Mar 22nd 2011, 11:45 by Buttonwood
CAST your minds back to 1994. The Federal Reserve had kept rates at (what seemed then) the low level of 3% for three years in an effort to allow the financial sector industry to recover from the savings & loan crisis, a problem that was the result of reckless expansion and lending (thank goodness they learned the lessons of that disaster). The Fed then started very modestly to tighten monetary policy with a quarter point rate increase. But the bond market had its worst year since the late 1920s. a number of investors were caught on the hop (most famously, Orange county in California); the Askin hedge fund collapsed; and rate-related scandals were unearthed from the problems at Kidder Peabody (prompting its sale by GE) through to disputes between Bankers Trust and various corporate customers.
So what will happen when rates rise this time? Mark Zandi at Moody's Analytics says that it is one of the risks that the regulators are most inclined to worry about. He can't believe that the big financial institutions haven't planned for it - and I am sure he is right. But this is one of these systemic risk problems; everyone can't get rid of the risk. Goldman Sachs, Morgan Stanley and Bank of America may have hedged the risk - but someone has to take the other side of the deal. One can hope that the risk is well dispersed, but economists said that about subprime lending and look how that worked out.
This all comes back to the "borrowing from the future" problem. If an economy faces a debt problem, cutting rates provides instant relief for borrowers. But the risk is that they become more indebted than they would otherwise be, making the adjustment to more "normal" levels of rates all the more painful. As central banks prop up asset prices, there is also the temptation for investors to assume that the Bernanke put will last forever because the bank can't afford to move. Most investors assume the Fed will be on hold for the rest of 2011.
But that creates the risk of sharp rate increases as central banks have to play catch up with rising inflation expectations. Britain may yet provide the first test. The CPI is up 4.4% year-on-year and the RPI 5.5%. My colleague on Blighty has pointed out that the clothing numbers look very odd. But I don't think there can be any doubt that Britain has a particular inflation problem. Chris Watling of Longview Economics keeps data on the median inflation rate, which prevents any distortions from an individual sector like clothing. From nearly 2% at the end of 2009, Britain's median inflation rate is now more than 5%; in the US and the euro-zone, it is still under 2%.
Economies will eventually have to cope with the withdrawal of both fiscal and monetary stimulus. The US has yet to lose either (the payroll tax holiday is kicking in this year), but Britain and the euro-zone are already tightening fiscal policy and may have to move in monetary policy. There will be (metaphorical) blood.
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I'm actually more intrigued by our difficulties in understanding the British inflation rate. Here we are arguing daily about economic models and whether fiscal stimulus works and how central banks influence investment and we can't understand a phenomenon that's happening right now as we watch. My theory relates to the drop in the pound back in the crisis: it was at about $2 and has hovered at about $1.60, with a similar fall versus the euro and this translates into higher prices for imports plus a boost in exports. But I'm guessing. I don't know Britain's capacity utilization in depth or the other factors that would drive inflation expectations - let alone the reality of it now.
Note how the central bank printed to bail out the S&L industry, not because the general economy needed it. The printing press is being used as the personal piggy bank for the financial industry. A printing tax is levied on consumers (especially fixed income retirees), and the proceeds are redistributed to the financial industry.
Printing the S&L bailout led directly to the tech bubble. Then central banks feared the consequences of the tech bubble deleveraging, so they printed up the world wide housing bubble to replace it. Now they are printing up yet another bubble, despite the fact that the housing bubble aftermath was much worse than just letting the tech bubble deleverage.
The only way to stop this cycle is to stop using the printing press to bail out the banks. This leads to serial bubbles, and a lower standard of living for the non financial sector. Retirees lose over half the purchasing power of their pensions/annuities over the course of an average retirement.
Milton Friedman wanted the printing press run by a computer to avoid just this kind of thing happening. 2% per year money supply expansion, just enough to keep up with population changes. Dramatic swings in the money supply cause bubbles, disruptive deleveraging, and needless pain for retirees. The vast majority of consumers want lower prices at the store as productivity improves, not ever more expensive food, gasoline and such. Consumers want the higher standard of living that lower prices would bring, not redistribution to the financial sector.
About Buttonwood's notebook
In this blog, our Buttonwood columnist grapples with the ever-changing financial markets and the motley crew who earn their living by attempting to master them.
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