'New Monetary Policy'
The latest years have not only seen a 'New Economy' yet also a 'New Monetary Policy'. As depicted in the next picture, M1 and M3 grow has considerably changed from the cyclical patterns in the latest decades.
The US Fed can actually control the growth of these aggregates through interest rates changes and open market operations. In order to better understand the major shift in Fed policy M1 is basically short term money (overnight rates) and M3 is basically long term money (bonds). As the interest yield curve is usually in contango, M1 rates are lower (cheap money) and M3 rates are higher (expensive money). The banking system works basically that banks borrow short money from the Fed and lend it to their customers for the long term at higher rates (prime rate).
In a normal business cycle the FED lowers overnight rates when the economy softens in order to stimulate lending of banks to their customers and thus increasing economic growth. This happened 1985/86 and 1992/93 when the Fed lowered overnight rates and consequently increased M1 as short money increased by a high rate. Unfortunately the increase in M1 has some side effects such as a low dollar (the opportunity costs for holding cash dollars are increasing through lower interest rates) and also high global money supply as countries outside USA can also lower their overnight rates. The consequence of this cyclical increase has been a sudden increase in inflation through higher raw material and worldwide higher finished goods costs.
In its learning curve, the Fed had now switched to another policy in the last seven years. As in the above chart shown, the Fed increased only M3 through open market operations and left M1 growth rates low through keeping the overnight rates at a relatively high level. So, M3 increased dramatically in the last several years while M1 growth stayed at a very low rate. Keeping short term interest at a high level had another positive side effect: the dollar has been on a high level despite an astronomical high current account deficit. As most of the money worldwide is in money accounts the high interest rates in the dollar relative to other countries ensured a high dollar stability.
The logic of this strategy is quite compelling. Through keeping dollar stability over high overnight rates, the long term rates could also stay on a low level through low inflation. Low long term rates had also the benefit of stimulating long term investments in capital, housing and big consumer items. As the long term interest rates are so low also banks can refinance themselves over selling bonds rather than borrowing money from the Fed over the money market. The prime rate stands still over 8 %, so banks can sell Treasury bonds at 5% and lend the money out at 8% making a margin of around 3%, which is quite decent when it is done in the billions. As the money is now spent for capital investments which will result in higher productivity, it will also have a real return to the economy.
This strategy has worked quite well in the last few years as each economic downturn could have been matched by a huge increase of M3. Nevertheless, the new monetary policy has also its drawbacks. To increase M3 growth is more expensive for the economy than to increase M1. Low long term rates are quite favorable for housing and other long term investments, yet they are actually not cheap money for the short term borrowing requirements of companies. As long as the economy grew very fast this has not been a big issue for many companies. Now as the economic climate through high costs and lower demand squeezes companies profit margins, the high short term rates are a big burden for many companies to regain their liquidity. This comes in addition to the already high interest rate expenses of many companies having invested in long term infrastructure, which is obviously not so profitable as initially planned (internet and communication).
It is now very important to increase short term liquidity through lowering short term interest rates. Yet this will have as a consequence a lower dollar and will drive up long term interest rates through inflationary expectations. This is the reason the Fed is now very reluctant to lower overnight interest rates. Dollar interest rates would fall below Euro interest rates and thus put a lot of pressure on the dollar.
So, the Fed just waits until housing, capital investments and other long term interest rate sensitive sectors will pull out the economy once again from the current slump.
Nevertheless, this time it will be quite challenging, as the debt load of many companies and consumers is already high and much of the new indebtness is actually made for consumption (i.e.California increases its debt for purchasing electricity) and not for capital investments.
As the high debt load and interest expenses - threatening many companies - become now very strong forces, even low long term interest rates cannot help the economy. Consumer need an income and a job in order to pay for their houses and cars. Low interest rates alone cannot stimulate demand as the Japanese example shows.
The Fed very likely will wait too long for lowering short interest rates as it waits until its strategy is working once again. Many companies will fail and thus many jobs will disappear. The readjustment of the economy will be for this reason quite disruptive for the US economy. After this adjustment the Fed will be forced to increase M1 and to print cheaper money to rebalance the economy. This will be also the time of gold, when central banks will have no other choice than to print easy and cheap money.
Dr. Heinrich Leopold
hleopold@barclays.net
www.globalfuturenews.com
15 March 2001
Printer Friendly Version
Email this Article