Monthly Archives: January 2016

Markets are Tweaking, Gold is Rising: The Interview

January 26, 2016

Earlier this week, I had the pleasure to sit down with Malcolm Palle at the Mining Maven and talk about markets, economics and some of the opportunities that are emerging in the commodity and mining sectors.

In the first part of the interview, Malcolm and I discuss the recent volatility in global financial markets. As discussed in an article last year titled “Monetary Base Expansion: The Seven Stages of Addiction”, I believe that global financial markets have become addicted to monetary base expansion and a low interest-rate environment. As the Fed gradually withdraws this drug, the markets are going to enter a “tweaking” phase, a phase that I believe began recently. If the Fed really commits to “normalizing” monetary policy, then markets will probably experience the “crash” and “withdrawal” phases that accompany the withdrawal of any hard drug.

In the second part of the interview, we discuss the recent rise in the price of gold. The view of The Money Enigma is that the gold price is inversely related to the level of confidence in the long-term economic future of society (see “What Determines the Price of Gold?”). Presently, confidence in the long-term prospects of the US are at high. But if this confidence wanes, then the gold price is likely to climb back towards the $1,500/oz level.

In the final part of the interview, we discuss some of the opportunities in the commodities and mining space. In particular, mining equities represent a fascinating opportunity at this stage of the cycle, but the challenge is to identify those companies that can execute in this environment and take advantage of the depression-style conditions that exist across the sector.

What Determines the Value of a Currency?

January 19, 2016

The view of The Money Enigma is that the value of a fiat currency is primarily determined by market confidence in the long-term economic future of the nation that issued that currency.

When confidence in a nation’s long-term economic prospects are strong, the value of its currency tends to be well supported. However, if confidence is damaged, for example by war or economic mismanagement, then the value of the currency will fall. In an extreme scenario, one where the economic survival of a nation is questioned, the value of a currency can collapse resulting in a condition known as “hyperinflation”.

Ultimately, fiat currency is only as good as the society that issues it. In this article, we shall explore why this is the case and why the value of a nation’s currency tends to fluctuate with perceptions regarding its economic future.

However, before we attempt to answer the question “what determines the value of a currency?” we need to answer two fundamental questions. First, why does the value of the currency matter? Second, why does fiat currency have any value at all?

Why Does the Value of the Currency Matter?

The value of the currency plays a critical role in the determination of foreign exchange rates and the price level.

The fiat currency in your pocket has value, i.e. it is “valuable” in the ordinary sense of that word. If fiat currency didn’t possess the property of market value, then you wouldn’t accept it in exchange for your services and others wouldn’t accept it from you in exchange for their goods and services.

If we measured the value of the fiat currency in your pocket in terms of a “standard unit” for the measurement of market value, i.e. in terms of a good that was invariable in the property of market value, then we would be able to observe that the value of that fiat currency rises and falls independently of the value of goods and services and all other currencies.

However, in practice, we don’t measure the value of currency in terms of a theoretical “standard unit”. Rather, we measure the value of the currency in terms of goods and other currencies that are themselves variable in value.

More specifically, we tend to measure the value of a currency in terms of either, (a) another currency, or (b) a basket of goods and services.

The value of one currency as measured in terms of another is known as a “foreign exchange rate”. A foreign exchange rate measures the value of one currency in terms of the value of a second currency.

The value of a currency as measured in terms of a basket of goods is known as the “purchasing power of money”. The purchasing power of money is the inverse of the “price level”, i.e. the price level measures the value of the basket of goods in terms of the value of currency.

A fall in the value of a currency will tend to have two important impacts. First, it will tend to lead to a fall in the price of that currency as measured in terms of other currencies. Second, it will lead to a decline in the purchasing power of money, i.e. prices for most goods will tend to rise.

Why is this the case? Well, if you think about it in simple terms, if each unit of currency in your pocket is suddenly “less valuable”, then, all else remaining equal, you would expect to have to give up more of it in order to obtain the things you want. It doesn’t matter whether those things are goods, services or other currencies: if the currency in your pocket is suddenly less valuable, then you will have to offer more of it to obtain those other items.

The relationship between the value of money and the price level is discussed in more detail in a recent article titled “Ratio Theory of the Price Level”.

In simple terms, Ratio Theory states that the price level can be calculated as a ratio of two values: the value of goods (the numerator) and the value of money (the denominator). All else remaining equal, as the value of money falls, the price level rises.

In summary, fluctuations in the value of money play a key role in the determination of foreign exchange rates and the price level. But why does the paper money in your pocket have any value at all? In order to answer this question, we need to examine the evolution of money.

Why Does Fiat Currency Have Any Value?

If you do a quick search on the question “why does fiat money have value?” you will find a whole range of answers, none of which are particularly compelling.

Indeed, mainstream economics struggles to provide a sensible answer to this question because it treats fiat money as an “exception”. What does this mean? Well, it means that rather than treat fiat money just like any other asset, economists try to invent new schemes and theories that apply solely to fiat money and not to any other assets. Inevitably, this creates a whole series of problems and objections, none of which have been successfully resolved.

Fortunately, there is a simple paradigm that can be used to explain why any asset, including fiat currency, has value: the real asset/financial instrument paradigm.

The real asset/financial instrument paradigm has its roots in accounting, rather than economics, and it is used to explain how any particular asset derives its value.

In essence, the real asset/financial instrument paradigm states that assets can only derive their value in one of two ways. Real assets derive their value from the physical properties. In contrast, financial instruments derive their value from their contractual properties.

In simple terms, if an asset doesn’t derive its value from its natural or intrinsic properties, then the only way it can derive its value is if it creates an obligation on a third party to deliver something of value.

Fiat currency is not a real asset. Rather, fiat currency is a financial instrument and derives it value from its implied contractual properties. More specifically, fiat currency represents a liability of society and claim on the future output of society.

In order to understand this point, it helps to think about how money evolved over time. [Readers that are interested in a more in-depth discussion of the evolution of money should read “The Evolution of Money: Why Does Fiat Money Have Value?”]

The first form of money used by early societies was “commodity money”, i.e. a commodity that found acceptance as a medium of exchange and unit of account. This early form of money was a real asset and derived its value from its natural physical properties. Over time, precious metals such as gold and silver became the most popular form of commodity money and were widely accepted across international borders.

At some point, kings and governments began to issue paper notes that represented promises to deliver gold and/or silver on request. This first paper money, know as “representative money” derived its value from its contractual properties. Suddenly, money was a financial instrument, i.e. it had value because it created an obligation on a third party (the king) to deliver something of value (gold/silver).

Ultimately, representative money, money backed by a real asset, limited the amount of money that kings and governments could create. Therefore, at some point, the gold convertibility feature was removed and “representative money” suddenly became “fiat money”.

In theory, this creates a problem. By removing the gold convertibility feature, the explicit contract that governed paper money was rendered null and void. So why did paper money maintain any value at all?

The view of The Money Enigma is that paper money only maintained its value when the gold convertibility feature was removed because the explicit contract that governed paper money was replaced by a new implied-in-fact contract or what some might call a “social contract”.

The key question is what is the nature of this new implied social contract? If fiat money is a financial instrument and can only derive its value contractually, then it must represent a liability to a third party. So, how is that third party and what obligation does it create against them?

What Determines the Value of Fiat Currency?

The view of The Money Enigma is that fiat currency derives its value from an implied social contract. Fiat currency is an asset to its holder because it represents a liability to society. Although government is the legal issuer of fiat currency, from an economic perspective, fiat currency is a liability of society and represents a claim against the future output of society.

More importantly, fiat currency represents a proportional or variable claim against the future output of society. What does this mean? Well, it helps to think about the general nature of financial instruments.

In general terms, a financial instrument represents either a fixed or proportional claim to some future economic benefit. For example, a corporate bond represents a fixed claim to the future cash flows of a business. In contrast, a share of common stock represents a proportional claim to the future residual cash flows of a business.

What determines the value of common stock? There are two key drivers. First, the expected cash flows that will be generated by the business: a share of common stock is a claim to those cash flows, so clearly the future level of those cash flows matters. Second, the expected number of shares outstanding in the future: if the market expects shares outstanding to skyrocket in the future, then each share will claim a smaller proportion of future cash flows and, all else remaining equal, will be worth less.

We can apply these same ideas to fiat currency.

Fiat currency represents a proportional claim on the future output of society. More specifically, the expected proportion of future output that fiat money will claim in any future period depends upon the expected future size of the monetary base at that time.

Now we can answer our key question: “What determines the value of fiat currency?”

If fiat currency represents a proportional claim on future output, there are two key drivers that influence the current value of fiat money.

The first is obvious: the value of fiat currency is positively correlated to the outlook for future output growth. If fiat currency represents a proportional claim against future output, then its value must be tied to optimism regarding the ability of the economy to grow.

The second is less obvious: the value of fiat currency is inversely related to expectations regarding the future size of the monetary base. If fiat currency represents a proportional claim against the future output of society, then its value will rise if people start to believe that long-term monetary base growth will be restrained and its value will fall if people suddenly believe that long-term monetary base growth will accelerate.

If this seems like a complicated idea, then consider what drives the price of common stock.

Ultimately, the price of common stock depends upon expectations regarding the long-term future path of earnings per share. Similarly, the value of fiat currency depends upon expectations regarding the long-term future path of real output per unit of money.

What does this mean in practice?

In practical terms, this theory implies that the value of fiat currency is primarily determined by confidence in the long-term economic future of the nation that issued that currency.

When confidence in the long-term economic future of society is high, people tend to expect solid real output growth to be accompanied by a disciplined expansion of the monetary base. This type of environment is very supportive for the value of fiat currency.

In contrast, if confidence in the long-term economic future of society is damaged, then people might reasonably expect lackluster economic growth or even economic contraction to be accompanied by aggressive expansion of the monetary base. This type of environment can lead to a significant fall in the value of the currency, an outcome that is typically reflected in both foreign exchange rates and the price level (prices rise across the economy).

One of the compelling aspects of this theory of fiat currency is that we can use it to build an expectations-based valuation model for fiat currency (see slide below). In turn, this can be used to build expectations-based solutions for foreign exchange rates, the price level and the velocity of money.

Readers who are interested in this valuation model for money should read the “Theory of Money” section of this website and an older post titled “A Model for Foreign Exchange Rate Determination”.

Author: Gervaise Heddle

Interest on Reserves: Bad Economic Policy, Bad Social Policy

January 12, 2016

Let’s start with a few uncomfortable facts.

If the Federal Reserve maintains the fed funds rate at its current level (0.25%) for the rest of 2016 and there are no further interest rate rises during 2016, then the Fed will donate more money to foreign and domestic banks during the course of 2016 than the US Government will spend on the entire National School Lunch Program.

If the Fed raises interest rates to 1.0%, then the Fed will give away nearly as much money to foreign and domestic banks in a year as the US Government spends on the Federal Pell Grants program. The Pell Grant program is a massive $40+ billion per year program that provides needs-based grants to over 5 million college students, or one third of the entire college student population.

If the Fed raises interest rates to 2.5% by using interest on reserves, as is current practice, and if it maintains banks reserves at roughly current levels (as the Fed has indicated it will for the time being), then the Fed’s new bank welfare program will be as large as the US Government’s entire food stamps program.

Yes, you read that right.

If the Fed raises interest rates to 2.5%, a level that is low by historical standards, then the Fed will pay out 2.75% on its $2.67 trillion in reserves, or roughly $73.5 billion per year to foreign and domestic banks.

In contrast, the Supplemental Nutrition Assistance Program (“SNAP”) that provides food assistance to roughly 46.5 million Americans, including one in every four children in the United States, cost taxpayers an almost identical $74.1 billion per year in FY 2014.

The worse aspect of all this is that, from an economic perspective, the Fed’s new bank welfare program, otherwise known as “interest on reserves”, is totally unnecessary.

While there is no question that the Fed must begin the process of reversing nearly a decade of excessively easy monetary conditions, the Fed doesn’t need to do it by handing out money to banks. Rather, the Fed should begin the process of tightening monetary policy by unwinding another implicit subsidy to corporate America, namely “quantitative easing”.

If the Fed unwinds QE, i.e. reduces the size of the monetary base by selling assets from the Fed’s bloated balance sheet, then long-term interest rates will begin to rise. If the Fed waits until this process of balance sheet reduction is largely complete, then the Fed will not need to use interest on reserves (“IOR”) and reverse repurchasing facilities (“RRP”) to raise the fed funds rate and will not have to donate billions of dollars every year to banks.

“Interest on Reserves”: A Little Background

The first point that needs to be made about the “interest on reserves” program is that the practice of paying interest on reserves is new.

Why does this matter? Well, prima facie, it raises an obvious question. If the Fed spent nearly 100 years raising interest rates without finding it necessary to pay interest on the reserves held by banks at the Fed, then why does it suddenly need to do this now?

Throughout the history of the Federal Reserve System, major banks in the United States have been required to hold a minimum amount of reserves at the Fed. In effect, this was money that the Fed forced commercial banks to put in the “penalty box” in anticipation of the mistakes that the banks would inevitably make, i.e. being too aggressive in making loans.

Historically, the Fed never paid interest on these reserves. Indeed, the Fed had no authority to pay interest on reserves until Congress passed the Financial Services Relief Act of 2006.

Did this inability to pay banks interest on their reserves at the Fed impede the ability of the FOMC to raise interest rates prior to 2006? No. For decades, the Fed was able to raise interest rates without paying interest on reserves, i.e. the Fed was able to raise the fed funds rates without directly handing money over to banks.

So, what changed? If you ask FOMC members today, they will claim that they need to pay interest on reserves in order to be able to raise the fed funds rate. But why is this the case? And does this claim by the Fed represent the whole truth or a disingenuous half-truth?

Technically, the justification used by the Fed for the introduction of interest on reserves is as follows:

“This (the introduction of interest on reserves) was important for monetary policy because the Federal Reserve’s various liquidity facilities initiated during the financial crisis caused upward pressure on excess reserves and placed downward pressure on the Federal funds rate. To counteract these pressures, on October 6, 2008, the Federal Reserve Board announced that it would begin paying interest on depositary institutions’ reserve balances.” [See “Federal Reserve Bank of San Francisco, Dr. Econ online section”]

OK, now let me translate that.

In response to the financial crisis of 2008, the Fed introduced a series of extraordinary and unorthodox policy measures, most notably quantitative easing or “QE”. In essence, quantitative easing entailed the creation of roughly $4 trillion in new money by the Fed and that money was then used by the Fed to purchase fixed income government securities.

By purchasing trillions of dollars worth of fixed income securities, the Fed forced down interest rates across the entire US government yield curve, making it very difficult to raise short-term interest rates using traditional means. Moreover, the banking system was suddenly awash with “excess liquidity”, most of which found its way into something called “excess reserves” held at the Fed. With so much money sloshing around in the “excess reserves” bucket, i.e. reserves held at the Fed that are not technically required to be held there, it made it all but impossible for the Fed to raise the fed funds rate using traditional means.

In other words, the Fed suddenly couldn’t raise the fed funds rate using conventional means because it had boxed itself into a corner. The Fed had pushed interest rates so low across all maturities that the only way it could raise the fed fund rate was by paying banks interest on the reserves that they kept at the Fed.

Now, let’s reexamine the claim that the Fed must use interest on reserves in order to raise interest rates. Is this the whole truth or a disingenuous half-truth?

Clearly, it is a half-truth. Yes, it is true to say that if the Fed maintains the current size of its balance sheet, then it can only raise the fed funds rate by using the interest on reserves facility.

But, this avoids the key issue.

Namely, why is the Fed trying to raise the fed funds rate at a time when its balance sheet is overloaded? Why doesn’t the Fed get out of this mess the same way it got into it, i.e. sell the assets it acquired through the QE program, allow the yield curve to normalize and then raise the fed funds rate using conventional methods?

It would be one thing for the Fed to pursue this erroneous policy (interest on reserves) if it had no social consequence. But it does have a social cost. In essence, it is a “Reverse Robin Hood” policy. The interest on reserves program introduced in 2008 by the Fed takes money from ordinary American taxpayers and gives it to banks. Not just domestic banks, but also foreign banks.

Is It Real Money?

There may be some people who read this article that might claim that the money the Fed gives to banks under the interest on reserves program is somehow not the same as the money that the US government spends on social welfare programs, i.e. the two aren’t comparable because one is real money being “given away” (food stamps) while the other is just some fancy handwork of ivory tower economists.

This claim is nonsense.

The fact of the matter is that the money that the Fed donates to the banks under the interest on reserves program is identical to the money that the US government uses to fund social welfare programs.

To be clear, I am not making any value judgments here. Rather, this is simply a question of accounting. Let me explain.

If you go to page 105 of the Fed’s FY 2014 annual report and look at the financial statement on that page, you will see at the bottom of that statement a line called “Earnings remittances to the Treasury”.

What are “Earnings remittances to the Treasury”? In effect, this is the profit that the Fed makes for the year. What does the Fed do with its profit? It sends it to the Treasury. [How does the Fed make a profit? It buys bonds and earns interest on those bonds, less a few staff costs.] Looking at our table, we can see that the Fed sent the Treasury $96.9 billion in FY 2014. Somewhere in the Treasury’s FY2014 accounts, you will find a matching entry recognizing the receipt of those funds from the Fed.

The key point is that any “profit” made by the Fed is sent back to taxpayers via a remittance to the Treasury.

What impact does the interest on reserves program have on this profit? Clearly, if the Fed pays interest on reserves to banks, then this is money that must be deducted from its annual profit. Consequently, the US Treasury receives less money from the Fed.

In essence, paying banks interest on the reserves they hold at the Fed has the same impact on the finances of the US government as any other hike in government spending. It is simply more money that the American taxpayer has to hand over to cover the random misadventures of policy makers.

[Note: this actually slightly understates the adverse impact of the interest on reserves program because it adds an additional cost to taxpayers: namely, short-term government debt becomes more expensive to issue as short-term interest rates rise in line with the fed funds rates].

The bottom line is that if the Fed does nothing else this year, then based on its current policy setting (0.25% interest rate and roughly $2.7 billion in reserves), the Fed will give away more than $13 billion to foreign and domestic banks. This $13 billion is real money. It is money that could be used to finance the entire annual cost of the National Schools Lunch Program (the program cost $11.6 billion in FY 2012).

[How does the math work? The key point to remember is that the interest rate the Fed pays on reserve balances is 25 basis points more than the fed funds rate, i.e. if the fed funds rate is 0.25%, then the Fed actually pays 0.5% on all bank reserves held at the Fed. Why? Good question. The answer is we don’t know. Theoretically, it allows the Fed to keep interest rates in a “range”. But frankly, 25 basis points seems unnecessary. Put it this way: if the Fed lowered the premium from 25 basis points to 5 basis points it would save taxes payers $5 billion per year!]

Perhaps more astoundingly, is how quickly the numbers get really serious if the Fed continues on its current path.

While the numbers should be treated as indicative only, the fact is that if the Fed maintains the current size of the monetary base and bank reserves remain at current levels, and if the Fed raises the fund funds rate to 2.5%, a level that is low by historical standards, then the Fed will give away roughly $70-80 billion per year. That is a lot of money by any standards. In fact, it’s enough to pay for the entire Supplement Nutrition Assistance Program, formerly known as the Food Stamp Program.

Why is the Fed Avoiding the Key Issue?

While the social justice argument against the Fed’s new interest on reserves program is strong, there is an even stronger case to be made when it becomes clear that the entire program is not only unnecessary but represents bad economic policy.

If you listen to most market commentators, then you probably believe that the key issue facing the Fed today is whether the Fed should raise interest rates, or more specifically, the feds fund rate. It isn’t.

As discussed in last week’s post, “The Interest Rate Rabbit and the Base Money Elephant”, the Fed may want the markets to believe that its actions on the fed funds rate are the key to monetary policy, but in truth these actions are a diversion from the real issue. The real issue is this: “Why isn’t the Fed reducing the size of the monetary base?”

Over the past eight years, the Fed has quintupled the size of the monetary base. This is an extraordinary action and represents a massive departure from historic practice. As discussed earlier, this action led to a decline in both short-term and long-term interest rates. Moreover, it put tremendous downward pressure on the fed funds rate to the point that traditional measures that were used to raise the funds fund rate are no longer effective.

The question that needs to be answered by the Fed is why doesn’t the Fed begin the process of tightening monetary policy by reversing out of this situation the same way got into it, i.e. by reducing the monetary base before its raises the fed funds rate?

Instead of adopting new methods to raise the fed funds rate (interest on reserves and reverse repurchasing facilities), why doesn’t the Fed simply unwind its balance sheet, allow the market for US government debt to operate freely and then begin the process of raising the fed funds rate in the traditional manner, i.e. without throwing money at the banks?

The view of The Money Enigma is that the Fed should begin the process of tightening monetary policy by dramatically reducing the size of the monetary base. Such a reduction in the monetary base would have largely the same desired impact on the economy as any hike in the fed funds rate. Moreover, there are two compelling economic reasons for why an immediate reduction of the monetary base is required.

First, the dramatic expansion in the monetary base has created a series of severe financial market distortions, or what some might call “bubbles”. By using newly created money to buy government bonds, the Fed has reduced the required rate of return on assets, thereby boosting prices of both less risky assets (bonds) and high-risk assets (stocks). While the immediate beneficiaries of this largesse might be happy today, this type of financial market distortion endangers the efficient operation of markets and the long-term economic future of our society.

The second reason is more theoretical, but far important. It is a subject that was addressed at length in a post written nearly nine months ago titled “The Case for Unwinding QE”.

In essence, the current level of the monetary base heightens the risk that, at some point in the next five years, the value of the US Dollar will collapse and the rate of inflation will surge.

At this point in time, markets believe that the dramatic expansion of the monetary base is only “temporary” in nature, i.e. the Fed will reduce the size of the monetary base eventually. However, if markets start to realize that the current level of the monetary base is more “permanent” in nature, then this could precipitate a sudden decline in the value of the dollar and a surge in prices.

Why is this the case? Well, the view of The Money Enigma is that fiat money is a proportional claim on the future output of society. In simple terms, this means that, over long periods of time, the value of a fiat currency tends to track the “real output/base money” ratio. If we are sitting here ten years from now and the monetary base is still at its current level while real output has only grown modestly, then it is very likely that the value of money will have fallen significantly.

Readers who wish to read more about this theory are encouraged to visit the “Theory of Money” section of the website and/or read a post titled “Does Too Much Money Cause Inflation?”

In summary, given these social and economic considerations, it is astounding the Fed is choosing to adopt interest on reserves as a key policy, rather than simply reversing QE and reducing the size of its balance sheet. It may be that the Fed simply wants to appear to be “doing something”. But “doing something” isn’t the same as “doing the right thing”.

The Interest Rate Rabbit and the Base Money Elephant

January 5, 2016

As we begin 2016, the key question investors should be asking themselves is whether the Fed can pull off the magic trick of the century. Can the Fed convince the markets that the elephant in the room doesn’t exist by pulling a rabbit out of the hat?

It’s a complicated magic trick. The first part of the trick involves pulling a rabbit out of the hat, i.e. raising the Fed Funds rate in an environment where the entire yield curve has been pressed against the floor. Normally, raising the Fed Funds rate, or the short-term interest rate, is a simple matter. However, this previously simple action is now a complex problem that involves new hidden mirrors such as “interest on reserves” and the “reverse repurchasing facility”.

The second part of the trick is even more complicated. In essence, the Fed is attempting to make the elephant in the room disappear, or at least disappear as an issue for investors. The elephant in the room is the bloated balance sheet of the Fed, otherwise known as the monetary base.

Over the past eight years, the Fed has quintupled the size of the monetary base through successive rounds of quantitative easing. Now, it seems that the Fed wants to keep its cake and eat it too: the Fed wants to keep its bloated monetary base, but wants investors to pretend that it doesn’t matter or forget about it entirely.

How do you distract people from the elephant in the room? Well, you make them focus on the rabbit. By being seen to be “doing something” on interest rates, the Fed hopes that markets will be distracted from the fact that they are “doing nothing” about the monetary base.

Why does the size of the monetary base matter? There are two key reasons:

The size of the monetary base determines the long-term required rate of return on capital. As the Fed increased QE, it brought down the required rate of return on capital, pushing up asset prices across the economy. If the Fed reverses QE, i.e. reduces the size of the monetary base, then this process will go into reverse.
The expected size of the monetary base determines the value of money and, consequently, plays a critical role in determining the rate of inflation. Fiat money represents a proportional claim against the future output of society. If people suddenly expect the monetary base over the next 20-30 years to be much higher than they previously anticipated then the value of money collapses and prices soar.

This week we will explore these issues by examining a little Fed history (what the Fed did and why) and dispelling a couple of misconceptions regarding the operation of monetary policy.

Monetary Policy Misconceptions

While monetary policy is a poorly understood topic at the best of times, there are two specific misconceptions regarding monetary policy that we need to address in the current environment.

The first misconception is that “the interest rate matters, but the size of the monetary base does not”. More specifically, there is a misguided view held strongly by many in the economics profession that the fed funds rate is somehow far more important to economic outcomes than the size of the monetary base.

The second misconception is one that has popped up more recently regarding the nature of the Fed’s first interest rate rise. More specifically, John Hussman recently argued that by raising interest rates by 25 basis points, the Fed has, in effect, reduced the monetary base by an enormous $1.7bn. It hasn’t. Rather, the recent interest rate decision does very little to unwind a decade of monetary excess and aggressive Fed policy.

However, in order to understand these points, we need to examine a little history and discuss some basic economic theory.

The first point to make, particularly for those not familiar with financial markets, is that while economists like to talk about “the interest rate”, in practice there exists a whole series of different interest rates on US government debt. Typically, the interest rate on a 30-year bond is higher than that on a 5-year bond, and the rate on a 5-year bond is higher than that on a 12-month or 3-month Treasury bill. This series of interest rates on government debt of different maturities is called the yield curve.

Historically, the Federal Reserve has focused its efforts on controlling short-term interest rates, i.e. it has focused on manipulating the short-end of the yield curve. The general principle was that lowering short-term interest rates would encourage banks to lend and drive economic growth, whilst raising short-term interest rates would have the opposite effect.

While this approach to monetary policy seemed to work fine for many years, over the course of 2007/2008 the Fed pushed short-term interest rates down to the lowest point they could… i.e., zero.

The problem was that this extraordinary policy response didn’t resolve the financial crisis that was occurring at that time (Lehman collapse, US housing market debacle, etc.) Therefore, the Fed needed a new way to stabilize markets and boost the economy. The answer: quantitative easing.

What is quantitative easing? Well, “quantitative easing” is a fancy way of saying “creating money and then using this newly created money to buy long-term government securities, thereby pushing down long-term interest rates”.

In essence, the Fed decided that if manipulating short-term interest rates no longer worked, then they would have to start directly manipulating long-term interest rates.

Sounds easy. So why didn’t the Fed always manipulate long-term interest rates? Well, the problem with manipulating the long-end of the government securities market is that it is a really big market. You remember those signs for the national debt clock? $20 trillion and counting? Well, it’s that market. More specifically, three-quarters of that market matures in more than one year. Manipulating a $15 trillion market takes a lot of money. As it turns out, about $4 trillion.

In order to lower long-term interest rates, the Fed had to create $4 trillion in money that never existed before and use this money to buy up some of the $20 trillion of outstanding US government debt. Buy enough long-term government debt and eventually the price of long-term debt rises and the interest rate on long-term debt falls.

If this sounds like a “big deal”, then your right… it is. What is strange is that standing here now in 2016, over seven years after QE began, many economists, including those at the Fed, seem to be preoccupied by short-term interest rates rather than long-term interest rates. Indeed, the message from the Fed seems to be “watch my left hand (the Fed Funds rate and the short end of the yield curve) but not my right hand (the monetary base and the long end of the curve)”.

Is this fair? Does the short end of the curve matter more than the long end of the curve to economic consequences? No. In fact, there is a good case to be made that the long end of the interest rate curve is more important to economic outcomes than the short end of the curve. Why? Well, to answer this question, it helps to remember why the Fed embarked on successive rounds of QE in the first place.

Long-Term Interest Rates and Asset Prices

The first round of QE, “QE1”, was primarily targeted at stabilizing financial markets. By the end of 2008, the entire US mortgage market had stopped working. By creating money and using this money to purchase mortgage-backed securities, the Fed helped this key pillar of the economy to get back on its feet.

Unfortunately, the Fed didn’t stop there. Rather, the Fed launched two more rounds of QE, “QE2” and “QE3”. Those rounds focused almost entirely on purchasing long-term government securities.

Why did the Fed do this? Arguably, the immediate financial crisis was resolved by QE1. So, why spend another $3 trillion in these subsequent rounds? The answer was to boost the economy. But how? What was the transmission mechanism from lowering long-term interest rates to higher economic growth? In a word: speculation.

By lowering the long-term risk-free rate, i.e. the long-term interest rate on US government securities, the Fed effectively lowered the long-term required rate of return across all asset classes, including the riskiest asset classes such as equities and venture capital.

Long-term interest rates matter far more to the price of most of assets than short-term interest rates. Why? Well, most assets are long-duration assets: equities, property and a substantial portion of fixed income securities are long duration assets. The value of these assets depends primarily upon discounted cash flows that will be received in the distant future. What is the rate used to discount these long-term cash flows? The long-term required rate of return on risk capital. What is a key factor in determining the long-term required rate of return on risk capital? The long-term, risk-free rate, i.e. the long-term interest rate on US government debt.

So, what happened when the Fed embarked on QE2 and QE3? Global asset prices soared. Why? Because, in effect, the Fed had artificially lowered the long-term required rate of return on risk assets.

The expansion of the Fed’s balance sheet and the associated manipulation of long-term interest rates has had a very significant impact on asset prices and, consequently, the real economy over the past seven years. By lowering the long-term interest rate and the required return on risk capital, the Fed has encouraged new business formation (shale oil and fintech bubbles) and the creation of jobs.

The problem the Fed faces today is that what works on the way up also works on the way down.

If the Fed begins to reverse QE and reduce the size of the monetary base, then it will have to sell government securities off its balance sheet, thereby forcing down the price of those securities and forcing up the long-term interest rate on government debt and, consequently, the required return on all risk assets. The result: a collapse in asset prices.

All of this raises an obvious question: why reduce the monetary base at all? If expanding the monetary base boosts asset prices and economic activity, then why should the Fed “normalize” the size of the monetary base?

Money isn’t Free… Even for the Fed

The view of The Money Enigma is that the role of the monetary base in the determination of the price level is one of the most poorly understood issues in economics.

At a general level, the relationship between money and prices has been explored in several posts, most notably “Does Too Much Money Create Inflation?” and “A New Perspective on the Quantity Theory of Money”. However, those that are interested in a specific argument for why the Fed must normalize the monetary base should read an article written six months ago, “The Case for Unwinding QE”.

We won’t go into all of the details of the arguments contained in those articles today, but at a simple level, the view of The Money Enigma is that expectations regarding the long-term future path of the monetary base are critical in the determination of (a) the value of money, and (b) prices as expressed in money terms.

More specifically, a permanent expansion of the monetary base carries with it a definitive cost: a devaluation of money and a rise in all prices as expressed in money terms.

Note that I emphasize the word “permanent” in the above sentence. By now, everyone knows that a central bank can dramatically expand the monetary base without causing a sudden increase in prices in the short run. However, this is also balanced by the strongest empirical observation in economics, namely that, in the long run, growth in the monetary base that is in excess of the growth in real output will lead to a commensurate rise in prices.

So, why does monetary base expansion cause inflation on some occasions but not on others? In essence, the issue boils down to one of expectations. If the market expects the monetary base expansion to be temporary, then this should have very little impact on the value of money. Conversely, if the market expects a monetary base expansion to be permanent, then this leads to an immediate fall in the value of money.

Currently, the market expects the recent expansion of the Fed’s balance sheet to be “temporary” in nature. However, if the Fed doesn’t begin to reverse QE in the near future, then expectations could change. More specifically, the market may begin to recognize that the recent expansion of the Fed is more permanent in nature. Such a shift in expectations would lead to a significant fall in the value of money and a rise in prices across the economy.

Why do long-term expectations regarding the monetary base matter to the value of money? Well, in simple terms, fiat money is only as good as the society that issues it. If a society must rely on expansion of the monetary base to support itself, then that society and its currency are in trouble.

In more technical terms, the view of The Money Enigma fiat money is the “equity of society” in that it represents a proportional claim on the future output of society, just as a share of common stock represents a proportional claim on the future cash flows of a company.

Rising expectations regarding long-term real output growth boost the value of each claim (the value of money rises and prices fall). Conversely, rising expectations regarding the number of claims to future output, i.e. the future size of the monetary base, reduces the value of each claim (the value of money falls and price rise).

The other way to think about it is this.

What is the difference between “QE” and “monetizing the deficit”? The short answer is “expectations”. If the Fed’s intention is to buy government debt and keep it, then it is “monetizing the deficit”. In contrast, if the Fed’s intention is to buy some debt and then sell it at a later date, then it is not.

The problem is that it is a fine line. You can’t buy government debt and never sell it and call it a “temporary” market intervention. If the Fed doesn’t unwind QE, then it is has monetized the deficit. There is simply no other way to look at it. Problematically, monetizing the deficit always ends with the same result: a collapse in the value of money and a surge in the rate of inflation.

In summary, while the Fed may be successfully using the interest rate rabbit to distract the markets from the base money elephant for now, this situation won’t last forever. If the markets suddenly realize that the Fed isn’t serious about “normalizing” monetary policy, i.e. reducing the size of the monetary base, then it will take a lot more than a rise in short-term interest rates to prevent a collapse in the dollar and an outbreak of high inflation.

“25 Basis Points” does not equal “$1.7bn Monetary Base Reduction”

There has been a story doing the rounds of social media lately that states that the recent rate rise by the Fed is the equivalent of a massive reduction in the monetary base. This isn’t right and I want to explain why.

I believe that the story originated with John Hussman, economist and fund manager. I have read Hussman’s work for years and I greatly admire his work. In a recent post, “Reversing the Speculative Effect of QE Overnight”, Hussman repeats his view that “the immediate first step of the Federal Reserve in normalizing monetary policy should have been to reduce the size of its balance sheet”. I completely agree with this view.

However, Hussman further argues in regards to the Fed’s recent 25bp interest rate rise that “from the standpoint of investors, the overall effect is just as if the Fed had suddenly removed every dollar of quantitative easing since 2009 ($1.7 trillion).

Hussman bases his view on the principle that supply and demand for money determines “the interest rate” which Hussman defines as the 3-month Treasury bill yield. Therefore, if the Fed raises this rate by 25bp, then, according to his chart, it is the equivalent of the Fed reducing the monetary base by $1.7 trillion.

As regular readers would know, the view of The Money Enigma is that supply and demand for money does not determine the interest rate. Rather, supply and demand for the monetary base determines the market value of money. [See “Supply and Demand for Money: Where Keynes Went Wrong”]

So what determines “the interest rate”? Supply and demand for each government security determines the interest rate on that particular government security. More specifically, supply and demand for 3-month bills determines the rate on 3-month securities and supply and demand for 10-year notes determines the rate of 10-year notes, etc.

The Fed uses the money it creates (the monetary base) to intervene in those markets. As discussed earlier, the Fed intervened in the short end of the market and drove short-term rates to zero. Then, when that wasn’t effective, it intervened in the long-end of the curve, an act that required a massive expansion of its balance sheet.

Hussman’s analysis lumps these two very distinct markets into one (the short-end of the curve and the long-end of the curve). It must be remembered that the Fed didn’t spend $1.7 trillion to push down the 3-month bill rate. It spent that money to push down the interest rate on 5-year, 10-year and 30-year debt.

Today, the Fed wants to raises short-term interest rates. In doing this, it has two choices. Either (a) reduce the size of the monetary base and let the entire yield curve rise, or (b) artificially manipulate short-term rates using interest on reserves and the reverse repurchase facility.

The Fed has chosen option (b). The view of The Money Enigma is that the Fed has chosen option (b) primarily to avoid the risk that Hussman raises: the Fed doesn’t want to raise the long-term cost of capital and thereby reverse the speculative effect of QE.

While I agree with Hussman that global equity markets are overvalued in a historical context, the primary driver of this overvaluation is Fed suppression of the long-term required return on capital. At some point, the Fed will have to blink and allow the long-term required return on capital to rise: that will be a bad day for stocks.

In summary, the Fed finds itself between a rock and a hard place. If the Fed reduces the size of the monetary base, global asset prices will fall markedly. However, if the Fed does not reduce the monetary base, then at some point expectations regarding the “temporary” nature of QE will shift, the value of money will fall and inflation will accelerate.

Using complicated mechanisms such as IOR and RRP to raise short-term interest rates might distract the markets and the mainstream media for a few months, but it won’t solve the big issue: what to do with the elephant in room.

Author: Gervaise Heddle

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