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5 THE INTEREST RATE CONUNDRUM,
Part 1 Economics of
denial By Henry C K Liu
Suddenly this summer, all eyes are trained
on rising interest rates around the globe. The
prospect of central banks tightening to ward off
impending inflation has abruptly interrupted the
spectacular rise of all stock markets driven by
abnormally ample liquidity, but has yet to
precipitate a market crash. Under normal
conditions, rising rates lower bond prices as well
as equity prices. But in the current liquidity
boom that has produced a persistently inverted
yield curve, high short-term interest rates have
crashed bonds but
have
left equity prices higher than market fundamentals
could justify.
Yet even as rising interest
rates will eventually reduce liquidity to reverse
the rise of stock markets, it will not arrest the
real decline of the US dollar. The anomalous
combination of rising interest rates and
overpriced stocks is explosive enough by itself;
but adding to it the shocking impotence of rising
interest rates to arrest the declining value of
the dollar, we have an unstable mixture of deadly
financial dynamite waiting to be detonated by even
seemingly unrelated minor events.
Normally, high interest rates should lift
the exchange value of a currency to reduce import
prices to constrain inflation, which is one of the
offsetting benefits of a tight monetary policy
that otherwise slows down the domestic economy.
Increased global capital inflow would also be
attracted by high interest rates.
But the
US dollar is not a normal currency. It is a fiat
currency that can be produced at will by the
United States, not backed by anything of intrinsic
value, yet assuming the role of a reserve currency
for international trade and finance. This unique
characteristic is what lies behind dollar
hegemony.
The US dollar is the head of the
world's fiat-currencies snake. As the fiat dollar
declines in value over the long term, as expressed
by its dwindling purchasing power, all other fiat
currencies decline with it because of dollar
hegemony within the current international finance
architecture, even though some currencies may
decline faster temporarily because of varying
local conditions such as different interest rates
and inflation rates. In that case, the market
registers the dollar as rising in exchange value
against these currencies, while in reality, all
currencies are following the dollar in steady net
decline against real assets. Market cheerleaders
then mislabel the persistent rise in asset prices
from the steady decline in currency value as the
sign of a healthy business boom in an allegedly
dynamic global economy led by the liquidity boom
in the United States.
At the same time,
some currencies may decline more slowly in
purchasing power than the dollar, causing the
market to view these currencies as rising in
exchange value against the dollar while in reality
they are also declining in real value. The
temporary divergence or convergence of exchange
values between and among currencies, caused
sometimes by market inefficiency or at other times
by market overshoots, are what make currency
arbitrage profitable, albeit with corresponding
risk of loss.
This global trend of
declining currency value has been going on in the
current international finance architecture for
several decades and has distorted the historical
and conventional relationship of interest rates to
inflation and economic growth. This distortion has
sent central bankers looking desperately for, if
not new, at least newly rediscovered economic
theories to construct improved algorithms to guide
their deliberations on monetary policy in the new
paradigm.
A new guru for the
Fed The Wall Street Journal (WSJ) on
October 3, 2000, reported that the Federal
Reserve, the US central bank then under the
chairmanship of Alan Greenspan, had of late fallen
under the influence of the views of Swedish
economist Johan Gustaf Knut Wicksell (1851-1926)
on the relationship among interest rates,
inflation and economic growth. Wicksell argued
that monetary policy works best at containing
inflation by pegging interest rates not to the
level of money supply as mandated by textbook
neoclassical economics theory, but to the rate of
return on investment (ROI). Some critics described
the Fed's new fad as asking for advice from dead
men who never had a chance to analyze present-day
data. Wicksell died three years before the 1929
stock-market crash.
Greenspan made his
famous "irrational exuberance" speech at the
conservative American Enterprise Institute in
Washington, DC, on December 5, 1996, when the Dow
Jones Industrial Average (DJIA) was at 6,442,
already more than twice the pre-1987-crash high of
2,722. Less than a year earlier, on January 31,
1996, the Fed had lowered Fed Funds Rate (FFR)
target 25 basis points from 5.5% to 5.25% to add
liquidity to the very same irrational exuberance
Greenspan later warned against. The Fed did not
raise the FFR target again until four months after
Greenspan's warning, and then only by 25 basis
points, back to 5.5%, on March 25, 1997.
Not surprisingly, the market kept rising
despite the Greenspan warning and, on January 14,
2000, with the FFR target still at 5.5%, the DJIA
peaked at a hyper-irrational level of 11,723,
rising another 83% over Greenspan's warning level.
But the US gross domestic product (GDP) only rose
from US$7.8 trillion in 1996 to $9.8 trillion in
2000, or 25.6%. The DJIA climbed three times more
than the GDP in the four-year period after
Greenspan's warning of irrationality. One can only
conclude that the US dollar had declined in value
by 57.4% in that time.
Two months later,
after some secular bull-market corrections in
which each down closing was erased by subsequent
gains, the DJIA scored on March 16, 2000, its
largest one-day point gain in history, 499.19
points, to close at 10,630.60. On April 14, 2000,
22 trading days later, the DJIA plummeted 617.78
points, closing at 10,305.77, its steepest point
decline in a single day so far, but the DJIA was
still 50% higher than the 6,442 that prompted
Greenspan's irrational-exuberance warning more
than four years earlier. This volatility came
purely from speculative forces operating in a
liquidity bubble. The real US economy did not
change in 22 trading days.
Interest
rates and elections The Fed in its board
meeting on October 3, 2000, the same day of the
WSJ report on Wicksell, with the DJIA closing at
10,719.74, left the FFR target unchanged at 6.5%,
keeping inflation-adjusted the real short-term
interest rate at a historical high. This decision
left the DJIA in the historical high range, but
left the Democratic Party with an anemic economy
despite a fiscal surplus under the administration
of president Bill Clinton and robust corporate
earnings in the crucial months before the
presidential election that November. Though a rate
reduction had been warranted by conventional
wisdom over weak economic data and ominous leading
economic indicators, the DJIA stayed high because
the market believed the Fed would have to cut
rates soon to prevent a sharp market correction.
As it turned out, the Fed did not lower
the FFR target until its January 3, 2001, board
meeting, after the US Supreme Court snatched a
near-victory from the jaws of Democratic
presidential candidate Al Gore and delivered a
bitterly contested White House to Republican
George W Bush. The Fed then lowered the FFR target
by the larger-than-usual amount of 50 basis points
to 6% to commence a long downward rate cycle, with
13 more cuts in 30 months, to bottom at 1% on June
25, 2003, pushing the short-term rate below
neutral, meaning below the inflation rate, feeding
a multi-year credit bubble.
Only five days
after the FFR hitting a historical low of 1%, the
Fed, in a belated epiphany on rediscovering
inflation threats that had been glaringly visible
for some time, reversed course and raised the FFR
target by 25 basis points, followed by a "measured
pace" of 18 more upward moves to 5.25% on June 29,
2006, and kept it there unchanged for over 11
months up to now, with no signs of ending the
cautious interest-rate "pause", extending a
liquidity boom that creates an interest-rate
"conundrum".
'Conundrum' just another
word for denial Maestro Greenspan confessed
publicly that with all his acknowledged wisdom, he
could not understand why long-term rates stayed
low despite a high FFR while the flat or inverted
yield curve had been obviously caused by the Fed's
own earlier actions of releasing too much credit
into the system. This easy credit fueled a trade
deficit that, because of dollar hegemony, was
recycled as a capital-account surplus in US
Treasuries, pushing long-term rates down.
This trend is still going on and is
exacerbated by endogenous liquidity generated
internally by debt securitization and hedging
through derivatives. What determines long-term
interest rates is sustained monetary liquidity, or
excess money already in the system from previous
short-term rates staying too low and too long, as
the Fed's subsequent gradualism in short-term rate
hikes was not able to stop the momentum
effectively and quickly.
Timed for
elections On Tuesday, November 9, 2004,
presidential-election day in the United States,
the FFR target was still at a below-neutral 1.75%,
with the DJIA closing at a bullish 10,386.37,
giving incumbent George W Bush a temporary bull
market, if not quite a
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