Let us take a moment to say we’re thankful for central bankers! They have an extremely difficult job, make monumental decisions under great pressure and uncertainty, only to be constantly second guessed by a crowd of ignoramuses, including us! Someday we’ll understand how close we came to the abyss, and if not for the decisiveness of Bernanke, Geithner, Paulson, and their respective staffs, most of the country would be eating bark and living under a freeway. They all deserve, in our book, the Presidential Medal of Freedom for their courage during the darkest days of the crisis and success in stabilizing the situation. Structural adjustment, reconstruction, and recovery is a work in progress, however.
Now let us weigh in with our thoughts on current global monetary policy.
How ironic is it that those countries with loose monetary policy and near zero interest rates are experiencing relatively tight financial market conditions, including low volume equity markets; and those with tight monetary policy and relatively high interest rates are flooded with liquidity? Given our experience in the emerging markets and many years of analyzing capital flows, we’re forming a new working hypothesis of monetary policy here.
Abnormally low interest rates displace capital from the domestic market to foreign markets as investors seek out higher returns. If the net capital outflows are not offset or replaced by domestic credit creation, the financial conditions of the country actually tighten. When the exchange rate of the receiving country is not allowed to equilibrate the flows, these capital outflows are recycled back into the originating country’s government bonds, allowing deficit expansion without upward pressure on interest rates. This is especially true in an economy where traditional channels of credit have been impaired, such as the case of the United States and Japan.
In a CNBC interview today, Larry Fink, CEO of Blackrock, touched on this,
Maria Bartiromo: ….Do you think the Fed should start raising rates?
Larry Fink: I actually suggested that to the Fed some time ago, but the economy has weakened a little bit since I made that suggestion. I believe low rates are going to be a problem in the long run. We’re seeing more and more investors, institutional investors, individual investors, are moving more of their money to emerging markets, to overseas… This is the money that used to invest in America, in the long-term vitality of America, they’re now investing in Indonesia, investing in other countries… You need now to move that money overseas to get those returns… The problem, I see, with a long period of time with low rates , we are going to see a large sum of money moving out of the United States. It will continue to put pressure on our currency…..and we are going to have less available capital to invest in this country.
In addition, the negative impact of the loss of income and confidence with a zero interest rate monetary policy should not be under estimated. Charles Schwab wrote last week in the Wall Street Journal,
The Fed’s super-loose policy has driven down the security and spending power of savers, particularly those in retirement who played by the rules during their working years and now depend on the earnings from their savings for a decent quality of life. As a result, savers and investors are being forced to take more risk with their money as they hunt for higher yields.
We had a conversation just tonight with an elderly woman, who is now drawing down her CD balances as her interest income has effectively vanished. She has reduced her spending; worries about how she going make her savings last; and is even considering allocating a portion of her savings to an agricultural ETF to protect against rising food prices. We’re all speculators now.
Incumbent politicians in the U.S. are about to feel the wrath of those who feel they have played by rules and are now subsidizing those who haven’t. We’ll continue to formulate our model. Stay tuned.