Best of the Week
Most Popular
1.Dow Stock Market Trend Forecast 2015 by Nadeem Walayat - Nadeem_Walayat
2.Gold And Silver – Forget The News. Silver $12 – 14? Gold $1,000 – 1,100? 5 - Michael_Noonan
3.A TOP Formation In Apple Inc. - Crash Condition Signal Recorded - David Harris
4.Gold Gets Safe Haven Bids But COMEX Has Stopping Power - GoldSilverWorlds
5.The Swiss 10-Year Bond Illustrates Central Banks` Flawed Monetary Policy - EconMatters
6.Exponential Explosions in Debt, the S&P, Crude Oil, Silver and Consumer Prices - DeviantInvestor
7.“Forgive Us Our Debts” – Only Way To Prevent Economic Meltdown - GoldCore
8.Is Russia Planning a Gold-Based Currency? - Marcia Christoff-Kurapovna
9.Stock Market Trend Forecast 2015 Video - Nadeem_Walayat
10.Gold GDX ETF Technical Analysis - Austin_Galt
Last 5 days
Stocks Bull Market Continues - 28th Feb 15
U.S. Debt Breaking Bad - 28th Feb 15
NATO Frankenstein - When Centralization Scales Beyond Our Control - 28th Feb 15
Gold And Silver Insanity Prevails; Precious Metals Without Direction - 28th Feb 15
Fed Raising U.S. Interest Rates - Shovelin’ Schmitt Against the Tide - 28th Feb 15
Don't Let This Stock Market Myth Cost You Your Gains - 28th Feb 15
Recession is On The Way; Beat The Stock Market Crowd, Panic Now! - 28th Feb 15
Stock Market Indexes Creeping Towards the Edge - 28th Feb 15
GGD Going for Mexican Gold - 27th Feb 15
Foreign Real Estate Is the New Swiss Bank Account - 27th Feb 15
10 Reasons Washington Has War Fever - 27th Feb 15
Gold and the Euro Tragedy, Iraq 3.0, Ukraine Conflict Three Ring Circus - 27th Feb 15
Deepak Chopra - New Age Genius or Bullshit Expert? - Video - 27th Feb 15 - Videos
New Greece Drachma Revealed Amid Bank Runs - Greeks Buy Gold Sovereigns - 27th Feb 15
Will Month Long Stocks Rally Continue? - 27th Feb 15
The Only Public Hedge Fund You Should Own - 27th Feb 15
UK House Prices Trend 2015 and the May General Election - 27th Feb 15
Why America is Ungovernable - The Republicans’ Civil War - 27th Feb 15
Gold vs Gold Stocks: Bullish Anomaly Developing? - 27th Feb 15
I Heart Capitalism, Nasdaq Stocks, Then And Now - 27th Feb 15
The Fed’s History of Assassination - 27th Feb 15 i
Gold Bull Market Forecast - Money Will Rotate Into These Dead Investments - 27th Feb 15
"Audit the Fed"? We've Already Done That (Well, Kind of) - 26th Feb 15
Forget Peak Oil; Worry About Peak Demand - 26th Feb 15
Currency Wars, Again - 26th Feb 15
The Fed Waited Too Long: Here Comes Inflation - 26th Feb 15
Investing Inertia Won’t Keep Your Cash Safe - 26th Feb 15
The Net Neutrality Scam - 26th Feb 15
Will Conservatives Out of Control Immigration Crisis Boost UKIP Election 2015 Prospects? - 26th Feb 15
EU Warns Ireland and Euro Zone of Debt Dangers - 26th Feb 15
Commodity Prices Set To Plunge Below 2008 Lows - 26th Feb 15
Ukraine Hyperinflation as Currency Plunges 44% in One Week! - 26th Feb 15
The State of the Global Markets 2015 - 53 Page Report - 26th Feb 15
NASDAQ New 15 Year High - Stock Market Death By Overdose - 25th Feb 15
12 Reasons Why Barry Ritholtz and Many UK Experts Are Mistaken On Gold - 25th Feb 15
Sugar Commodity Price To Sweeten Up - 25th Feb 15
Investor Profits from China 2,000-Year Unstoppable Trends - 25th Feb 15
How to Borrow Cheaply from a Government-Owned Bank - 25th Feb 15
Debt Be Not Proud - 25th Feb 15
Liberal Democrat Election Blood Bath - Could Nick Clegg Lose Sheffield Hallam? - 25th Feb 15
Wheat Commodity Price Technical Trend Forecast - 24th Feb 15
Bitcoin Price Might Stay below $250 - 24th Feb 15
Another Important Stock Market Inflection Point Approaching - 24th Feb 15
Gold: The Good, Bad, and Truly Ugly - 24th Feb 15
Eurozone Gold Holdings Increase to 10,792 Tonnes As “Reserve of Safety” Amidst Crisis - 24th Feb 15
Bird Doo; Yellen Goes to Congress - 24th Feb 15
Is Gold Investing Risk Free? - 24th Feb 15
The Bull Case For Gold Price 2015, and the Bear - 24th Feb 15
Europe - The Intersection of Three Crises - 24th Feb 15
Gold Price Just Needs More Time - 24th Feb 15
Gold Price Downtrend Looks Set to Continue - 23rd Feb
Silver Price Depressing Downtrend Will Eventually End - 23rd Feb 15
5 Reasons Why You Should Sell Amazon Stock - 23rd Feb 15
Global System Catastrophe Is Key Threat To Human Civilisation - 23rd Feb 15
Greece Crisis Yields Ideal Market Opportunities - 23rd Feb 15
Gold and Silver Stocks or General Stock Market Indices? - 23rd Feb 15
Swimming With Sharks: Goldman Sachs, Schools and Capital Appreciation Bonds - 23rd Feb 15
Stock Market - The Fed Still Has Your Back - 23rd Feb 15
Soybean Commodity Price Technical Outlook - 23rd Feb 15
Gold Weekly COTs and More - 23rd Feb 15
Stock Market New Highs With Weak Breadth - 23rd Feb 15

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

The State of the Global Markets 2015

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

Free Report - Financial Markets 2014