There are well-known dangers in relying on a reserve currency that lacks a built-in control or alarm signal. The problem is currently illustrated by China’s ability to collect “rents” on its resource of a large, low-cost labor pool, which China’s rulers suddenly allowed to be “discovered” by the rest of the world. China recycles a substantial portion of its export earnings by purchasing U.S. Treasury bonds. Money leaves the U.S. and comes right back — regardless of the level of U.S. interest rates. A long-lasting deficit can develop in the U.S. balance of payments because foreign settlements no longer automatically reduce the amount of credit available at home.
Suppose, however, that the Chinese government decides, under pressure, to let its currency float and the yuan appreciates against the dollar. China will then expand its economy at a slower rate, collect fewer rents on its labor pool, and consequently recycle fewer dollars via Treasury purchases. (This outcome will be averted only if the country democratizes its domestic capital markets, a reform not currently contemplated by its communist government.)
Both countries may experience bank failures, recession, and inflation due to the resulting reduction in both growth rates and global demand for dollar liquidity. The source of the problem is the Fed’s reliance on mis-measured aggregates to control the supply of dollar liquidity, rather than market prices — such as gold, commodity prices, and yield curves. Until it turns its attention to market-based indicators, global central banks and governments involved in managing a reserve currency, as well as other countries linking their currencies to those reserve currencies, may compound their mistakes by perpetuating policies premised on current fads and a casual disregard of facts.
The interest-rate mechanism currently used to control domestic inflation of a reserve currency is wrong-headed. If the Federal Reserve decides that there is too much dollar liquidity in the world, it can directly absorb it in a number of ways other than the indirect mechanism of managing interest rates. Using more direct methods, such as buying or selling bonds, while targeting the aforementioned market-based prices, would have the desired effect on both domestic inflation and exchange rates, while also diminishing market volatility.
In contrast, the indirect impact of raising interest rates is twofold: It reduces the supply of dollar liquidity, but at the same time diminishes the global demand for dollar liquidity. The paradoxical effect may be higher domestic inflation if the global demand for dollar liquidity drops. If this happens, gold will rise and the dollar will go down, effects that may then show up in higher measured price indices. Misguided by its focus on price indices, the Fed may raise rates again — with similar consequences.
Investor reaction to Ben Bernanke’s apparent focus on price indices — jumping into the stock market when he hints that he may not raise rates, and jumping out when they suspect he will — is understandable. These reactions do not imply that investors prefer inflation, but rather that they expect the Fed may be overshooting or undershooting. The following historical graph makes it clear that investors prefer stable price levels. Stock prices rose at anemic rates in the 1960s and 1970s as inflation accelerated from its earlier, moderate pace. Conversely, when inflation decelerated in the 1980s, stock price performance turned sharply higher, reaching its zenith in the 1990s as inflation receded to a level last witnessed three decades earlier.
The question is by what mechanism a central bank chooses to eliminate or prevent inflation. Past and present volatility suggest that investors do not have confidence in the present mechanism of central banks targeting interest rates, capacity utilization, and unemployment. They would prefer that central banks stay focused on market-based price signals of inflation or deflation.
As Mark Twain observed, history does not repeat itself, but it rhymes. Back in the late 1970s and early 1980s, the Fed announced its “monetarist” approach to monetary policy. While there should be no doubt that preventing the money supply from growing too fast prevents inflation, defining “too fast” is no simple matter when the global demand for a reserve currency fluctuates. Recall that even though Milton Friedman seemed to advocate a 3 percent money-growth rule when writing textbooks, in his articles concerning Japanese monetary policy, he recommended an 8 percent annual growth rate. In recent interviews Friedman has suggested that he should not have been recommending overly rigid monetarism; perhaps it is not a coincidence that the Fed has stopped publishing the M3 series. Although Paul Volcker’s control of the growth of monetary aggregates eventually eliminated inflation, getting there was accompanied by volatile interest rates, recession, and, by February 1980, gold reaching $850.
We do not know whether the gold price signaled a devaluing dollar (because recession in the U.S. diminished global demand for the dollar, lower monetary growth notwithstanding) or investor uncertainty that the Fed would be disciplined enough to stick to its guns in the face of intense political pressure. The fact is that raising interest rates was not sufficient by itself to dispel inflationary expectations. Eventually, the combination of tighter control on monetary growth and Ronald Reagan’s sweeping tax reform — which increased the global demand for the dollar — solved the problem.
Raising interest rates neither prevents further dollar devaluation nor reduces inflation. What the Fed does accomplish by boosting interest rates is to boost stock market volatility in the bargain. For example, on May 10, the Chicago Board Options Exchange SPX Volatility Index (VIX) stood at 11.78. That was just a fraction above the ten-year low reached in the first quarter of 2006. Between May 10 and June 13, stock prices plummeted by 8 percent, a move widely attributed to increased fears that the Fed would tighten further and overshoot. Over the same period, the VIX doubled to 23.81.
As Sen. Daniel Moynihan once observed, people are entitled to their own opinions, but they are not entitled to their own facts. Perhaps it is time to get rid of the macroeconomic myths and jargon — to discard undue focus on mis-measured, incomprehensible, statistical aggregates, and, instead, let market prices guide Fed policy.
– Reuven Brenner holds the Repap chair at McGill’s Desautels Faculty of Management, and is partner at Match Strategic Partners. He is also the author of Force of Finance (2002). Martin Fridson is publisher of Leverage World and author of Unwarranted Intrusions: The Case against Government Intervention in the Marketplace (2006).