For the Fed, where’s the worry?

Featured Image Credits: Dan Smith and “Dontworry” on Wikimedia Commons.

The past month or so, US equities have been zealously barreling towards past highs, buoyed by the most exceptional and exquisite of all financial drugs: forward guidance.

Mostly, however, the markets’ high originated far abroad in Europe; Portugal, to be precise. Mario Draghi’s dovish tone convinced investors of the ECB’s ability to use both the rates and quantitative easing mechanism to bolster growth. Given in the past decade or so that global developed-market rates tend to move synchronously with each other, the march upward of US equities wasn’t exactly surprising either.

Nothing in this saga after Draghi’s recent speech has come as all too unexpected, including Jerome Powell’s warnings on the global economic outlook. The proverbial sea of central bank governors is teeming with doves, eager to cut interest rates as soon as the slightest threat of a slowdown or (God forbid!) a recession rears its ugly head. It seems to make sense; who wants the music to stop?

Until you realise what the current US federal funds rate is.

2.5%.

One question springs up instantly from this: where’s the wiggle room? If things do go topsy turvy and then some, what can Powell do? You could say he could use quantitative easing. When you’re one of the biggest global players, though, and your best maneuver is a policy that’s efficacy is doubtful at best, you might indeed find yourself asking how you put yourself in that position.

Is it really worth exhausting your best shot on somewhat reduced growth from a large boom in the economic cycle? Yes, there are the fears of a trade war with China. Yes, concerns regarding Iran persist. And yes, we have no idea what Trump’s fellifluous self could conjure up at any moment. There are a lot of tailwind risks to the US and global economy right now, but my take is they don’t necessitate cutting interest rates by the expected 0.5%. Especially not when in the first quarter of 2019, the US grew at a more than healthy clip of 3.1% annualised.

We’re about a decade on from the Great Recession, a time where an investment banking behemoth collapsed, credit froze over and consumer confidence sunk faster than Rory Stewart’s hope of being Prime Minister. That (or at least something close to that) is when you suck the last drops of juice from the interest rate mechanism. In my opinion, a time where economic stimulus in the form of, for example, cuts in corporation tax have (perhaps unsustainably) bolstered growth is not a good time.

Recent dovishness has led the US two-year yield to drop to as low as 1.82%, and cuts in interest rate could potentially inflate further already huge equity valuations. A dollar of an American company’s earnings has gone from setting you back around $15 to setting you back $22 or $31, depending on the data which you use. When Netflix shares dropped significantly on the back of decreased US subscribers, it may have indeed been a sign that valuations are becoming increasingly optimistic (and perhaps superfluous). Not to preempt any sort of bubbles which may be occurring in equity and broader asset markets, but signs such as this don’t really point towards much else. As any five-year-old child will tell you, inflate too much and the bubble goes “pop!”. And when the bubble affects millions of people’s livelihoods and could pose a huge threat to pensions everywhere, you really don’t want to inflate too much.

While Powell brings about legitimate concerns regarding slowing global trade and inflation, I question the need for any substantive change in policy at the present moment. Growth was frequently demeaned as laggard in the years following the 2008 recession, and it seems when economic growth finally picked up meaningfully, he thought it would continue for far longer than it did. Moreso, forward guidance can backfire, in signalling to investors that there’s some sort of grave boogeyman ready to jolt the US economy any time soon. In fact, this is simply not the case. Powell should save his best for when we’re far nearer to the trough of an economic cycle, when growth is closer to 0% than 3%, and the US labour market isn’t adding nearly as many as 224,000 jobs in June. Otherwise, he might find himself out of ammo, just when he needs it the most.

 

So Trump is a hypocrite: what’s new?

Featured Image credits: The White House

Not to say that we in the UK don’t have our own share of clownish politicians, but the phrase “hypocritical Donald” isn’t exactly an oxymoron. How about the fact that he’s pro-life and yet not disclosing how many abortions he’s paid for (hint: he should be saying zero). Or what about when he criticised Obama for playing golf while in office before playing even more golf himself in the same time period while in office? Regardless of all these, though, I’m here to talk about quite a recent example of hypocrisy from the 73-year-old’s Twitter. The tweet, from yesterday, read:

“German DAX way up due to stimulus remarks from Mario Draghi. Very unfair to the United States!”

Where to begin with this? Trump’s rationale (presumably, at least; do we ever really know?) is that Draghi’s statements that the European Central Bank (ECB) could enact stimulus measures (including cutting policy rates further) in the future adds further negative pressure on the euro. This in turn makes US manufacturing uncompetitive with respect to that of Europe, and thus has the potential to depress the US economy through reducing exports and increasing imports. This is because the dollar appreciating vis-a-vis the euro makes exports from the US more expensive for foreign buyers, and makes imports into the US less expensive for US buyers.

While this train of thought is logical, it ignores the myriad of other reasons why the ECB would try and cut rates. Growth in the Eurozone has been flagging, due to, among other factors, the risk of a disruptive Brexit and a global trade war; OECD projections state growth as most likely around 1% for the year. While I’m not denying that a part of Mr Draghi’s army of reasons to act this way would be to add downwards pressure to the euro, Occam’s razor suggests that the currency argument isn’t the primary reason why Draghi is considering such action. Moreso, it’s not as if what the ECB is doing is unconventional; monetary authorities have been using interest rates as a tool to manage the economic cycle for decades.

However, it is also true that Trump never explicitly said that the intention was to depreciate the euro; he merely said it was unfair to the United States. Does this absolve him of any blame for the statement?

I don’t think so, for the following reason: Trump has repeatedly maintained his opposition to the mildly hawkish tone of the Chairman of the Federal Reserve, Jerome Powell, with respect to interest rates. If it’s so unfair that the ECB may cut rates in case of future economic stagnation, then why is it not also unfair for the Federal Reserve to cut their interest rates instead of raising them? The world Trump lives in, where interest rates are a primary tool of exchange rate warfare, is a world where there is every action is an act of hostility. If Trump really believes his own tweet, he should expect a barrage of European criticism once he inevitably again tries to persuade Powell to halt his hawkish tone on rates.

It’s not as if Draghi is actually cutting rates right now either; his point is that they remain a tool in case Eurozone growth slows even further, a perfectly rational position to take. Draghi’s speech was somewhat reminiscent of his “whatever it takes” speech in 2012, which is widely credited for saving the euro. If Trump means that even suggesting that interest rates should be used to curb a potential recession (or decrease in growth) is unfair, he means that a central banker looking out for the interests of those he or she governs (as Draghi did in 2012) is unfair as well. In this case, one has to ask: isn’t all this “America First” nonsense that Trump keeps spouting wildly unfair as well?

The fact I’ve read so deeply into what is probably an off-the-cuff tweet from one of the most volatile Presidents in US history is a carry-forward from previous administrations. A tweet (or any sort of official statement from the President) used to be taken seriously by all, and was almost always well crafted and thought out. It speaks volumes about Trump that more and more, his tweets are beginning to look like jokes, and the markets his personal see-saws to tip up and down as he wishes. I suppose Trump being a hypocrite isn’t exactly a groundbreaking observation, but the blatant ignorance that comes with a tweet such as this is something that I felt I had to comment on.

On Bitcoin as a global currency

The featured photo is licensed under the Creative Commons Attribution-Share Alike 4.0 International license.

The recent bullish trend in the market for Bitcoin has seen the fledgling currency really capture the eyes of the general public. In many ways, the cryptocurrency can be seen as technology’s answer to today’s fiat money, and in the same vein it has been suggested that it could grow into a new global currency, coming into greater worldwide use for transactions. Fascinating though the prospect may be, for me there are several reasons why I doubt this could happen, which relate both to how a global shift to Bitcoin could be implemented and also to how this new economic paradigm could actually work once implemented. The first of these reasons is its volatility, and with that, I’ll begin.

Reasons why to me it is unlikely Bitcoin can become a new global currency

  1. Its volatility. It is likely that over the past few months bullish speculators on Bitcoin have made substantial profits, and if the price signal of the free market is anything to go by, the upward trend in Bitcoin price shows more people are accepting its viability as a currency. However, it is this very appreciation of the currency that is a great example of the point I am trying to make: at the current moment, Bitcoin is far too volatile to be held confidently by consumers. Take the example of the pound sterling. In the immediate aftermath of the Brexit referendum, the movements of the pound were taken as an unusual sign of volatility, perhaps signalling uncertainty regarding the future trajectory of sterling exchange rates. When we compare this with Bitcoin, which has previously risen against the dollar by 50%, 33%, and 20% in 23, 60 and 63 days respectively, we can see just how unusual Bitcoin’s price movements are compared to a widely-used currency. In a potential transition period whereby Bitcoin begins to come into common use, it may be economically rational for consumers to choose not to hold Bitcoins and instead to hold currencies that are far less volatile against others. This is because sharp rises and falls in the value of the currency can significantly reduce or increase purchasing power (in countries where Bitcoin has not become as mainstream) from one day to the next. In turn, this can create uncertainty regarding future spending and hence a reluctance to hold Bitcoins as a reserve currency due to this uncertainty, limiting its potential to be a truly global currency.
  2. Limitations of monetary policy. A potential counterargument to the point raised above is that Bitcoins will stop being produced when the supply of them hits 21 million. This actually promotes price stability, and means that in the long term, the point above is moot. Fair enough. What I would say to that is it then becomes very difficult for central bankers to use monetary policy tools (such as lowering the interest rate) to stimulate aggregate demand, in, for example, the aftermath of a recession. A big point often raised about Bitcoin is that it does not lie under the jurisdiction of any government or central bank, so therefore they cannot influence the money supply and hence it would be hard for political consensus to be reached on the adoption of Bitcoin as a national currency. For the sake of the all-important flexibility of monetary policy, then, I would argue that it is not only unlikely that bitcoin will become any country’s national currency, but it is also essential that it does not. However, it is true that Bitcoin can be widely accepted for transactions without becoming a national currency – but the point below indicates to me that this is unlikely to happen.
  3. Trust. In my previous article, I talked about how paper money nowadays was backed by the trust of its users. On the surface, bitcoin can seem somewhat familiar to the fiat money I mentioned: it is not backed by any tangible commodity and hence only relies the trust of societies that use it to function as a store of value, a unit of account and a medium of exchange. However, recent happenings make this trust somewhat hard to attain for bitcoin. Firstly, the volatility which I mentioned above can create uncertainty over the future prices of bitcoin in terms of other major currencies, potentially scuppering its use. Secondly, with figures such as Jamie Dimon, the CEO of JPMorgan Chase, claiming that bitcoin is “only fit for use by drug dealers, murderers and people living in places such as North Korea.”, public perception of the currency as a means to enable criminal activity may limit its general use. Factors such as these contribute to a general lack of acceptability in transactions, which severely limit bitcoin’s potential as a worldwide currency. Similarly, the failing of Bitcoin exchanges like Mt Gox also can contribute to this lack of trust and acceptability.

To summarise, Bitcoin is indeed a hugely interesting, and potentially revolutionary, new currency. However, I hope I’ve done a good job of illustrating why I think it is unlikely to be a new global currency. Regardless, I think it’s really important to keep a huge eye out for it; to me one of the most interesting developments in the global economy is how the fledgling currency does. Let’s just wait and see.

On money and its value

Money (a good that acts as a medium of exchange in transactions, among other things) is the blood that flows through the veins of any capitalist economy. As Lord King proclaims in his book The End of Alchemy, money helps us to cope with an unknowable future by enabling us to hold a store of generalised purchasing power with which to buy goods and services that might not yet exist. A capitalist economy is inherently dynamic; after all, the innovation of economic agents is what drives its existence. Generally, the free market mechanism (using money) works to maximise sales of the goods that we feel maximise our utility, or satisfaction, with relation to their cost. Returning to King’s book, however (after reading it last year), I was struck by some of the examples the ex-Bank of England chief used to illustrate some key points about what gives money its value. Most notably, the example of the different Iraqi dinars used in two parts of Iraq before Saddam Hussein was deposed piqued my interest. Rather than trying to explain it better than Lord King did, I implore all the readers of this article to read about it in The End of Alchemy. The example, though, got me thinking – what backs the paper money of today, giving it value?

The easiest way for me to think about this was to ponder what has historically given money its value, and draw parallels with today. In the past, the widely-used gold standard meant that you could exchange your paper currency for a specific quantity of gold, essentially meaning the paper money was backed by the relevant authority’s gold reserves. Such a system was commonplace, used in both the UK and the USA. The last time we saw the pound or dollar being convertible on demand to gold (either directly or indirectly) was in the Bretton Woods system of the late 20th century, which collapsed in 1971, and it’s a relatively safe bet to say that we won’t see another gold standard anytime soon. We can see how gold is valuable, though; it can be used for a variety of things, from piping to jewellery. So, holding a quantity of gold means that we hold something of value, and exchanging a claim on this value for goods and services gives someone else a claim to that value. Perhaps, then, money must be backed with something valuable to the real economy.

What, of value, backs the paper money we use today? For one, an independent central bank (or an equivalent branch of government), present in much of the developed world today. History has shown us that central banks can, and have recently been successful in taming inflation (see below). This alleviates the probable fear that holding fiat money means rapidly decreasing purchasing power from one year to the next. Good governance, then, may give money its value. That may perhaps be why we are so quick to accept that what a central bank says is £5 is actually £5; we have confidence in the entity issuing the notes and can trust that it will continue to be worth roughly £5. This also explains why countries with questionable governance, such as Venezuela, are suffering such extreme bouts of hyperinflation (although it’s not the whole story). But is the backing of dependable monetary governance really “value”? We can’t build pipes or make jewellery with it. What we can do, however, is convince others to buy our goods and services with paper money, assuring them with reasonable certainty that the value of the money will not suddenly appreciate through a sharp bout of deflation. We trust our notes and coins to not rapidly appreciate or depreciate in value, and that’s why we make and receive payments when we do.

If trust is present, then, do we need a central bank or government to “back” the currency? History says no. Take a look back at the example above – in one part of Iraq whose currency was the so called “Swiss dinar”, there was no credible system of government or central bank, however the Swiss dinar broadly retained its value.  This proves by contradiction that we do not actually need any sort of centralised authority to give our fiat money its value. We can see, though, that we still need the trust that a centralised authority can instil.

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Source: Reproduced by moneyandbanking.com from Alesina and Summers, “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit and Banking, May 1993.

Concluding, then, it’s clear that our paper money isn’t backed by something as physically valuable as gold, and for the flexibility of our monetary policy’s sake, that’s probably a good thing in my opinion. What I would say here is that our fiat money, today, is backed by trust, namely trust that our money will broadly retain its value from one day to the next, and continue to be widely used in transactions. Can this be instilled by centralised government or a central bank? Definitely; we’ve seen that in the UK and the USA. Does it have to be? Iraq tells us no. Social cohesion and/or a record of money previously maintaining its value, among other things, could deliver the trust that is essential to preserve money as the lifeblood of a thriving capitalist economy. Such an arrangement connecting money and trust is fragile, yes, and it is scary to think of the impact on our economy should we lose our trust in money’s ability to retain its value. It is for this very reason that I believe that sound social institutions and governance are some of the most important prerequisites for a successful capitalist economy to form. Without them, people lose trust in money, and without money as we know it, we see the end of our brand of capitalism.

 

 

Why central banks should target 4% inflation

Photo by Remy Steinegger

It is October 29, 1929 , also known as Black Tuesday. The Great Depression, one of the largest economic downturns in history, has just begun. Unbeknownst to the everyday man and woman, this will last a backbreaking decade, during which these everyday people will see their dreams slashed in the face of lower wages. That is, if they even find a job in the first place; unemployment will reach almost 25% in America at the height of the depression in 1933. During this time, it’s obvious that we will start looking to policymakers for solutions to this problem, however, even they have been silenced by the lunacy of the gold standard: there are no solutions in the pipeline.

Time for a voyage into the future. 1990, specifically – New Zealand. The Reserve Bank of New Zealand has just introduced a pioneering measure that will shake up monetary policy: the inflation target. They say they target a rate of price increase of 0 to 2%. Fast forward 22 years, and on the 25 January 2012, Ben Bernanke, the chairman of the most famous central bank in the world, the Federal Reserve, has introduced a 2% inflation target. Nowadays, the magic “2” is the norm, with central banks from the Bank of England to the Bank of Japan adopting the target. The problem? Well, there’s more than one, but the most arresting drawback is that we’re veering into very dangerous territory should we be even slightly amiss in meeting these targets.

Say we undershoot from our inflation target. That can happen, right? People make mistakes – even big, bad central bankers. If prices, therefore, appreciate by only 1% a year, that’s not too bad. But say we adjust the degree of error even more, and then we’re veering dangerously into deflationary territory – a nightmarish decrease in prices. In both my opinion and the opinion of many others, deflation is far worse than even high levels of inflation. This is because a deflationary slump in an economy causes people to think twice about purchasing goods and services, reducing demand for these goods and services, decreasing their prices to levels lower than they already are. Intuitively, this causes job layoffs as the reduction in demand causes a corresponding reduction in corporate revenue, and so the freshly unemployed aren’t very likely to buy non-essentials like a bottle of Coke or a packet of gum, let alone a new house. The ensuing vicious downward price spiral amidst a plethora of redundancies has historically been extremely difficult to get out of; deflation can batter an economy like nothing else. Where do we look for an example of this? Back to the past, that’s right – the Great Depression, where prices plummeted and redundancies soared due to a collapsing banking sector.

Moreover, recessions happen. We can’t prevent all of them, and it’s a fact of life that the average person is overwhelmingly likely to experience at least one or two in their lifetimes, if not many more. It’s how a central bank deals with the recession that defines how strong and robust their monetary policy is, and when you can only decrease interest rates by a small amount, then you’ve got a problem. Take the Bank of England. Interest rates currently sit at staggeringly low levels: 0.5%, to be precise. Let’s assume they meet their inflation target of 2%, and so the nominal interest rate (the interest rate when we don’t take into account inflation) will be 2.5%. Now, let’s hypothesise that they increase their inflation target to 4% and meet it (I know, I’m optimistic about their abilities). Now we have a wiggle room of a whole 4.5% should we face a recession, so we have a greater chance of stimulating the economy and getting it back on track. Even taking into account that central banks may not meet these targets, it’s logical to believe that they’ll at least achieve a higher inflation rate than before, and so regardless of the scenario, the overwhelming likelihood is that we’ll have more chance of beating back a recession than before.

Finally, we need to lend the companies that are the backbone of our economy a hand in being able to dish out nominal wage increases. Again, let’s take a scenario whereby we have higher inflation, say 3% (due to central banks undershooting the 4% inflation target) and the nominal wages of not very productive employees operating in, for example, McDonalds rise by 2%. In reality, they’ve still got 1% less purchasing power than they did before, however McDonalds’ 2% rise in wages keeps them happy and satiated; they won’t go on strike or resign or do all the things that corporations fear so much. Say we had a much lower inflation rate, perhaps 1%. Now, McDonalds is in hot water because they can only increase wages by a small, small amount, risking the ire of its employees. If the inflation rate went even lower, then we have even more of a problem; McDonalds cannot hand out relatively large nominal wage increases, as if they were to do so, their costs would increase, therefore enabling a reduction in profits. So now we have annoyed corporations, annoyed employees and perhaps an economy on the verge of recession, with very little room to alter interest rates when we enter one. All because of those dastardly low inflation rates.

Since 1990, the inflation target has become one of the key symbols of monetary policy and central banking. We need to increase it; I think it’s time to change this symbol for the better.

Do you?

Shrey Srivastava, 16