• Sun
  • Dec 21, 2014
  • Updated: 1:59pm

US Federal Reserve

Founded in 1913, the Federal Reserve is the central banking system for the United States.

BusinessBanking & Finance
MONETARY POLICY

Why US interest rates aren't going higher any time soon

While recent data looks encouraging, the US economy remains weak and vulnerable, which is why the Fed won't raise interest rates anytime soon

PUBLISHED : Monday, 09 June, 2014, 10:26am
UPDATED : Tuesday, 10 June, 2014, 1:06am

Financial markets have been primed for about a year now to expect higher US interest rates. They haven't arrived yet and probably won't until well into 2016.

Don't be fooled into thinking that the tapering of the Federal Reserve's massive asset purchase programme heralds the imminent normalisation of monetary policy.

The massive distortions created by the Fed's interest rate manipulations will be with us for far longer than most analysts anticipate. Why? Because the American economy is still in the midst of the Great Recession.

Recent data looks encouraging, but the US economy remains weak and vulnerable. Aggregate demand, as measured by final sales to domestic purchasers, tells the tale.

When … Volcker … pushed interest rates up, the opportunity cost of holding cash increased

The annual trend rate of growth in nominal aggregate demand has been 4.95 per cent since 1987. At the depth of the Great Recession, that plunged to an annual rate lower than minus 4 per cent.

Aggregate demand almost reached the trend rate of growth in late 2011, but since then it has slumped to its current 3.19 per cent annual rate.

And the reason why nominal aggregate demand is so weak is because money supply is tight.

Economists might believe the Fed's monetary taps are wide open, but they are looking at the wrong indicator when making that assessment.

A lesson from 1979 makes the point perfectly. That was when Paul Volcker took the reins of the Fed with the annual rate of inflation running at 13.3 per cent.

He immediately saw that restoring the economy to good health meant wringing inflation out of it and that killing inflation required tight control of the money supply.

By 1982, inflation had dropped to 3.8 per cent, but Volcker's squeeze triggered a relatively short recession that started in January 1980 and lasted less than a year, only to be followed shortly afterwards by a more severe slump that ended in November 1982.

Volcker's problem was that the monetary speedometer he watched was defective. Each measure of the money supply - M1, M2, M3 and so on - was shown on a separate gauge, with the various measures being calculated by a simple summation of their components.

The components of each measure were given the same weight, implying that all of the components possessed the same degree of usefulness in immediate transactions where money is exchanged between buyer and seller.

The Fed's gauges seemed to be saying its policy mix was the equivalent of tapping the money-supply brakes with just the right amount of pressure, when in fact it had effectively slammed them on from 1978 until early 1982.

A different measure of money supply, the Divisia index, would have revealed the flaw in the Fed's reliance on a conventional measure.

Divisia reflects that money takes the form of various types of financial assets that are used for transaction purposes and as a store of value - or its "moneyness".

Money created by a monetary authority - notes, coins, and banks' deposits at the monetary authority - represents the underlying monetary base of an economy. This state money, or high-powered money, is imbued with the most moneyness of the various types of financial assets that are called money.

The monetary base is ready to use in transactions in which goods and services are exchanged for "money".

In addition to the assets that make up base money, there are many others that possess varying degrees of moneyness - a characteristic that can be measured by the ease of and the opportunity costs associated with exchanging them for base money.

These other assets are, in varying degrees, substitutes for money. That is why they should not receive the same weight when they are summed to obtain a broad money supply measure.

Instead, those assets that are the closest substitutes for base money should receive a higher weight than those that possess a lower degree of moneyness.

So when the Volcker Fed pushed interest rates up, the opportunity cost of holding cash increased. In consequence, retail money market funds and time deposits, for example, became relatively more attractive and received a lower weight when measured by a Divisia index.

Faced with a higher interest rate, households had a much stronger incentive to avoid cash and current account balances.

The higher Fed interest rates went, the greater the divergence between the simple-sum and Divisia measures of money supply.

When measuring money supply, the broadest measure is always best, and Divisia measures are the best of all.

The US is fortunate to have Divisia M4 available from the Centre for Financial Stability in New York, and when you look at that data, it becomes clear why US nominal aggregate demand and the wider economy have followed the course that they have - the annual Divisia M4 growth rate is an anaemic 2.6 per cent.

The Fed has not taken its foot off the state money accelerator, but there has been an outright drop in the quantity of bank money in the economy since the collapse of Lehman Brothers in September 2008.

Since bank money accounts for 80 per cent of the Divisia M4 measure, its decrease has dragged down the overall money supply growth rate.

Tougher bank supervision, stricter prudential bank regulations and higher bank capital requirements explain the drop, and these pro-cyclical squeezes are unlikely to be released soon.

In consequence, the Fed will probably be forced to keep official rates zero bound much longer than most think - perhaps well into 2016.

Steve Hanke is professor of applied economics at Johns Hopkins University. He is also a senior fellow and director of the Troubled Currencies Project at the Cato Institute in Washington

Share

Related topics

For unlimited access to:

SCMP.com SCMP Tablet Edition SCMP Mobile Edition 10-year news archive
 
 

 

3

This article is now closed to comments

singleline
The US is now facing the same dilemma as Japan.
Both governments want their own economies to quickly recover.
But this also means a gradual rise in the interest rate, burdening much more the highly-indebted governments than before, in terms of much more interest payments that have to be made by them --- a catch 22.
Of course they want the best of both worlds, which is both a quickly recovering economy and a persistent low-interest-rate environment.
Let's see whether the no-free-lunch postulate can be refuted by them once again.
If successful, the US government can continue the same old trick as before, by selling pieces of paper (now, perhaps just electronic figures) called government treasury to China and other countries, get back real goods and services through imports, and pay next-to-nothing interest.
Meanwhile, her currency's real value has been going downhill.
As was said by Abraham Lincoln, you can fool all the people some of the time, and some of the people all the time, but you cannot fool all the people all the time.
singleline
Regarding Japan, the US faces another dilemma.
Japan can be encouraged by the US to militarise herself so as to limit the expansion of China in Asia, but doing so also means that Japan, now ‘much more powerful and much less dependent on the United States for its security,’ could no longer be fully trusted by the Americans.
The possibility of a second Pearl-Harbour-like Japanese attack on the American territories cannot be fully discounted.
(‘America’s Late Imperial Dilemma’
****www.project-syndicate.org/commentary/ian-buruma-defends-barack-obama-s-retreat-from-pax-americana#Sx68Rvwy1i8SXt1H.99)
singleline
In response, imitating the US, China can subcontract the manufacture of some of the government’s military weapons to the private bidders (not to the SOEs, for the sake of efficiency and equality).
This way, part of the problem of excess capacity currently afflicting the country can be solved, even though the weapons are known to be the investment with the least possible rate of return.
 
 
 
 
 

Login

SCMP.com Account

or