Best of the Week
Most Popular
1.Crude Oil Price Trend Forecast 2016 Update - Nadeem_Walayat
2.Will Deutsche Bank Crash The Global Stock Market? - Clif_Droke
3.Gold Price In Excess Of $8000 While US Dollar Collapses - Hubert_Moolman
4.BrExit UK Economic Collapse Evaporates, GDP Forecasts for 2016 and 2017 - Nadeem_Walayat
5.Gold Stocks Massive Price Correction - Zeal_LLC
6.Stock Market Predicts Donald Trump Victory - Austin_Galt
7.Next Financial Crisis Will be Far Worse than 2008/09 - Chris_Vermeulen
8.The Gold To Housing Ratio As A Valuation Indicator - Dan_Amerman
9.GDXJ Gold Stocks - A Diamond in the Rough - Rambus_Chartology
10.Gold Boom! End Game Nears As Central Banks Buying Up Gold Mining Companies! - Jeff_Berwick
Last 7 days
Why Trump Lost, Hillary Won the 1st U.S. Presidential Debate - 29th Sept 16
Is a Dollar Crash Imminent After the Senate Overrides Obama Veto on Saudi 9/11 Bill? - 29th Sept 16
2017: Gold and Silver's Year of "Public Recognition" - 29th Sept 16
Did Trump Win the 1st US Presidential Election Debate? - There's Something Happening Here... - 29th Sept 16
FED Goes from ZIRP to NIRP! - 29th Sept 16 - Chris_Vermeulen
Here’s Why You Should Be in Cash Right Now - 28th Sept 16
The Fed Put a 50% Tax on Your Retirement Plan - 28th Sept 16
Massive Chinese Debt And Why They Are On A Gold Buying Binge! - 28th Sept 16
Stocks Commodities and FX Markets Waiting Technically While Fundamental Data Neutral Poised - 28th Sept 16
This Commodity Has Perked Up its Investors' Portfolios - 27th Sept 16
Charting the Continuing Gold Market Correction - 27th Sept 16
Stock Market Crash and Recession Indicator Warning: Extreme Danger Ahead - 27th Sept 16
Financial Markets and FX Setups 27th Sept - 27th Sept 16
Crude Oil, Forex and Stock Market Trend Forecasts - 27th Sept 16
Why There is Trump - 27th Sept 16
Save Up to 70% in Shopping Expenses for Daily Items - 27th Sept 16
Gold’s Moving Averages and Long-Term Outlook - 26th Sept 16
September Stock Market - The Not So Silent Demise of Deutsche Bank - 26th Sept 16
SPX sell signal confirmed - 26th Sept 16
SPX is testing the next level of support - 26th Sept 16
Outrageously Entertaining US Presidential Campaign Final Stages - What Happens Next? - 26th Sept 16
BoJ, FOMC and Where To Now? - 26th Sept 16
Stock Market New All Time Highs Next - 26th Sept 16
Why Trump Will Win US General Election 2016 Prediction Forecast - 26th Sept 16
Martial Law Rolls Out Across the US As Jubilee Nears - 26th Sept 16
Stock Market More Correction Likely - 25th Sept 16
US Presidential Election Forecast 2016 - Trump Riding BrExit Wave into the White House - 25th Sept 16
US Economy GDP Growth Estimates in Free-Fall: FRBNY Nowcast 2.26% Q3, 1.22% Q4 - 24th Sept 16
Gold and Gold Stocks Corrective Action Continues Despite Dovish Federal Reserve - 24th Sept 16
Global Bonds: Why Our Analyst Says Things Just Got "Monumental" - 24th Sept 16
Where Did All the Money Go? - 23rd Sept 16
Pension Shortfalls Could Be 4X To 7X Greater Than Reported - 23rd Sept 16
Gold Unleashed by the Fed - 23rd Sept 16
Gold around U.S Presidential Elections - 23rd Sept 16
Here’s Why Eastern Europe Is Doomed - 23rd Sept 16
Nasdaq NDX 100 Big Cap Tech Breakout ? - 23rd Sept 16
The Implications of the Italian Banking Crisis Could Be Disastrous - 22nd Sept 16
TwinLakes Theme Park Summer Super 6 FREE Return Entry for Real? - 21st Sept 16
Has the Silver Bullet Run Out of Fire Power? - 21st Sept 16
Frack Sand: The Unsung Hero Of The OPEC Oil War - 21st Sept 16
What’s Happening With Gold? - 21st Sept 16
Gold vs. Stocks and Commodities, Pre-FOMC - 20th Sept 16
BrExit UK Inflation CPI, RPI Forecast 2016, 2017 - 20th Sept 16
European banks may be more important than the Fed this week - 20th Sept 16
Gold, Silver, Stocks and Bonds Grand Ascension or Great Collapse? - 20th Sept 16
Mass Psychology in Action; Instead of Selling Gilead it is Time to Take a Closer Look - 20th Sept 16
Hillary - Finally Well Deserved Recognition for Deplorables - 20th Sept 16

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

The Power of the Wave Principle

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.


© 2005-2016 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

Catching a Falling Financial Knife