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Fixing the Price of Money
The major problem with letting bureaucrats (or politicians) set the price of something is that they will almost always set the price either too high or too low, thus creating an imbalance. Occasionally, by pure luck, they may set the price at the correct level – the level at which supply and demand are brought into balance. This ideal level is, of course, where the market price would naturally be in the absence of our helpful bureaucrats. We can't figure out why so many intelligent people – people who would normally rail against the notion that the government should be allowed to fix prices – accept, without question, that it is reasonable for a team of bureaucrats at the central bank to fix the price of money.
The reason that a team of bureaucrats at a central bank, or any other committee or individual for that matter, can never hope to consistently set interest rates at the correct level is because doing so requires a consistently-accurate view of the future. That is, it requires the impossible. Due to the substantial delay (commonly estimated to be around 6-12 months ) that exists between a change in monetary policy and the effects of that change being felt throughout the economy, today's monetary policy must be based on the economic/financial conditions that will prevail at least 6 months into the future. It is possible for an astute market observer, none of which appear to be employed by the Fed and none of which are economists, to get a feel for what the economy will be doing in 6-12 months time by studying cycles and by comparing the current price-behaviour of various markets with that of past periods. However, even the smartest forecasters are completely wrong some of the time. Strangely enough, the smartest forecaster of them all tends to be 'the market'.
We spent a lot of time over the past 3 years arguing that Fed policy was excessively loose. While others were busy subtracting the heavily-manipulated CPI from the Fed Funds Rate and coming to the ridiculous conclusion that real interest rates were too high, we were looking at the rate of growth in the money supply and concluding that real interest rates weren't just low, they were negative.
Throughout 1997, 1998 and 1999 we argued that the Fed was accommodating a speculative boom by holding the price of money at an artificially-low level. Then, around April/May this year, we suggested that the Fed would soon begin running the risk of fixing the price of money too high. That risk is not yet evident as the money supply has grown at a rapid pace over the past few months, meaning that nominal interest rates are still lower than where they would naturally be if determined by market forces alone. It should be noted that the Fed hasn't been actively promoting money-supply growth as it did last year (the monetary base is still below its January level and has been essentially stagnant for most of the year), at least not yet. Until now it has simply watched from the sidelines as various financial institutions expanded their balance sheets and, in the process, expanded the total supply of money.
Although the risk of overly-high short-term interest rates is not immediately evident, the stock market and the reports/guidance being issued by companies may be indicating that a severe economic slowdown looms on the horizon.
On a day-to-day basis the stock market is mostly irrational and driven by the emotions of greed and fear, but over a longer time-span it is rational. It is continually trying to assign a present value to a company based on expectations of future earnings and the future level of interest rates. For example, the market may be willing to assign a value of $1B to a company based on an expected future earnings stream. However, the present value of those earnings is determined by expectations regarding the future level of interest rates that are, in turn, determined by the expected future inflation rate. The higher the expected future level of interest rates, the lower the present value (discounted value) of future earnings will be and the lower the market value of the company will be. Therefore, any change to the expectations of the market regarding the future rate of inflation, the future level of interest rates or the future rate of earnings growth can (and usually does) have a pronounced effect on today's market value.
The point is that when the market drops as it has since early September there are certainly emotions at work that are causing the huge daily swings in the averages and individual stock prices, but there is also a discounting process going on. The market is looking 6-12 months into the future and, at the moment, it doesn't like what it sees. Perceptions can change and it is said that the stock market has discounted 5 of the last 2 recessions, so the recent market decline may turn out to be another mischievous cry of wolf. In fact, based on the strong performance of cyclical (economically-sensitive) stocks over the past few trading sessions it is possible that perceptions are already changing. However, the bond market also tries to discount the future and the performance of corporate bonds over the past few months suggests a substantial and growing risk of debt-defaults during the next 12 months. Stocks and bonds are, of course, inter-related – a healthy stock market cannot exist, for a prolonged period, in the absence of a healthy corporate bond market.
Divining the economic future is an extremely complex task and even 'the market' – the greatest of all forecasters with its ability to continuously adjust prices based on a veritable ocean of variables – is sometimes caught off-guard. So the 7-trillion dollar question is, why do we dramatically magnify the risk of a mistake by making slow-thinking/slow-moving/politically-biased bureaucrats responsible for setting the price of money?
Steve Saville
Hong Kong
3 November 2000
The reader is invited to respond to Mr. Saville's wisdom via email:
sas888@netvigator.com
