Here are the facts to be reconciled:
- M3 (or its equivalent) is growing smartly in most major nations around the world year-over-year at present.
- Most major central banks are tightening or on hold; few if any are loosening.
- The US current account deficit persists, and nations that trade with us continue to buy our bonds.
- The US dollar continues to sag slowly against most major currencies.
Here’s the way that I reconcile them. Many of the central banks are not very independent, and so they are under pressure not to let their currencies appreciate versus the dollar. So, they take excess dollar liquidity and buy US bonds, forestalling the problem, because bonds will pay them more dollars in the future. This gives some lift to the dollar, but not enough, because not all central banks are willing to do this, so the US dollar sags slowly.
Because of the excess liquidity, M3 rises, and in response, the foreign central bank tightens monetary policy, but then they undo a large part of it by buying US bonds as a part of their monetary base. It will take many interest rate rises to cool off these economies, or an unwillingness to buy US bonds with their US dollar liquidity.
The Business Week article that I linked to talked about how interest rates rose 1.5% in less than two months when foreigners ceased to lend to the US in early 1987. (This followed a fall in the US dollar in late 1986.) This could happen again, but it will take a large central bank that acknowledges that they have embedded losses on their US bond portfolio not reflected in current prices, and then works to limit their losses by eliminating dollar reserve.
My advice: be aware, and don’t keep all of your bonds in US currency-denominated issues.
David,
My explanation is that conventional wisdom is wrong. It is assumed that Central Bank rate increases result in tightening. I do not see that in the factual record of the last three years. When the U.S. Fed raised rates from June 2004-2006, total reserve credit actually increased for much of that period. Gold and other commodities continue to reflect excess liquidity (as do the Ms as you point out). This is a result of the flawed Fed mechanism. Using the Fed Funds Rate target to control liquidity or inflation is inefficient at best, ineffective at worst.
Fed funds by itself is inadequate, as Volcker proved when he targeted money, and let interest rates went where they would. Oddly, the BOJs quantitative easing is another example of targeting money, though a perverse one.
Though I think goods inflation is mismeasured in the US, most of the excess money has trickled into the asset and commodity markets, together with the liquidity from foreigners buying our debt.
Thanks for the comment, REW.
Thanks for this post David. It makes a nice follow-up to some of the questions I had after reading the 12 point piece.
I have a follow-up question if you please. Perhaps more hypothetical than something that can be put into practical investing advice. So, if you’d prefer to skip it I’ll understand.
As I understand it, there are two ways to effect liquidity: margin req’s and interest rates. Policy in the US seems to concentrate exclusively on rates. I’ve always thought this is the wrong way to deal with speculators as it hurts honest/conservative participants far more and far earlier than spec’s… one reckless with leverage is unlikely to be bothered by small changes in carry costs. I notice China has been increasing the reserve req’s on their banks instead of raising rates. So any thoughts as to China’s style and likelihood for success?
The other thing, when I am feeling less charitable, is that raising rates to stem inflation is going to be favored by bankers over raising reserve req’s. Increasing reserves will immediately hurt their bottom line, while rates is something they can pass through, at least for a while. It will effect the bankers’ profits, but long after, um, the “workin’ man”. Might this explain the US’ fixation with rates instead of reserves? Too cynical of me?
Thanks much.
I’ve written about this at RealMoney. In general, the Fed never wants to hold the smoking gun. Changes in reserve and margin requirements act rapidly. If a disaster happened after an increase, it would be obvious that the Fed had caused it. With rises in the Fed funds rate, that is not so, because the actual effect moves slowly, even if the bond market takes it all down in a flash.
Regarding China, the central bank is inexperienced, and will keep moving until something blows up. Given that the US relies on them for liquidity, that may have a material effect on us as well.