Wednesday August 25, 2010 - 14:28:44 GMT
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Black Swan Capital - www.blackswantrading.com
Should the Fed raise rates? Absolutely!
A friend wrote to me the other day and sent a link to an article on Bloomberg.com wherein the IMF former chief economist argues the Fed should hike interest rates. My friend wrote:
My question to you is, what can Central banks do to prevent another bubble; can they really increase rates when there is so little demand for credit?
As to the first part of my friendâ€™s question, I didnâ€™t really respond. But I think history shows bubbles are formed by the central bankâ€™s suppressing interest rates well below where a normally functioning market would price credit, thereby creating fuel to bid up asset prices in the financial economy and stimulate additional malinvestment in the real economy. And of course we know the game: as real asset prices are bid up, it creates more collateral value to bid up financial asset prices in a self-reinforcing manner even though it should be clear to all that interest rates are artificially low.
As to the second part, I absolutely believe the Fed should raise interest rates. Why? Because it will help to unlock the interbank lending market. Who cares about the interbank lending market you may ask, knowing it is a market where banks lend excess reserves to each other? Anyone who lives and works in the real world and is seeking credit to fund a viable business should care because the interbank lending market is the conduit through which all those excess reserves now sitting on banksâ€™ balance sheets make their way to the real economy.
[Chart not available in text format
This is a topic we covered back in late 2009. It is still pertinent today. Sadly, given the Keynesian zeitgeist mentality, the idea of raising rates in the midst of a so-called â€śdemand problemâ€ť leads to shrieks of horror even if it is the right thing to do. Our esteemed leaders have a penchant for rarely doing the right thing when it gets in the way of their political fabrications.
Because credit is an input into working capital, a credit constraint acts very much like a supply constraint on physical capital. In either case, dumping more liquidity into the system does not increase output. But why should congestion in the wholesale interbank market constrain banks who see good retail lending opportunities? Why donâ€™t such banks just raise their interest rates to final (retail) borrowers enough to maintain their profit margins and willingness to lend? This is an important and not generally understood point. Retail lending involves making risky forward commitments, much like transacting in forward markets in foreign exchange. For example, a bank might open a line of credit to a well-known corporate customer that could be drawn upon over the next year. But below some well-defined maximum, the customer chooses when to draw it down, and by how much. The willingness of banks to make such forward commitments to lend to nonbank firms and households depends very much on the wholesale interbank market. If the wholesale interbank market works smoothly without counterparty risk at positive interest rates, then even currently illiquid banks can make forward loan commitments to their retail customers. If such a bank happens to be still illiquid when a corporate customer suddenly draws down its credit line, the bank can cover its retail commitment by bidding for funds in the wholesale market at close to the â€śrisk-freeâ€ť interest rate. Because the riskiness of making forward retail loan commitments is thereby reduced, the bankâ€™s willingness to do more retail lending increases. (Otherwise, without participating in the interbank market, each commercial bank would have to hold much higher liquid reserves against its potential retail lending opportunities.)
Stanford Professor Ronald McKinnon, writing in the Fall 2009 edition of International Economy magazine
So, for all those that believe low interest rates are a panacea, think again. Add to this the fact that consumer income from savings is suppressed by artificially low interest rates, which in turns adds some incentive for consumers to stretch for yield into risky assets, as they say. But being burnt in risky assets, it then leads to consumers going into their collective shells and creates yet another drag on the economy. These dislocations are all created by the manipulation of credit and so called â€śstimulusâ€ť only leads to prolonging recession/depression. But I digress.
Take a look at the charts below. We have lined up an Interbank Lending chart with the S&P 500 Index. We wonder if this dearth of lending to the real economy is about to catch up with the bidding up of financial assets thanks to the juice provided by the Fedâ€¦
S&P 500 Index Weekly:
[Charts not available in text format
In addition to sipping wine and eating croissants, the supposed best and brightest economic mindsâ€”in the world central banks (I realize that may be a bit oxymoronic)-- will be sharing thoughts and ideas on how best to get the worldâ€™s economies moving again. Going out on a limb, I suspect the assembled brain trust will once again tell us they are on the right course, as stimulus is the only path to nirvana.
We donâ€™t need a position paper or a PhD. to counter that nonsense; all we need to do is ask the brain trust this question: Have you guys ever heard of a place called Japan?
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