Thoughts on Eric Rosengren’s talk
Mike Luciano, a regular reader of and sometime contributor to this site also attended the lecture by Boston Fed president Eric Rosengren yesterday which I wrote about earlier. Mike comments on Rosengren’s remarks follow:
On Monday, Boston Federal Reserve President, Eric Rosengren gave a talk at the UMass Lowell Inn and Conference Center as part of the Moses Greeley Parker Lectures series. (Is that enough proper nouns for you?) What follows are my thoughts, which are based on some perfunctory notes I took at the lecture.
In his presentation on monetary policy in a slow recovery, Rosengren reiterated the Federal Reserve’s standard line about the need for further “quantitative easing” (QE) This is a fancy way of saying, “money printing,” which is done when the Fed purchases assets—typically treasury bonds and bills. During QE, the Fed therefore expands its balance sheet in an effort to pump liquidity into the economy by lending money to banks, which are in turn supposed to lend to businesses and consumers. Currently, the rate at which the Fed is lending to banks (called the federal funds rate) is at 0% to 0.25%.
By purchasing massive amounts of treasuries, the Fed is aiming to drive down their yields. The Fed is hoping that low interest on treasuries, combined with a microscopic federal funds rate, will have the effect of convincing Americans to part with their dollars and increase consumption. The idea is to get credit flowing so that businesses and individuals can borrow and consume more easily. As consumption (demand) increases, so does production and employment. Meanwhile on the foreign exchange market, this increase in the money supply and cheap credit is supposed to produce an inflationary effect that will weaken the US dollar relative to other world currencies, which would boost American exports.
The most damning objection to QE is that this was already tried in the wake of the 2008 financial crisis. Indeed, this latest round is being dubbed QE2, the successor to the failed QE1. During that phase, the Fed expanded its balance sheet by gobbling up treasuries and $1.2 trillion in mortgage-backed securities (MBS), most of them probably toxic. MBS purchases, along with those homebuyer tax credits that expired earlier this year, were supposed to “stabilize” (in Fedspeak) the real estate market. However, a more accurate term would be “prop up”—artificially I might add—as the government still refuses to let real estate prices hit bottom. The sooner that happens, the sooner they can begin a natural and gradual upward ascent. Furthermore, the position of the Federal Reserve’s Open Market Committee (FOMC) regarding interest rates has remained static for two years.
There is little reason to believe that QE2 will succeed where QE1 failed. As far as I can tell, there are three significant obstacles to a successful QE2.
1. Lack of consumer and investor confidence. (I could actually count these as two, but I won’t.)
With wages stagnant and unemployment high, many Americans are reluctant to make substantial purchases. Many of those who have jobs at the moment cannot be sure they will have them a few months from now. Furthermore, Americans are already a very indebted people—the ratio of household debt to income is approximately 125%, an all time high. In such an economic climate, we cannot be surprised if investors are reluctant to put money into American firms. For their part, businesses will obviously remain reluctant to hire new workers and buy new equipment as long as consumer spending remains low.
2. Banks will not lend despite the cheap money they borrow from the Fed.
As long as Obstacle 1 remains in play, Obstacle 2 is academic. Even if commercial banks were itching to lend, this is moot if consumer confidence remains low. The Fed has been trying to foster a highly liquid credit market since 2008 to no avail, thanks to low demand.
Even if consumer confidence levels weren’t in the tank, this hardly means banks would invest domestically. Over the years, the US and dozens of other countries have been continuously knocking down barriers to international commerce, including hindrances to capital flows. Given the state of the American economy and the emergence of new markets in Asia and Latin America, capital flight is a potentially serious problem for the US, if it is not already. An emerging economy such as China can be quite appealing to international investors because it has a large untapped consumer base with significant growth potential.
3. A currency war that featuring several countries trying to competitively devalue their currencies on the foreign exchange market.
With QE1 in 2008 and 2009, the US dollar was supposed to decline in value on foreign exchange market where currencies float freely against one another as traders buy and sell various currencies. But thanks to a series of sovereign debt crises in the UK and the Eurozone, the US dollar actually appreciated versus the Pound and the Euro, and has only recently reversed itself.
China, meanwhile, does not allow its currency to float freely against others on the foreign exchange. For some time now the US has been trying to get China to allow its yuan to appreciate relative to the dollar. This would have the effect of making Chinese goods more expensive in the US, and American goods cheaper in China. While by all accounts the yuan is undervalued and the Chinese government is keeping it artificially low, the US is throwing stones from inside a glass house when it accuses China of currency manipulation. Recently, China has indicated it is willing to allow the yuan to appreciate, but it remains to be seen how much of an impact this will have on the balance of trade between the two countries.
As both developed and developing countries vie to make their exports competitive in the global economy in this era of slow growth, the prospect of a currency war is quite real. Competitive devaluation will be the name of the game, as countries alter their monetary policies or even intervene in the foreign exchange market in an effort to weaken their respective currencies. But at some point, the threat of hyperinflation becomes a real possibility as countries continue to up the ante with each another. Let’s hope we don’t get to that point.