July 1, 2006
In 2001 the Bank of Japan, after years of prodding by people pointing out that the bank’s “zero-interest-rate” policy wasn’t working, adopted what it called “quantitative easing.” This was a policy of direct expansion of the monetary base, which in practice became a bank reserves target. The BOJ was not nearly aggressive enough, and the whole project was compromised by pressure on Japan not to let the yen fall, for the tired old competitive reasons that drove Japan into deflation in the first place. But “quantitative easing” was ultimately successful, resulting in the reflationary recovery being enjoyed today. If they hadn’t been such a bunch of foot-draggers, Japan could have enjoyed today’s reflationary recovery back in 1999 or so — or 1993!
I was watching Larry Kudlow on CNBC yesterday, and he was doing his best to start the discussion I mentioned two weeks ago, namely that of the Fed abandoning its interest rate target policy in favor of one of direct monetary base adjustment with a goal of raising the dollar’s value, notably against gold. Kudlow was also prompting the Fed to express its “manhood” (???) by raising its interest rate target further, which I thought was interesting since Kudlow was a “no more hikes” guy about one year and 150bps ago.
The fact is the Fed did raise its rate target last week, and will likely do so again in August. I personally do not think that 25 bps in August or even 50 bps will make all that much difference to the declining dollar, just as the previous seventeen rate hikes have not exactly stopped gold in its tracks. The Fed would succeed in blowing up the economy however, although the economy is ready for a recession in any case due to the totally unsustainable housing boom and related lending/spending. About a trillion dollars worth of adjustable-rate mortgages are due to adjust in 2007, and we can imagine what that would be like if the Fed is around 6%. Add 200bps to LIBOR for a typical ARM, and you get 8%, plus amortization of 2% or so, for a total payment of 10% of outstanding mortgage value per year. A more “manly” approach, such as a surprise 50bps target hike, would also threaten to shake a variety of levered players out of the boat, as was the case in 1994 when a surprisingly hawkish Fed resulted in the bankruptcy of Orange County and some very wild bond market moves. Plus, the stock market would be most unhappy.
What would a move toward direct monetary adjustment entail? We can call this “quantitative tightening.” In Mexico it was called the corto (“short”). In Mexico, it amounted to a policy of leaving the money market a little “short” of money each day. Certainly the first result of such a policy would be that short-term interest rates would float, which would strike many people as rather shocking as they have gotten used to the idea of an interest rate target. The longer-maturity bonds would be more stable than the short end, which is something of an inversion of today’s situation. In practice, short-term lending rates are not all that important as long as one-year or longer maturities are relatively stable. This “floating” of the short end could easily be on the order of +-50bps per day, maybe more, which would not be that important economically but it would confuse people who are fixated on 25bps changes that take place every six weeks.
The purpose of “quantitative tightening” would be to move the dollar’s value back toward the $350/oz. of gold average of the 1980s and 1990s. To do this the Fed would gradually shrink the monetary base (or reduce its rate of growth) by selling assets from its balance sheet. This would tend to put upward pressure on short-term interest rates in the immediate term, perhaps as much as 100 or 200 bps. However, the longer maturities would likely stay roughly where they are. In cases where monetary inflation is well recognized and interest rates are already rather high, the result of such “quantitative tightening” (as was the case in Mexico) would be a decline in longer-maturity interest rates, followed by a decline in short rates as well, accompanied by a strong currency.
Having longer maturities “stay roughly where they are” and the short end bouncing around — while the Fed experiments with some new system that it would be virtually incapable of explaining to journalists — doesn’t exactly sound like an improvement to most people, which is why I doubt the Fed is ready for such a change in its operating framework at this time. (Journalists never figured out how “quantitative easing” worked in Japan, nor the corto in Mexico.) The people at the Fed basically do not know what they are doing, and you need to know what you are doing to guide the implementation of a new policy that is not, at this time, being clamored for by the masses. The Fed is run “on the applause meter,” as Bill Fleckenstein likes to say, and right now it gets the most applause by not rocking the boat, being “vigilant” on inflation (whatever this means), and suggesting that it is not going to do anything rash that would cripple today’s healthy-seeming economy.
While my “quantitative tightening” scenario would likely lead to higher short-term interest rates for at least a little while (or maybe it wouldn’t in practice, it’s hard to tell), the end result would be a stronger dollar, lower interest rates, less inflation and a healthier economy. In other words, it would work, because it is not focused on “raising rates” but on reducing base money supply and raising the value of the currency. What is not likely to work (as we will eventually discover), is “raising rates” within today’s interest rate-targeting framework. “Raising rates” does not “combat inflation,” at least not in any reliable fashion, because it does not directly and reliably affect base money supply or the value of the currency. Inflation is caused by the “dollar going to $0.50,” and is solved by the “dollar going from $0.50 back to $1.00.” The mainstream approach to the present situation would be to “raise rates” with the expectation that this would lead to less inflation in the future, but it wouldn’t work, even if the rate raisers do discover their manhood in the process. I suspect we’ll see the dollar gradually slip lower, and then slip lower not so gradually toward the end of the year, and the Fed “raising rates” in a rather panicked fashion sometime around the first half of 2007. At that point, we might be able to say that “quantitative tightening” would not only just allow interest rates to stay where they are (not exactly the most convincing sales pitch), but to reduce inflation and interest rates significantly, which would generate the applause that would register high enough on the Fed’s applause meter that they might actually do something.
Just my guess.