by Gary North
Half a century ago, the daily puppet show, "Kukla, Fran, and Ollie" delighted millions of children and a lot of their parents. It was the creation of puppeteer Burr Tillstrom. He and Fran Allison did the show without either script or rehearsal for a decade, 1947—57. Although I was never a big fan — I was a "Time for Beany" partisan — I recognized early that Ollie the Dragon, with his one enormous tooth, was mostly toothless.
I was reminded of Ollie this week when Alan Greenspan announced that the Federal Reserve System would raise the federal funds rate by .25 of a percentage point. This was big news in the media. Why, I do not understand.
THE REALLY BIG NEWS
The most important economic news of the last six months has received little attention in the English-language financial press. China is now running a trade deficit. In the June 25 issue of the English language edition of People's Daily Online, we read:
China recently announced a trade deficit of 8.4 billion yuan for the first quarter of this year, the first quarterly unfavorable balance of trade registered by the country in 17 years.
In simple terms, economists explain that a country with a favorable balance of trade is lending money for others, while one with an unfavorable balance of trade is borrowing money.
The situation in China has thus thrown the ordinary Chinese people, who place their future in bank savings, into anxiety.
However, Chinese government officials, and economic and trade experts exhibit calmness, and even coolness in face of the trade deficit.
Despite the trade deficit in the first quarter, China expects to reach trade balance as a whole for the year, said Fu Ziying, assistant to the Chinese Minister of Commerce, and at most would have only a small amount of trade imbalance.
This means that China is no longer accumulating Western currencies, net. It is now dispersing Western currencies to purchase imports. Presumably, these imports are mainly raw materials: oil, cement, and steel. China is now the second-largest importer of oil in the world after the United States. It is consuming over half of the world's cement and almost 40% of the world's steel. An unprecedented construction boom is going on in China.
If China is no longer accumulating Western currencies, then its central bank will cease buying T-bills, net. It may even begin selling T-bills in order to obtain dollars in order to buy oil. The world's oil price is set in dollars.
This means that demand for T-bills will fall, which means that T-bill interest rates will rise. The Treasury will have to offer a higher interest rate to lenders because of falling demand from China.
This leads me to my main point: the recent announcement by the Federal Reserve System regarding the increase of interest rates has the scent of pre-emptive strike about it. As I argue in this report, the FED has not adopted a monetary policy that is consistent with its public commitment to raising interest rates. Yet its announcement has sent a message to the financial community: interest rates will be rising from here on.
Interest rates will indeed be rising. At this point, however, the FED has nothing to do with it, except as an English translator of Chinese central bank policy. This makes it appear as though the FED is setting interest rates. It isn't.
ALAN GREENSPAN'S DRUM
We read a lot of press reports recently about how the Federal Reserve System has just raised interest rates. The financial community had sat for weeks at its Bloomberg screens, breathlessly waiting for the announcement from the Board of Governors. And then it came! The Associated Press reported on July 1:
The modest one-quarter percentage point increase ordered Wednesday nudged up a key short-term interest rate controlled by the Fed to 1.25 percent, from a 46-year low of 1 percent.
Notice the language. It is in the passive voice, which would have upset our high school English teachers: "The modest one-quarter percentage point increase ordered Wednesday. . . ." Got that? Ordered!
I have a mental image of Alan Greenspan and the other members of the Board of Governors sitting around a table. Greenspan counts the votes. He then announces: "We will raise rates. It is so ordered." Then he hauls out the official Federal Reserve System interest rate drum, grabs the official interest rate drumstick with the large wad of red tape at its end, and begins hammering out the familiar rhythm. He chants: "Bunga, bunga, bunga — rise, rise, rise." It worked! The AP story continues:
In response, commercial banks, including Wells Fargo and Wachovia, announced that they were boosting their prime lending rate by a corresponding amount — to 4.25 percent, from 4 percent. The prime rate, a benchmark for many short-term consumer and business loans, also hasn't gone up in four years.
The prime rate is the rate at which commercial banks lend to their most credit-worthy customers.
What we seldom read is an explanation of how, exactly, the FED raises rates. Does it do this merely with a press release? "The Board of Governors of the Federal Reserve System today announced that interest rates will be raised by .25."
How can the FED raise rates? I have heard of fiat money, but the world today believes in fiat interest rates. I understand that the FED can create fiat money, but how does it create fiat interest rates?
HOW THE FED WORKS ITS MAGIC
The FED controls the amount of reserves that can serve as the monetary base, on top of which commercial banks create money by purchasing debt instruments or making loans. The FED does this by buying and selling securities, primarily U.S. government debt instruments.
So, what has the FED been doing lately? Two words: "Nothing much." The annual rate of increase in the adjusted monetary base since April 28, 2004, is 6.1%. The rate of increase since August 25, 2003, is 4.8%. The rate is increasing marginally.
Conventional economic theory tells us that when the FED is adding reserves in a non-inflationary environment, this tends to lower short-term rates by adding to the supply of money. More supply + constant demand = lower price. But the rate is rising.
In an inflationary environment, the increase might increase the long-term rate by creating a fear of rising prices. Lenders would then tack on an inflation premium to protect themselves from depreciating money. But the discussion about the FED's looming increase has not been focused on long-term rates but the shortest of short-term rates, the federal funds rate: the rate at which commercial banks lend money to each other overnight.
If the FED is attempting to raise the federal funds rate by .25% per year, what monetary policy would achieve this? I can see a case for reducing the rate of increase in the adjusted monetary base, i.e., reducing the rate of increase in the supply of loanable funds. But why? Let us return to the AP wire story.
With the economic recovery now firmly rooted and the jobs climate improving, the Fed felt it was safe to start raising rates to head off inflation, which has been moving higher, analysts said.
The Fed suggested that for now it wasn't overly worried about inflation. "Although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to transitory factors," the Fed said.
Inflation is not a problem. Then why raise rates? Aren't low rates good for business?
What is coming next?
"The Fed will proceed at an extremely cautious pace in this tightening cycle," said Sherry Cooper, chief economist at BMO Nesbitt Burns.
Cautious. I see. The economy is cautiously inflationary, so there is FED policy to match.
"Cautious" does not begin to describe its policy. The FED has not changed its monetary policy. It merely made an announcement to the media about where the federal funds rate should be.
There are times when I think that Greenspan clears his announcements with his wife, NBC's Andrea Mitchell. "Sweetheart, do you think this week is good? Or should we wait?" To which she replies: "Are you talking about the Board of Governors?"
FINE TUNING THE ECONOMY
How can the Federal Open Market Committee (FOMC), which decides how many dollars' worth of securities to buy or sell, decide the precise quantity of T-bills to buy in order to attain exactly a .25 percentage point increase in the federal funds rate? Unless the FOMC has developed forecasting tools that would make its members rich by means of insider trading, it is all guesswork.
But if it is all guesswork, why does the press spend so much time writing about FED policy, a .25 percentage point increase, and the effect on the economy?
Commercial banks announced a .25% increase. Well, not quite. The banks announced a .25 percentage point increase. When the rate is 1%, a .25 percentage point increase is a 25% increase. But when a commercial lending rate is 4%, then a .25 percentage point increase is a 6.25% increase.
Now this is fine tuning, indeed. The FED announces an increase, but does nothing to establish this by means of a perceptible change in monetary policy. Then commercial banks announce a far lower percentage increase as a direct response to the FED's imperceptible change in monetary policy.
"Bunga, bunga, bunga — rise, rise, rise!"
What is going on here?
YOU AND I AND THE OTHER GUY
Interest rates are set by free market forces, just as other prices are. Borrowers of dollars and lenders of dollars get together and haggle. Out of this haggling comes legally objective contracts. Out of arbitrage — the buying and selling of these contracts (e.g., by Fannie Mae and Freddy Mac) — come commercial rates that other lending institutions adopt.
Interest rates are the price of money over time. They also allocate the supply of future goods (discounted) in relation to present goods.
So, why do we pay attention to Greenspan's testimony to Congress ("Bunga, bunga, bunga, Senator, with reservations"), Federal Reserve press releases, and AP news stories? Why is there any predictable relationship between .25 at one end of the spectrum (federal funds rate) and the other (prime rate)? What, precisely, has a 25% increase got to do with a 6.25% increase?
If commercial borrowers head over to Wachovia and start lining up, the actual rate will go to 4.35% or 4.5% or 4.7%. The prime is used for advertising purposes. But if demand is heavy, bankers will tell customers that this rate is not available to them, only to some other guy, who has a better credit rating. If bankers were not men of impeccable morals, we would call the prime rate "bait & switch."
Of course, if borrowers decide that 4.25% is too much, then there will be discounts from prime, kind of like the loan rate available on a brand new Mitsubishi, which isn't selling too well these days. Call it the "Act now — supplies are limited!" rate.
If I am right about this, then the Federal Reserve System does not control interest rates. Anyway, it does not control interest rates with the same degree of predictability that it controls Congress. It influences the public's perception of what the FED intends to do, one of these days, Real Soon Now, in monetary policy.
The FED intends to buy T-bills. Or sell T-bills. Or swap T-bills. It will see which way interest rates go, and it will then fine tune the monetary base. Unfortunately for the textbook version of the process, there is not much short-term correlation between changes in the monetary base and changes in the direction and magnitude of interest rates.
Some economists predict the funds rate could rise to 2 percent by the end of this year, which would mean the prime rate would move up by a corresponding amount to 5 percent.
I see. Some economists think that an increase in the Fed Funds rate of 60% (2 — 1.25 = .75, divided by 1.25) will increase the prime rate by 17.6% (5 — 4.25 = .75, divided by 4.25).
Then again, some economists don't.
When you think "Federal Reserve System," think of a used car lot. You drive by and see signs like these: "A Real Beauty!" "High Flyer!" "You Can't Beat This!" and the always popular, "Won't Last Long!" Then you see that other sign, the one that lies at the heart of the business: "We tote the note."
When you deal with a used car salesman, you negotiate. You both make assessments of what the other guy is really willing to pay. Neither of you tells the whole truth.
Think of Alan Greenspan as a used car salesman. He goes before Congress. He tells his plans for the economy. But there is one thing that Congress never gets out of Greenspan: a warranty. "All policies sold as-is."
The FED can announce a rate increase. Bankers can announce rate increases. AP stories can announce what the FED and the bankers have announced. It makes good copy. It may even be the opening story on the evening news. Nevertheless, interest rates are set by you and me and the guy behind the tree. Out of the hustling and bustling for loans, prices emerge. These prices are interest rates.
There is monetary inflation. I pay attention to the adjusted monetary base because that is the only monetary aggregate that the FED can directly control. It tells me if FED policy has changed. Monetary inflation today is in the mid-single digit range: business as usual.
What about price inflation? I use the Median CPI figure, published by the Cleveland Federal Reserve Bank. It was up .2% in May. This is 2.7% at an annualized rate. The monthly rate was up in April by .3%. So, there has been a downward move.
Price inflation is mild. We have not seen price deflation since 1939. I think it is safe to say that we won't see it later this year.
Then why is Greenspan giving the green light for commercial banks to raise rates? I have no inside evidence. I can merely speculate — intellectually and then entrepreneurially. I think it has to do with maintaining the illusion that the FED is in control of interest rates.
There is no sign of an accelerating stock market bubble. He is sending a message, but to whom? To home buyers? But why? He keeps telling us that rising home prices are creating a wealth effect. People save less because they see themselves as better off. They are looking at their homes as retirement funds. But he says this is fine — no problem.
The American savings rate is low. It is in the 3% range. Rates paid to money market fund holders and bank CD owners are abysmal. If there is one group that would seem to benefit from rising rates in a low price inflation environment, it is savers.
The big money for investing in any capitalist economy is the upper 20% of the wealth curve. It is not grandma with her passbook savings account. It is the bond investor.
What FED monetary policy could raise the real rate of return on bonds? Stable money. Stable money would produce falling prices, which would produce a higher real interest rate for a time. But then long-term rates would fall.
To raise short-term rates, the FED must provide a monetary policy designed to do this — assuming the FED is really in control. I see only one policy that can achieve this result: reduced monetary inflation, producing a lower supply of fiat money loans. That would produce lower price inflation and a higher real return for bonds — until long rates begin to fall.
I think the FED is trying to slow the housing market. This makes sense of the policy of announcing rising rates.
The FED is also trying to reduce the carry trade, i.e., borrowing short to lend long. A reduction in the carry trade in response to the rising risk of short-term rates would tend to raise long-term rates for a time: reduced purchases of bonds, i.e., lower supply of fiat money to buy bonds ====> rising rates.
This is bad news for existing bond holders. The market value of their bonds will fall when interest rates rise. It is bad news for anyone employed in the home refinance trade. That profession is just about doomed. It may be bad news for anyone who just bought a home in Boston or coastal ("blue") California.
The economy is rising. Greenspan must think that a series of ticky-tacky increases will not throw the recovery into recession. As the Lakers' announcer Chick Hearn used to say, "No harm — no foul."
This is an election year. FED Governors do not normally vote to establish a policy that will create an economic recession in an election year. They did in 1980, in the midst of an inflationary crisis, but not since then.
The FED seems to be assuming that the economy will still be rolling in November. It also seems to be trying to slow down the boom in housing. But, so far, its policy has been entirely verbal. It has abandoned the stable money policy that prevailed from August, 2003, through December. It has been inflating — a policy calculated to reduce short-term rates, not raise them.
I think the message to the carry trade will get through. Long-term rates will rise. I don't see a rise above 7% in mortgages as long as Fannie Mae and Freddy Mac are out there, sopping up savings. But I could be wrong.
I see the hike in the fed funds rate as a warning shot across the bow of the carry trade market. But I do not yet see FED monetary policy backing up the higher-rate policy.
China is a different story. If China really does stop buying T-bills and stays out of this market, as seems likely, then all rates will rise, and not at a ticky-tacky rate of increase. What China's central bank does is more relevant than what the FED has done so far.
I begin to perceive Alan Greenspan as a hand puppet. He continues to speak in central bank Esperanto. This is appropriate. It enables the voice behind the image to communicate inconspicuously. No one notices his Chinese accent.
Frankly, I liked Burr Tillstrom better.
July 3, 2004
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