Can the Federal Reserve "Really" affect interest rates?

At the end of When is an Investment not an Investment I talked about the inevitable rise of real interest rates once the RBA has finished lowering them by printing money. It’s now time for a discussion on real and nominal variables. While this isn’t totally necessary to understand the next article, it does highlight an interesting anomaly: a lower interest rate at the bank shouldn’t necessarily induce anyone to borrow more.

In So what’s the best way to hedge against inflation? I talked about how nominal interest rates (the full interest rate quoted by banks) are made up of two components (check out paragraph three for a recap). The “expected inflation” component is simple enough to undertand, but businesses generally don’t care about this. Once you borrow money, inflation in a funny way is your friend (making Ben Bernanke your hero). Just as the dollars that Rob Mariano won in 2010 weren’t worth as much as the dollars his wife won six years earlier on Survivor, the dollars that businesses use to pay back their loans years later are not worth as much. To understand this abstract use of the term value think which dollars you rather have, the ones that Rob was given, or the ones that Amber was given six years earlier, that could buy more goods. Businesses that borrowed in 2004 got Amber’s dollars, and the banks that lent the money were getting Rob’s dollars back in 2011. So if the nominal interest rate rises (and hence your nominal borrowing costs rise) but expected inflation rises as well, they tend to cancel each other out, and the real cost of borrowing hasn’t changed. What’s left is the real interest rate that businesses need to be concerned about. This relationship holds virtually one to one. If the expected inflation rate falls by one percent, the nominal interest rate tends to falls by one percent, but businesses have no incentive to invest further, even though the nominal interest rate has fallen. In the long run lenders face the same trade off. If their inflation expectations rise they will be happy as long as nominal interest rates rise to compensate them (one percent higher inflation, one percent higher nominal interest rates). you can see that even though the nominal interest rate has changed, no one has borrowed more or saved more. The nominal interest rate is (approiximately) equal to the real interest rate plus inflation expectations.

Its only when that residual, the real interest rate, changes that there is an incentive to move money. This residual is simply determined by borrowers and sellers getting together and deciding on an interest rate in the market: it is determined by the demand for and supply of savings. It should be becoming clear now that it is not controlled by the central bank, at least in the long run. So what’s the best way to hedge against inflation explains how investors vote with their feet and determine interest rates. In the short run the RBA can print money and lower nominal rates as in The Wonderful Central Bank of Oz (which, holding all else equal lowers real rates) but rates will eventually rise back to their original level to maintain the real interest rate, and then a little bit more to compensate savers for the extra inflation from the additional money printing. The primary point to take away is that the real interest rate hasn’t changed.

This illustrates, and this is common, accepted, mainstream economics, that the reserve bank can only affect the real interest rate and borrowing in the short term. Any investment made at the lower interest rate thanks to the Central Bank will be unprofitable when things normalise.

Something's gotta give

China has chosen to widen the band on its Yuan exchange rate, starting today, allowing its currency to fluctuate a further one half of a percent either side of the peg. However most people can only see the Yuan appreciating. This makes our recent articles on the ballooning money supply of China, caused by its undervalued exchange rate, quite timely (that’s my version of a brag). Following China’s gradual easing of its capital controls, it was either going to have high inflation or a higher exchange rate. It also shows that china is not going to be bullied by anybody about its exchange rate. When the US was screaming the loudest about the Yuan being undervalued (which as we said causes large exports) China’s trade surplus was massive (when exports are larger than imports it’s called a trade surplus) boosting the economy along!  But the data of late on Chinese trade has shown a drop in exports! If China was going to bow to US pressure to raise its exchange rate, you’d think they would bow in the face of bullish economic data, not soft. What’s more, the soft trade surplus data has resulted in diminished outcries from the US. I think this is evidence that Yuan appreciation will never have anything to do with US tantrums (which will never be as scary to Hu Jintao as having the wrath of all China bearing down on him, but that’s an article for another day).

But we can think of some other reasons that China might want to raise its currency!

More on the business cycle soon. I haven’t forgetten.

When is an investment not an investment?

On Tuesday we talked about the loose monetary policy of theFederal Reserve and how it was propping up stock prices. This process falls under the term mal-investment in its simplest form. Mal- investment is a term developed in the Austrian school of economic thought. It simply refers to poor economic decisions being made by firms, and resources being allocated inefficiently to areas of the economy where prices would otherwise not send them. The Austrian business cycle predicts that the artificially low interests rates (the price of money) and government intervention give misleading price signals and result in money pouring into the wrong places, ultimately causing asset bubbles. It is a competing economic theory with the more mainstream neoclassic economics, which tends to believe that you can smoothly adjust monetary (central bank) and fiscal (government spending) policy to adjust the level of investment in the economy. With the booms and busts in the business cycle, you can’t help but wonder if they’re wrong.

The Austrian Business Cycle Theory predicts that when interest rates are lowered by a monetary authority for an extended period, businesses will borrow and overspend on capital goods in order to ramp up production (the credit expansion phase). The eventual end is that businesses have large loans which were used to purchase equipment which is not needed. The resulting default on these loans causes the contraction in credit and the ensuing chaos. The big problem with the Austrian Business Cycle Theory is that it doesn’t provide a very convincing reason why people would make these bad economic decisions. The sophistication of forecasting techniques and relative transparency of central banks lead me to believe that a recurring and erroneous overspend on capital goods by the whole business sector is unlikely. I believe booms and busts are more to do with the short term outlook of business, moral hazard, and an inability to comprehend a system as complex as a national, let alone global economy (although we do our best to make some sense of it here). However, whatever the reason for it, you can’t deny that “mal” or “bad” investment occurs. Did the economy really need 2 million houses in 2005? Did it really need a company called webvan.com so bad that it was worth 1.2 billion dollars? History suggests it didn’t. And yet these investments continue to go ahead, cycle after cycle.

The green shoots of the next cycle of mal-investment in its simplest form are occurring as investors are pushed out of bonds and into riskier investments like stocks as described in Economy doing too well. Stocks Slump. This is how bubbles begin. Initially, long term capital investments are too illiquid for businesses to be convinced to invest; a fund manager will invest in shares knowing that he can sell them at the push of a button, whereas a factory cannot be quickly sold before it drops in value when Bernanke announces a withdrawal of stimulus. However hold interest rates down long enough, and mal-investment eventually sprouts into more complex forms of investment as the boom cycle gains momentum, but with one thing in common: being inefficiently allocated, they are unlikely to make a sufficient return. The reserve bank can lower interest rates to make borrowing less expensive, but it can’t engineer profitable investment opportunities.

Mal-investment doesn’t just come from the private sector. Governments around the world have been “allocating” (blowing) cheap money to “inefficient projects” (cash for clunkers) like it’s going out of fashion. It is private sector mal-investment that is the primary concern though, as it has the ability to grow to epic proportions. Eventually enough printed money runs out of profitable avenues  for investment, and so it starts chasing bad ones. These bad investments are profitable when it costs 3% per year to borrow, but when rates inevitably rise the investments tank. Next article I plan to show exactly why reserve bank stimulus won’t help the economy.