Greenspan says it is a puzzle why long-term rates remain low while short-term rates have risen. But this is not a puzzle at all. Since June 2004, despite raising the fed-funds rate target, the Fed has actually lifted the pace of pumping money into the system. The yearly rate of growth of the Fed’s balance sheet—Fed Credit—rose from 4.5% in June 2004 to 7% in November of the same year. Since then the rate of growth has stood at around 6%. In short, the Fed has been talking tough while acting loose. FULL ARTICLE
Source link: http://archive.mises.org/3712/whats-behind-the-interest-rate-condundrum/
What’s Behind the Interest Rate Condundrum?
Previous post: Consumer Protection: A Case for the Free Market
Next post: For and Against the Printing Press
{ 44 comments }
Thanks for the article. It’s very enlightening. This shows the practical nature of Austrian economics for the businessman. An old professor once told us that the most common mistake people make is to believe the good times will last forever. If a businessman follows Austrian economics, he’ll have an edge over the competition in deciding when to invest and when to save.
http://www.hussmanfunds.com/html/fedirrel.htm
Although I would not go as far as calling the Fed irrelevant I do think we obsess over the influence of the Fed. Hasn’t its relative influence declined with the ability of more institutions to print (more accurately electronically create) money and the outright meddling of foreign central banks in their domestic yield curve?
Isn’t the real culprit fiat money/ fractional reserve banking without which none of these shenanigans would be possible?
I’m not specifically against “fractional reserve”. I thing institutions that practice it should be allowed to fail spectacularly, and their officers be held personally responsible for any fraud involved.
However, yes, the fiat nature of “our” currencies is itself a great evil that propagates other great evils in its wake.
Somewhat along the lines of Johnathan’s comment, it is my understanding that the Fed has reasonably accurate control only over short-term rates. Long-term rates are also considerably influenced by international capital flows. Could another possible explanation as to why longer-term rates have not risen as much as expected be increased foreign demand for longer-term treasury securities? As an example, I think we all know the considerable lenghts that the Chinese government has gone to maintain the peg of its currency against the U.S. dollar.
It is my understanding that the market rate of interest is the price of loanable funds, and like all prices it is determined by the interplay of supply and demand.
According to the Austrian view, changes in time preference is the main cause of changes in interest rates. Obviously, foreign purchases of US bonds will affect rates to some degree, but shouldn’t the dollar be climbing if foreigners are purchasing US securities? The Chinese remnimbi is tied to the dollar, so it alone wouldn’t affect exchange rates, but other purchasers would and I don’t think the Chinese purchases are large enough to effect bonds by themselves. Also, don’t central banks tend to hold shorter term securities?
Roger,
In the Austrian view, time preference is the fundamental and only cause of what is termed originary interest. I believe that Austrian school economists hold that actual market (money) rates of interest are determined by the supply and demand of loanable funds for loans of various maturities and risks. In fact, when the Fed lowers interest rates through its open market operations, time preferences have not changed, but the supply of loanable funds has been increased by the Fed’s actions.
Also, based on the large U.S. current account deficit, the U.S. dollar should be depreciating, which would make Chinese imports to the U.S. more expensive. To prevent this, the Chinese government increases the demand for the dollar by purchasing Treasury securities, which not only halts the depriciation of the dollar that would otherwise occur as a result of the large U.S. trade deficit with China, but also has the effect of boosting the prices and lowering the yields of Treasuries. As to whether central banks tend to hold more short- or long-term Treasury securities, I am not sure, and possibly the proportion may be notably different at different times.
Hi Jonathan: In response to your question “Hasn’t its relative influence declined with the ability of more institutions to print (more accurately electronically create) money”
The way i understand it, the significance of the fed is hard to over state. The reason for this is that it is the sole originator of the increases in bank reserves upon which the other banking institutions, to which you refer, are expanding credit on. Each week the fed goes out on the open market and buys (generally on net) Treasury securities with money that is in the most incredible and stark sense from out of thin air. These new reserve dollars go directly into the banking system and are used by the banks as new reserves for new credit expansion. And there is a multiplying effect due to the small reserve ratio required by law. So for each dollar of new reserves from the fed, you might see eventually, ten dollars of new credit expansion from the banks. This is credit expansion that would not be possible without the fed. When the money supply increases, it is fundamentally due to the fed. If the fed halted its open market activities tomorrow, all further US bank credit expansion would also cease tomorrow, and US interest rates would finally begin to reflect the nation’s actual time preferences and would probably rise.
I think the big question is what will happen to the base reserves of the system (treasuries) if things get tough … If every attempt at “reflation” (the cycle of state spending, state borrowing, and Fed monetizing) is met with an offset of greater and greater treasury selling, then the game is up and the Fed cannot inflate any further. So I am not so sure the Fed has as much control as is supposed. The market will move to sounder collateral, and foreign central bank buying will only make the decline spread to foreign currencies.
Hi Dennis: The subject connected with your comment “…based on the large U.S. current account deficit, the U.S. dollar should be depreciating…” is one i have been studying recently with great interest.
It turns out that at the bottom of the issue of exchange ratios between the domestic currency and the foreign currencies is purely a question of the prices of commodities in the two countries and the relative purchasing power of those two currencies. Canges in purchasing power are due strictly to a relative domestic inflation. So the bottom line is that while trade deficits between countries are influenced by domestic inflation, it is the domestic inflation itself that is responsible for domestic price increases, and therefore currency devaluations. Mises refers to the bourse, which is a market which anticipates changes in commodity prices and based on that, they adjust the exchange ratio. Further, Mises states that a “…rise in foreign exchange rates merely anticipates the movement of domestic commodity prices.”
As Mises explains in Human Action:
“Let us consider again the practically very important instance of an inflation in one country only. The increase in the quantity of domestic credit money or fiat money affects at first only the prices of some commodities and services. The prices of the other commodities remain for some time still at their previous stand. The exchange ratio between the domestic currency and the foreign currencies is determined on the bourse, a market organized and managed according to the pattern and the commercial customs of the stock exchange. The dealers on this special market are quicker than the rest of the people in anticipating future changes.
“Consequently the price structure of the market for foreign exchange reflects the new money relation sooner than the prices of many commodities and services. As soon as the domestic inflation begins to affect the prices of some commodities, at any rate long before it has exhausted all its effects upon the greater part of the prices of commodities and services, the price of foreign exchange tends to rise to the point corresponding to the final state of domestic prices and wage rates.
“This fact has been entirely misinterpreted. People failed to realize that the rise in foreign exchange rates merely anticipates the movement of domestic commodity prices. They explained the boom in foreign exchange as an outcome of an unfavorable balance of payments. The demand for foreign exchange, they maintained, has been increased by a deterioration of the balance of trade or of other items of the balance of payments, or simply by sinister machinations on the part of unpatriotic speculators. The higher prices to be paid for foreign exchange cause the domestic prices of imported goods to rise. The prices of the domestic products must follow suit because otherwise their low state would encourage business to withhold them from domestic consumption and to sell them abroad at a premium.
“The fallacies involved in this popular doctrine can easily be shown. If the nominal income of the domestic public had not been increased by the inflation, they would be forced to restrict their consumption either of imported or of domestic products. In the first case imports would drop and in the second case exports would increase. Thus the balance of trade would again be brought back to what the Mercantilists call a favorable state.”
So i think Mises has refuted the cause/result relationship of trade deficits/exchange rates.
I’m with you on this comment: “I am not so sure the Fed has as much control as is supposed”, after all, how much control does a bull in a china shop possess, unless power to destroy is control. Ability to induce inflation, trash the economy and re-distribute wealth to some at the expense of others, the fed has it. Ability to B.S. the public, they’ve got it in abundance.
Yes, of course, Fed pumping of money has been a factor in holding down interest rates. But other central banks have had far more influence. Later this week statistics for international transactions for the first quarter are due, but last year a foreign central banks bought $355 billion of U.S. assets . By contrast the Fed has “only” bought $44 billion of U.S. assets . Both the Japanese and Chinese central banks have each alone pumped more money into the U.S. asset markets then the Fed.
Regarding the exchange rate, as I’ve pointed out before, whether or not a exchange rate rise or fall in response to a current account deficit/capital inflow is whether the driving force behind the imbalance is the domestic demand for foreign goods or the foreign demand for domestic assets. In the former case the exchange rate will fall, in the latter case it will rise. And since in recent years the driving force has been excess domestic demand driven by budget deficits and low interest rates, this has put a downward pressure on the dollar. The decline has however been mitigated by the mass purchases of U.S. assets made by foreign central banks wishing to limit the dollar decline.
Lately the dollar has actually strengthened but only against the euro and the european currencies and to a lesser extent against the yen, reflecting expectations of rising interest rates in America and unchanged and falling interest rates in Japan and Europe respectively. But other Asian currencies like south korean won and the taiwan dollar is close to their highest level since the Asian financial crisis 1997-98.
Hi Stefan, you state that “…other central banks have had far more influence. Later this week statistics for international transactions for the first quarter are due, but last year a foreign central banks bought $355 billion of U.S. assets . By contrast the Fed has “only” bought $44 billion of U.S. assets . Both the Japanese and Chinese central banks have each alone pumped more money into the U.S. asset markets then the Fed.”, however, unless i am misunderstanding you, i would counter this by saying that only the $44 billion of assets bought by the fed came from thin air and resulted directly in an additional $44 billion more in US bank reserves on which the US banks further pyramided. On the other hand, the actions of the foreign banks, and any other institution outside of the US banking system, has no affect whatsoever on reserves or the supply of US money. It seems that only by inflating its own currency can a foreign central bank devalue its own currency to maintain a peg to the fed inflated US currency.
I might agree with the statement “And since in recent years the driving force has been excess domestic demand driven by budget deficits and low interest rates, this has put a downward pressure on the dollar. The decline has however been mitigated by the mass purchases of U.S. assets made by foreign central banks wishing to limit the dollar decline”, if you are saying essentially that the driving force behind the US dollar’s decline has been US inflation and that the mitigating factor has been foreign inflation generated by the foreign central banks wishing to limit the US dollar’s decline. My contention, still, is that at the heart of changing exchange ratios is almost purely a question of competing domestic inflations and not what foreign central banks buy with the incredible volume of US dollars they accumulate. Going out on a limb, I will argue that if they bought US tractors, cars and computers instead of US securities, the effect on the US dollar would be the same. And if not, what is it about how the US government spends its borrowed money that would make the analysis different?
Paul,
Very pertinent quote from Mises. Implied in my argument about the trade deficit was that its ultimate cause is a relatively higher rate of domestic inflation. It is a higher rate of domestic inflation that enables one country to initially import more from foreign countries than it exports. And it is the differential rates of domestic inflation and the effect that they have on each country’s domestic price levels that ultimately drives changes in exchange rates.
As you quote Mises: “If the nominal income of the domestic public had not been increased by the inflation, they would be forced to restrict their consumption either of imported or of domestic products. In the first case imports would drop and in the second case exports would increase. Thus the balance of trade would again be brought back to what the Mercantilists call a favorable state.”
However, as Stefan has detailed, the fall in the foreign exchange value of the dollar has been mitigated by large net purchases of U.S. assets, especially Treasury securities, by foreign central banks. Part of these foreign purchases of U.S. assets are “paid for” with foreign currency newly created by the foreign central banks. Hence, the possibility of increased inflation in certain foreign countries, and the effects noted by Mises on foreign exchange rates, become more probable.
And as a general (one not specifically directed to Paul) observation, wasn’t the topic of this posting about the Fed and the “Interest Rate Condundrum?” How easy it is to move to different, but still related, topics.
Stefan: It turns out i did misunderstand your first comment because you were talking about interest rates, rather than exchange rates. Sorry. I think you can ignore the first part of my response.
Hi Dennis: (Is that three “n” s in your name?) Just for a friendly laugh, i’m going to point out that it was your post that got me going on exchange rates. So i’m blaming you!
(I’m just kidding.)
So going back to interest rates for a moment, does anyone contest the argument, that if the fed quit it’s open market activities completely, that interest rates would most likely rise, and regardless, the interest rates would then more accurately reflect (given some adjustment time) the nation’s time preferences? I think i contend it would. Or in other words, in a fed-less world, would our interest rates likely remain (assuming they are now), highly influenced by Chinese and Japanese etc. central banks? My contention is that they would not, that the free US economy would then tend to dictate US interest rates.
Paul,
Your comment, “Going out on a limb, I will argue that if they bought US tractors, cars and computers instead of US securities, the effect on the US dollar would be the same” I believe is correct. The important factor affecting the foreign exchange value of the U.S. dollar is that foreign central banks are demanding and purchasing dollar denominated assets, and not the specific assets purchased. The advantage of purchasing Treasury securities to foreign central banks is that they are much, much, more liquid, have virtually no transportation costs, and pay interest. However, as far as the determination of the foreign exchange value of the U.S. dollar is concerned, what specifc dollar denominated assets are purchased by foreign central banks is of virtually no importance.
OK, you’ve got me going on my favorite topic, so don’t blame me if I find it hard to shut up on it.
If we agree that it’s not important “what” the central banks buy with its dollars, then what is the important thing that affects the US/Chinese exchange rates? For instance, is it important who does the buying? If the Chinese people themselves, who are selling goods to US markets in the first place, were to directly buy back American assets with the US dollars they accumulate, how would the analysis be different? Only in one significant way; there would be no Chinese currency inflation involved in the central bank’s currency pegging when they give yuan and take dollars from the Chinese exporters. So, my argument is that it is the Chinese central bank’s inflating, as apposed to its buying of US assets that buoys up the US dollar relative to the Chinese yuan.
There is a way where the Chinese (for instance) could cause an increase in the value of the dollar against the yuan without the Chinese central bank inflating. That case is where the people of China, on net, wish to increase their US dollar cash holdings. That is, they just want to hold on to dollars and not spend them, invest them, or otherwise buy any assets with them whatsoever. In that one case, as they increase their US dollar cash holdings, they would increase the demand for US dollars, and therefore increase its exchange rate. This would be a transitory situation.
On re-reading my argument above, it occurred to me that it relies heavily on the argument that if a baker establishes a trade deficit with a butcher, it in no way affects the price of bread or meat. Also, if the butcher buys a large amount of bread from the baker, eliminating the baker’s deficit, or lends some bread back to the baker, the price of the bread will remain the same. In short, it is not the deficits that dictate the prices of the commodities, including money; it is always only supply and demand. I apply this approach implicitly in the above argument on exchange rates.
Paul,
If the Chinese Central Bank, in its process of attempting to maintain a fix exchange rate between the yuan and the dollar, gives Chinese exporters yuan in exchange for dollars, I believe you are correct in that there is no Chinese currency inflation necessarily involved in the process. This of course assumes that the Chinese central bank did not newly print up the yuan that it gave the exporters. But given the underlying currency fundamentals, I do not think that the Chinese central bank can obtain enough dollars in this manner to maintain the peg. The pressure for the dollar to depreciate against the yuan is just too great. In actuallity, I believe the Chinese central bank does inflate the yuan partially to have more yuan available in order to purchase dollars on the foreign exchange markets and maintain the peg. I am no expert on this topic, and maybe Mr. Karlsson and/or Mr. Shostak can comment further as to the mechanics of the yuan/dollar peg.
Dennis, aka Dennnis
Hi Dennis: (you really should have kept the third “n”; I liked it)
If i may take the liberty to modify your comments just so as to more closely reflect my thinking just to be sure you and i are connecting, it would go as follows:
“If the Chinese Central Bank, in its process of attempting to maintain a fixed exchange rate between the yuan and the dollar, gives Chinese exporters yuan in exchange for dollars, I believe you are correct in that there is indeed Chinese currency inflation necessarily involved in the process. This of course assumes that the Chinese central bank really did newly print up the yuan to give to the exporters…”
So yes, my contention is that given the underlying currency fundamentals, the only way that the Chinese central bank can obtain enough yuan to trade at the pegged rate for all these imported inflated dollars is to print more and more yuan. The pressure for the dollar to depreciate against the yuan is just compensated for by the depreciation of the yuan due to the printing of yuan to maintain the peg.
You and i are in agreement when you say “…I believe the Chinese central bank does inflate the yuan partially to have more yuan available in order to purchase dollars on the foreign exchange markets and maintain the peg.”
This is the coolest topic.
Paul,
I do not think we were ever in much, if any, substantive disagreement. Your Mises’s quote was extremely illustrative of the fundamental causal factor at work in foreign exchange rate determination. Maybe in spots, our wording or emphasis was different, but, in my opinion, these were relatively minor.
Cool. Your other post on the the Yalta thing sounds interesting too.
This is a very interesting discussion, but I am not sure about the conclusion that you have reached.
Paul suggest that if the Fed got out of open market operations, then interest rates would be determined by the norm.
Our experience in New Zealand does not reflect this. Our central bank sets the overnight cash rate, but does not engage in open market operations along the lines that you describe. Over the last year, the balance sheetof the Reserve Bank has shrunk. Ye we have seen a dramatic increase in the supply of money and the same housing boom as prevails in the rest of the west. The situation is described more fully at Monetary
Policy.
The answer to this problem seems to be that banks in New Zealand have access to an unlimited supply of money at low interest rates. This has expanded the supply of money in New Zealand.
Bill Bonner says that the world has been flooded with American liquidity. That seems to be the case. Therefore, if you are not big enough, refraing from open market operations is not enough.
I would appreciate your expert comments on this situation.
Hi Ron: We’ve been swerving in and out on this thread going back and forth between discussing the two separate topics: the original question of interest rates and the other topic of exchange rates. Since you’re asking about New Zealand interest rates, i’ll take a swing at it.
I do think the US fed, because of the size of and the influence it has on the US economy has the power to influence NZ and world money markets.
Ultra low interest rates in the US makes it appealing to buy NZ dollars to lend in NZ at perhaps a lower rate than the norm, as you put it, yet higher than what we can get here. So i agree that because of extremely available credit in the US and its corresponding low interest rates, it means that lendable money will spill over and be more available in NZ than would otherwise be.
Although you didn’t ask, i would add that this apparently tighter policy of NZ’s central bank in fact does mean less actual domestic credit expansion and therefore less domestic NZD inflation, and therefore, a generally strengthening NZ dollar against the USD. The charts i see, suggest it has been a jagged path, but generally a path of an increasing value of the NZD vs the USD over the past few years.
I think it is useful also, to distinguish in our minds between an increase in the supply of money, and an increase in the supply of lendable money. The two are connected, but the former influences inflation, and the latter influences interest rates. I believe NZ is seeing an influx of lendable money through external influences, however, i guess i’m suggesting that it is not experiencing the increase in the supply of money, which the US and China presently are.
So congratulations to NZ!
(That’s Paul as in Paul Edwards)
If we grant the entrepreneur the significance that Austrians give them, I do find it confusing why they are mostly wrong footed with a cluster of errors at the same time (business cycle) by the consequences of predictably over-easy monetary policies.
Secondly, central banks can set short dated interest rates between the banks but banks set the rates at a premium above this rate to corporates to reflect credit risk and so on. If they know, as surely they do, that the Fed sets rates way below that likely to be more ‘natural’ then why do they not charge corporate borrowers a higher rate that accurately reflects time preference, credit risk and so on.
I believe the Austrians credit the entrepreneur with a lot of foresight to navigate risk taking, customer demand, production and so on to make profits but somehow they overlook the relatively simple fact that they shouldn’t depend too much on interest rates staying so low.
Jonathan,
The way I understand the Austrian position is that the Fed’s manipulation, lowering of the rate of interest below the rate that would have prevailed based on previous real savings, distorts an important, possibly the most important, price that entrepreneurs use to forecast, appraise future business conditions. It is hard enough to consistently and correctly forecast future business conditions given the prevailing uncertainty of the future, and distorting this important price makes the task harder. Furthermore, because the Fed’s action results in a lowering of the rate of interest, this leads to the malinvestment that is characteristic of the initail phases of the business cycle, as more investment projects apparently appear profitable. In short, the Fed’s interest rate manipulation impairs the ability of entrepreneurs to calculate, appraise the worth of the business projects that they are considering undertaking. I hope this helps.
We all know that once the credit money expansion funded malinvestments (“the boom”) have been made there must come a time when they are cleared out of the system (“the bust”).
Of course this means that people suffer, and many of them will be good hard working people. However, trying to put off the bust by maintaining the credit money boom, just makes the eventual bust worse.
In the end there is only one policy. Allow the bust to take place and make sure (by removing government regulations, especially such things as labour union supports) that prices and wages are as free to adjust as possible.
In this way suffering will be reduced – both in the number of people who will suffer, and the time for which they suffer.
This is just as true in Britain as in the United States – indeed I suspect that there will be a worse bust in Britian that in the United States.
This will come as a shock to Mr Blair and Mr Brown – who claim to have abolished the boom-bust cycle.
There is only one way to that – avoid the credit-money expansion in the first place. And they certainly have not done that.
“I might agree with the statement “And since in recent years the driving force has been excess domestic demand driven by budget deficits and low interest rates, this has put a downward pressure on the dollar. The decline has however been mitigated by the mass purchases of U.S. assets made by foreign central banks wishing to limit the dollar decline”, if you are saying essentially that the driving force behind the US dollar’s decline has been US inflation and that the mitigating factor has been foreign inflation generated by the foreign central banks wishing to limit the US dollar’s decline.”
Well, yes, provided for one thing that you by “inflation” do not merely include consumer price inflation but also asset price inflation and also that the effect on inflation is equal on highly tradable goods, services and assets as it is on goods who are almost non-tradable.
If the newly created money is used to bid up only the prices of things which are more or less non-tradable, then however inflation will have virtually no effect on the foreign exchange rate.
“My contention, still, is that at the heart of changing exchange ratios is almost purely a question of competing domestic inflations and not what foreign central banks buy with the incredible volume of US dollars they accumulate. Going out on a limb, I will argue that if they bought US tractors, cars and computers instead of US securities, the effect on the US dollar would be the same.”
Yes, it is true that the effect on the exchange rate would be ewual if they bought U.S. tractors, cars and computers. However, the effect would be somewhat different, particularly in the short-term, if they bought assets (or goods and services) in their own countries.
Mr. Karlsson’s comment has prompted me to indicate that anytime I have used the term “inflation”, I meant an increase in the supply of money, and not an increase in prices. Of course, an increase in the supply of money will, other things remaining unchanged, cause a rise in prices, but, as Mises so brilliantly noted, this increase in neither smooth nor mechanical.
A significant casualty of modern economics is the unfortunate perversion of the common sense meaning of the term inflation. We do not want to utilize a definition that points to the cause, as opposed to the result, do we?
Thanks for that, Stefan. It sounds like we agree.
I definitely agree with your point “Well, yes, provided for one thing that you by “inflation” do not merely include consumer price inflation but also asset price inflation and also that the effect on inflation is equal on highly tradable goods, services and assets as it is on goods who are almost non-tradable.” In fact, for the bourse to notice this change in a money relation, i would say it would necessarily be via price increases they notice in the commodities they trade in. But with credit expansion, i would think this is exceptionally likely as it is usually such commodities that are the factors of production that get bit up first by businesses who are usually the first to spend the newly created credit.
I’m not sure i understand the comment “However, the effect would be somewhat different, particularly in the short-term, if they bought assets (or goods and services) in their own countries”. Is buying assets in their own countries with US dollars an option? It seems in the end, if you posses US dollars and want to spend them, you have to do it on US assets.
Hi Jonathan: I thought there was an article on mises.org by William L. Anderson that gave what i thought was a really great answer to the question of why even Austrian entrepreneurs have trouble overcoming business cycles. Amazingly, i can’t find it, but i can find a blog discussing it here:
http://mises.org/daily/1730
Paul Edwards,
The essay you are referring to is the following:
http://mises.org/daily/1664
In the essay, Anderson wrote that even if a business owner knows the boom will inevitably bust, not all, or even most of his customers, his investors, and his suppliers will, and the business owner will inevitably face pressures to participate.
Thank you for yor response Paul.
You distinguish between an “increase in the supply of money, and an increase in the supply of lendable money.” That is useful. I presume the former has a multiplier effect, whereas the latter does not. It that correct?
Hi Ron: The way i might put it is that the former is purely the nasty consequences of central banking: inflation, fraudulent redistribution of wealth, mal-investments and a depreciated currency. The latter can result from the former, BUT, it can also arise simply from an effective reduction in time preferences. In the case of NZ, i think, by an increase in foreign investment there. It strikes me that this situation is not such a bad thing because it means NZ’s economy is able to accumulate capital at a faster rate than it otherwise would without this foreign investment. In fact, I think it was Rothbard who suggested that the US economy benefited a great deal from a large amount of foreign investment during the 18th or 19th centuries, while a great deal of profitable capital investment took place there during that time. Further, since it is fueled more from actual investor’s money, rather than by bank credit expansion, it means the interest rates more closely approximate market rates, and so there is less mal-investment.
The things I’ve written above are from off the top of my head, and would probably benefit from some refining, so take me with a grain of salt.
Paul, I think you misinterpreted me. I didn’t mean buying assets in their own country with US dollars but that the central bank would buy domestic assets with newly created yuans, yens etc. instead of buying US assets with these newly created money, just like the Fed buys domestic assets with newly created dollars.
Stefan: I certainly did misinterpret you. Thanks for the clarification. Now you’ve got me thinking. If the Chinese central bank let the Yuan float against the USD, and instead inflated the yuan by simply buying Chinese assets like the fed does, at a similar pace, what would the effect be? My guess is that the yuan would fall more against all currencies in general, but it would be much less effective in pegging the yuan to the USD. What is your take?
Actually, I believe that the effect of such a policy shift would be that the yuan would strengthen in value in the currency exchange markets, particularly in the short term, as this would mean a strong decrease in demand for dollars.
This shift would however to a large extent be counteracted by the secondary effects of this policy, namely that U.S. interest rates would rise while Chinese interest rates would fall. Also, as this means that monetary inflation would be more likely to affect prices in the product markets it together with the yuan appreciation itself reduce the Chinese trade surplus.
Thanks Stefan: I agree that the yuan would strengthen in respect to the USD, without the explicit peg, and that is what i meant to say with “it would be much less effective in pegging the yuan to the USD”. On the other hand, do you agree that in respect to most other currencies, a yuan inflation of this nature would tend to quickly devalue the yuan?
I agree with your thinking on how the US interest rates would be affected, assuming (which i do) that the chinese people themselves would tend to buy more US commodities with their US dollars rather than just exclusively investing them in the US. And the chinese interest rates would fall due to the injection of reserves and the resulting chinese credit expansion. Also i agree that this chinese inflation would increase prices in china and therefore induce more imports, less exports and so reduce the chinese trade surplus. Essentially, the banking and trade dynamic in china would more closely reflect that of the US.
Then we agree. Except I believe the yuan would rise against other currencies than the dollar too, albeit by a smaller number. A Chinese policy shift towards domestic assets would reduce the numbers of yuan offered on foreign exchange markets and would not just raise its exchange rate against the currencies it is now purchasing but against other currencies as well. Moreover, the People’s Bank of China is actually not only buying dollar assets it is buying large quantities of assets in many other currencies as well.
On the other hand as I´ve indicated before, if the yuan peg is dropped or revalued to a higher level this will likely reverse the strong inflow of speculative capital which has gone to China hoping to benefit from a expected revaluation. That could greatly limit the rise of the yuan’s foreign exchange value.
Hi Stefan: I’ll insert my responses between your comments.
“Except I believe the yuan would rise against other currencies than the dollar too, albeit by a smaller number. A Chinese policy shift towards domestic assets would reduce the numbers of yuan offered on foreign exchange markets and would not just raise its exchange rate against the currencies it is now purchasing but against other currencies as well.”
Are we discussing the scenario where the Chinese central bank is generating a yuan inflation as it buys up these domestic assets, or are you thinking of some other non-inflationary activity. I was assuming we were considering the former. If we are, then will not this inflation result in domestic price increases and hence a general devaluation of the yuan on the currency exchange?
“Moreover, the People’s Bank of China is actually not only buying dollar assets it is buying large quantities of assets in many other currencies as well.”
Are you talking about under the present scenario with the peg, or the alternative we’ve been considering? If the former, then since the Chinese central bank is pegging only to the USD, but not others (perhaps I’m mistaken?), isn’t it mainly USD s that it tends to collect in massive quantities with which it can only buy US securities with?
“On the other hand as I´ve indicated before, if the yuan peg is dropped or revalued to a higher level this will likely reverse the strong inflow of speculative capital which has gone to China hoping to benefit from a expected revaluation. That could greatly limit the rise of the yuan’s foreign exchange value.”
Forgive me for being obtuse: You are saying that a reverse in the inflow of speculative capital going to china would have a tendency to lower the yuan’s foreign exchange value. I would argue that regardless of the direction of flow of capital to china, the only thing that can influence china’s exchange rate is the relative purchasing power of the yuan for internationally traded commodities. Further, this depends purely on the supply and demand for yuan (demand being the demand for cash holding, not to spend or invest with). Assuming the demand to hold yuan is stable, it is then purely yuan inflation (supply of yuan), generated by the Chinese central bank that can influence this purchasing power. As I understand Mises, it is a fallacy to attribute any change in or “deterioration of the balance of trade or of other items of the balance of payments” to changes in the exchange ratio. Am I off base?
“I was assuming we were considering the former. If we are, then will not this inflation result in domestic price increases and hence a general devaluation of the yuan on the currency exchange?”
Yes, I was refering to a scenario where the rate of total money creation growth is unchanged but where the path of the new money is shifted from foreign to domestic assets.
Just as a shift in the path of money creation from consumer credit to mortgage loans will produce a shift from consumer price inflation to a housing boom so will a shift in the path of money creation from foreign to domestic sources produce a shift from a cheap currency in the currency exchange markets to domestic price inflation.
Of course domestic price inflation will to the extent it affects internationally traded items at least in the long term also lower the foreign exchange rate. But the effect would be smaller particularly in the short term but to a smaller extent in the long term as well (given the higher spill over into non-traded items).
“Are you talking about under the present scenario with the peg, or the alternative we’ve been considering? If the former, then since the Chinese central bank is pegging only to the USD, but not others (perhaps I’m mistaken?), isn’t it mainly USD s that it tends to collect in massive quantities with which it can only buy US securities with?”
The yuan is only pegged to the USD, but nearly a fourth of the foreign exchange reserve of the People’s Bank of China is in assets in other currencies.
“Forgive me for being obtuse: You are saying that a reverse in the inflow of speculative capital going to china would have a tendency to lower the yuan’s foreign exchange value. I would argue that regardless of the direction of flow of capital to china, the only thing that can influence china’s exchange rate is the relative purchasing power of the yuan for internationally traded commodities.”
That is obviously false as anyone who has followed currency market movements know. The relative purchasing power of internationally traded commodities in the euro zone sure didn’t fall by nearly 2% the day after the “No”-vote in the French referendum. And I don’t think it rose by 1.5% relative to US product prices this Friday compared to this Thursday either.
And indeed if that were really true then the purchases of dollar assets by Asian central banks wouldn’t have any effect on the exchange rate.
Prices on currency exchange markets is decided by the quantities of say US$ being demanded by holders of other currencies relative to demand for other currencies by holders of US$.
The supply and demand on currency exchange markets is in turn decided by in part the relative purchasing power of traded goods, but also by relative purchasing power of traded assets ( which is to say interest rate levels) and in the short-term by speculative capital flow.
Hi Stefan:
I hope none of my comments have irritated you. Your observations about currency market movements would not be obvious to me because I don’t follow these markets very carefully. I think I should start though, as it seems pretty interesting.
Thanks again.
Investors this week will be hoping the Consumer Price index (CPI) luminousld.com shows a similar lack of inflationary growth,freebies-search.com as that would bode well for bets that the Federal Reserve will end its 18-month rate hiking campaign soon Jewelry http://www.ourhawaii.us/links/Shopping.html
Comments on this entry are closed.