Page 2 of
5 THE INTEREST RATE
CONUNDRUM, Part
1 Economics of
denial By Henry C K Liu
sustainable strong economy, to
achieve an easy win over challenger John Kerry,
all the while with the Fed keeping a straight face
about its being an apolitical institution that
operates on scientific monetary principles. The
Fed raised the FFR target to 2% in its meeting the
day after the election when it was politically
safe to raise the rate, and kept it going upward
to the
current 5.25%.
The
DJIA had closed at 10,719.74 on the same day of
the WSJ-Wicksell report on October 3, 2000, having
broken the psychological 10,000 for the first time
in history on March 19, 1999. The DJIA had risen
50% from its previous low of 7,161.15 recorded on
October 27, 1997, when it suffered a big one-day
fall of 554.26 points, or 7.2%, from contagion
from the Asian financial crisis.
On
Monday, June 4, 2007, defying persistent news of a
slowing economy, the key index rose 91% higher
than its 1997 low to close at an all-time high of
13,673.
Volcker's bloodletting
experiment Monetarists, who have dominated
the Fed throughout most of its history, subscribe
to the theory that inflation can only be prevented
either by high interest rates to reduce growth by
reducing the growth of money supply, or by high
unemployment to depress wages, which are two faces
of the same coin. Wicksell argued that monetary
policy works best at containing inflation by
pegging interest rates to investment returns
rather than money supply.
Wicksell's
theory was given credence empirically in 1980 by
then Fed chairman Paul Volcker's brief experiment
with targeting the monetary base with automatic
interest-rate adjustments by his "new operating
procedure". The disastrous and damaging result of
violent fluctuation of the FFR forced the Fed to
drop Volcker's misguided approach after about six
months.
The "new operating procedure" was
adopted on October 6, 1979, by the Fed as a
therapeutic shock treatment for Wall Street, which
had been conditioned by former Fed chairman Arthur
Burns' brazen political opportunism during the
Richard Nixon era in the 1970s to lose faith in
the Fed's political will to control inflation. The
new operating procedure, by concentrating on
monetary aggregates, and letting it dictate FFR
swings within a range from 13-19%, to be
authorized by the Fed Open Market Committee
(FOMC), was an exercise in "creative uncertainty"
to shock the financial market out of its
complacency about the Fed's traditional policy of
interest-rate stability and gradualism.
There had been a traditional expectation
in the market that even if the Fed were to raise
rates it would do so gradually so as not to permit
the market to be volatile. The banks could
continue to lend as long as they could profitably
manage the gradual rise in rates.
Under
the new operating procedure, the banks would be
exposed to risks that interest rates might
suddenly and drastically go against even their
short-term credit positions. Also, banks had been
seeking higher earnings by expanding new loans
beyond the growth of deposits, by borrowing
shorter-term funds at lower interest rates. This
practice was given the benign name of "managed
liability" by regulators, allowing banks to profit
from interest-rate spreads over the yield curve,
which had seldom if ever been allowed by the Fed
to stay inverted, that is, with short-term rates
higher than longer-term rates, at least for long.
This practice of interest-rate arbitrage
later came to be known as "carry trade" in bank
parlance and, when internationalized, eventually
led to the Asian financial crisis of 1997 when
interest-rate and exchange-rate volatility became
the new paradigm that could roil equity and
currency markets.
The Fed's new operating
procedure greatly increased the banks' risk
exposure, at least before the widespread practice
of loan securitization shifting individual bank
risk to systemic risk for the entire financial
market. On top of it all, Volcker set an
additional 8% reserve on bank-borrowed funds for
lending.
The new operating procedure
violated the traditional mandate of the Fed,
which, as a central bank, was supposed to be
responsible for maintaining orderly markets, which
meant smooth, gradual changes in interest rates
that in turn would keep money-supply fluctuation
moderate and gradual so that prices would not be
detached excessively from market fundamentals. The
new operating procedure was a policy to induce the
threat of severe short-term pain to stabilize
long-term inflation expectations.
Most
economists agree that when money growth slows,
market interest rates go up. The trouble with the
use of the FFR target to control money supply is
that it has to be set by fiat, which exposed the
Fed to political pressure to keep a liquidity boom
going forever. A case can be made, and is
frequently made, that the Fed's FFR targets tend
to be self-fulfilling prophecies rather than a
device to manage future trends. High FFR targets
deflate while low targets inflate, and there is
little argument about that relationship, at least
before the age of structured finance when virtual
money can be created within the system circularly
outside of the Fed's control. Under structured
finance, high FFR targets can actually inflate
because they raise the cost of money needed for
protection through hedging and for profiteering
through financial arbitrage.
But there is
plenty of argument about the Fed's projection
ability on the economy. History has shown that the
Fed, more often than not, has made wrong decisions
based on faulty projection that at times borders
on blind denial of clear data. The new operating
procedure let the monetary aggregates set the FFR
targets scientifically and provide political cover
for the FOMC members if the FFR target needed to
go to double digits. This amounted to monetarism
through the back door, not by heroic intellectual
confidence in scientific truth, but by political
cowardice.
The Federal Advisory Council
(FAC) of the Federal Reserve Board is unique in
that it is a big-bank lobby composed of 12
representatives of the banking industry that
officially advises the Fed, itself a peculiar
institution: an all-powerful public institution
mandated by law, but owned by private banks. The
FAC meets in secrecy four times a year with Fed
officials to give the banking industry an inside
track on influencing Fed deliberation, if not
decisions.
The since-declassified minutes
of the FAC show that four weeks before the Volcker
Fed announced its "new" operating procedure on
October 6, 1979, the FAC had recommended a review
of the Fed's "traditional" operating procedure,
before even the president of the United States,
then Jimmy Carter, was alerted of the Fed's
deliberation and final decision to adopt a "new"
operating procedure. Initially, the FAC was
concerned that political pressure was likely to
push the FFR down, not anticipating that money
supply would turn volatile to create extreme
interest-rate volatility. Carter, preoccupied with
the Iran hostage crisis, was totally in the dark
about the impending volatile high-interest-rate
policy with which the Fed under Volcker, a
Republican, was going to hit Carter's Democratic
administration running for a second term within a
year.
To stabilize money supply, the Fed
announced on March 14, 1980, a program of
Emergency Credit Controls. The program affected
not only commercial banks, but also money-market
mutual funds and retail companies that issued
credit cards. Banks would be limited to 9% credit
growth instead of the 17% they had seen in
February.
By April, the Fed was shocked by
data showing money disappearing from the financial
system at an alarmingly rapid rate. The last two
weeks in March saw more than $17 billion vanish,
representing an annualized shrinkage of 17%,
yielding a 34% change. Money was evaporating from
the banking system as credit dried up and
borrowers paying off their debts in response to
Carter's moralistic jawboning to save the nation
from hyperinflation through personal restraint on
consumption. Another cause was the shift from bank
deposits to three-month T-bills that were paying
15%, causing money to exit the market back into
the Fed's vault.
Volcker's new operating
procedure adopted six months earlier now faced a
critical test. According to monetarist theory, the
Fed needed to pump up new bank reserves to stop
the money-supply shrinkage. But in practice,
Volcker and the FOMC were applying monetarism,
which by definition must be a long-term
proposition, to short-term turbulence, and in the
process undermined their own
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