15
The Day the Stock Market Shook the Earth: Takeaways From the Dow’s 1,000-Point Drop - 30th Aug 15
Gold Price Rally Marked by Short Covering - 30th Aug 15
Aging Stocks Bull Market - 29th Aug 15
Economic Destabilization, Financial Meltdown and the Rigging of the Shanghai Stock Market? - 29th Aug 15
The Stocks You Should Be Buying After the Market Drop - 29th Aug 15

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

Global Stocks Slide

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.


© 2005-2015 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

Biggest Debt Bomb in History