Try, fail, lose control - Disaster formula of US Federal Reserve

The Federal Reserve of United States prints $85 billion every month. It puts this money into the financial system by buying bonds. With all this money going around interest rates continue to remain low. And at low interest rates the hope is that people will borrow and spend more money.

Vivek Kaul September 20, 2013 07:51:29 IST
Try, fail, lose control - Disaster formula of US Federal Reserve

"Now we know better. If we learn from experience, history need not repeat itself," wrote economists George Akerlof and Paul Romer, in a research paper titled Looting: The Economic Underworld of Bankruptcy for Profit.

But that doesn't seem to be the case with the Federal Reserve of United States, which seems to be making the same mistakes that led to the financial crisis in the first place. Take its decision to continue printing money, in order to revive the American economy.

In a press conference to explain the logic behind the decision, Ben Bernanke, the Chairman of the Federal Reserve of United States, said "we should be very reluctant to raise rates if inflation remains persistently below target, and that's one of the reasons that I think we can be very patient in raising the federal funds rate since we have not seen any inflation pressure."

Try fail lose control  Disaster formula of US Federal Reserve

The Federal Reserve has an inflation target of 2 percent. Inflation remains well below this level. Reuters

The Federal Reserve of United States prints $85 billion every month. It puts this money into the financial system by buying bonds. With all this money going around interest rates continue to remain low. And at low interest rates the hope is that people will borrow and spend more money.

As people spend more money, a greater amount of money will chase the same number of goods, and this will lead to inflation. Once a reasonable amount of inflation or expectations of inflation set in, people will start altering their spending plans. They will buy things sooner rather than later, given that with inflation things will become more expensive in the days to come. This will help businesses and thus revive economic growth.

The Federal Reserve has an inflation target of 2%. Inflation remains well below this level. As Michael S Derby writes in the Wall Street Journal "As of the most recent reading in July, the Fed's favoured inflation gauge, the personal consumption expenditures price index, was up 1.4% from a year ago."

So, given that inflation is lower than the Fed target, interest rates need to continue to be low, and hence, money printing needs to continue. That is what Bernanke was basically saying.

Inflation targeting has been a favourite policy of central banks all over the world. This strategy essentially involves a central bank estimating and projecting an inflation target and then using interest rates and other monetary tools to steer the economy towards the projected inflation target. The trouble here is that inflation-targeting by the Federal Reserve and other central banks around the world had led to the real estate bubble a few years back and a dotcom bubble towards the turn of the century. The current financial crisis is the end result of the real estate bubble bursting.

Stephen D King, Group Chief Economist of HSBC makes this point When the Money Runs Out. As he writes "the pursuit of inflation-targeting...may have contributed to the West's financial downfall."

King writes about the United Kingdom to make his point. "Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher 'domestically generated' inflation.

In other words, credit conditions domestically became excessive loose...The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom."

What this means is that the Bank of England(as well as other central banks like the Federal Reserve) kept interest rates too low for too long because inflation was at very low levels. Low interest rates did not lead to inflation, with people borrowing and spending more, primarily because of low cost producers in China and other parts of the emerging world.

Niall Ferguson makes this point in The Ascent of Money - A Financial History of the World in the context of the United States. As he writes "Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labour kept down US wage costs. As a result, it was remarkably cheap to borrow money and remarkably profitable to run a corporation."

The same stood true for the United Kingdom and large parts of the Western World. With interest rates being low banks were falling over one another to lend money to anyone who was willing to borrow. And this gradually led to a fall in lending standards.

People who did not have the ability to repay were also being given loans. As King writes "With the UK financial system now awash with liquidity, lending increased rapidly both within the financial system and to other parts of the economy that, frankly, didn't need any refreshing. In particular, the property sector boomed thanks to an abundance of credit and a gradual reduction in lending standards." What followed was a big bubble, which finally burst and its aftermath is still being felt more than five years later.

As newsletter write Gary Dorsch writes in a recent column "Asset bubbles often arise when consumer prices are low, which is a problem for central banks who solely target inflation and thereby overlook the risks of bubbles, while appearing to be doing a good job."

A lot of the money printed by the Federal Reserve over the last few years has landed up in all parts of the world, from the stock markets in the United States to the property market in Africa, and driven prices to very high levels. At low interest rates it has been easy for speculators to borrow and invest money, wherever they think they can make some returns.

Given this argument, it was believed that the Federal Reserve will go slow on money printing in the time to come and hence, allow interest rates to rise (This writer had also argued something along similar lines). But, alas, that doesn't seem to be the case.

As Claudio Borio and Philip Lowe wrote in the BIS working paper titled Asset prices, financial and monetary stability: exploring the nexus (the same paper that Dorsch talks about) "lowering rates or providing ample liquidity when problems materialise but not raising rates as imbalances build up, can be rather insidious in the longer run."

Once these new round of bubbles start to burst, there will be more economic pain. The Irish author Samuel Beckett explained this tendency to not learn from one's mistakes beautifully. As he wrote "Ever tried. Ever failed. No matter. Try Again. Fail again. Fail better."

The Federal Reserve seems to be working along those lines.

(Vivek Kaul is a writer. He tweets @kaul_vivek)

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