Expansionary Monetary Policy: Easy Money

Marc Faber explains why the US’ Expansionary Monetary Policy led to strong consumer spending growth but did not lift capital spending — and why the obvious answer isn’t necessarily a sufficient one.

THE FED EMBARKED on an ultra-easy and expansionary monetary policy whereby, despite six interest rate hikes over the previous six months, real interest rates remained negative. Then, after 2002, the impact of the tax cuts began to kick in; combined with the ultra-expansionary monetary policies, this led to rapid credit expansion, asset inflation (particularly in home prices), and (through mortgage refinancing activity) a consumption boom, which lifted consumption as a percentage of personal income and GDP to record levels.

What these U.S. monetary policies failed to do, however, was to lift capital spending and produce gains in private sector employment. (The U.S. government, on the other hand, has added almost a million jobs since 2000.) In fact, capital spending is still below the level of 2000 and, as a percentage of GDP, is at one of its lowest levels ever.

Now, one can ask oneself why easy monetary policies didn’t lift capital spending — which is vital for sound economic growth — but only led to strong consumer spending growth. The obvious answer might be that there were large excess capacities in the system after the capital-spending boom of the late 1990s.

However, this answer is not satisfactory, because overcapacities existed in some sectors of the economy everywhere in the world, yet capital spending in China grew, until recently, at annual rates of up to 50%. So the real question is why capital spending and industrial production soared after 2001 in China, but not in the United States.

The simple answer is that the costs of production are so much lower in China than in the United States; therefore, the corporate sector had — and still has — an interest in shifting investments and production to China. But why did the cost of production become so much lower after 2001 relative to the United States, when the fact was that the Chinese currency was pegged to the U.S. dollar? I suppose that part of the answer must relate to asset inflation in the United States, which increased production and investment costs relative to China.

Expansionary Monetary Policy: America’s Monetary Conundrum

In the Feb. 24, 2005, issue of The Economist, there are three articles that discuss America’s “monetary conundrum.” An article under the headline “Are Central Banks Watching the Wrong Measure of Inflation?” discusses some of the issues involved in properly measuring the rate of inflation. In particular, The Economist seems to lean towards the view that today, “consumer-price indices are arguably too narrow” and that “central banks should instead track a broader price index which includes the prices of assets, such as houses and equities.”

The Economist then refers to Ian Morris, an economist at HSBC, who devised a broader index that includes house prices, giving them a 30% weight, the same now attributed to the notional rent paid by homeowners in the core CPI. According to The Economist, “In the year to the third quarter, inflation as measured by this broad index was 4.9%, more than twice the rise in the core CPI.”

Assuming that house-price inflation has continued at the same pace, The Economist calculates “that broad inflation is now 5.5%, the highest since 1982. Moreover, during the past three decades, the gap between the two measures of inflation has never been so wide for so long. If inflation in America is really higher than the official index suggests, then interest rates should also be higher.”

The Economist then goes on to say:

“The idea that central banks should track asset prices is hardly new. In 1911, Irving Fisher, an American economist, argued in a book, The Purchasing Power of Money, that policymakers should stabilize a broad price index which included shares, bonds, and property as well as goods and services. Central banks already take account of asset prices by estimating their effect on wealth and hence on demand and future inflation, but the idea behind a broad price index goes much further, acknowledging that asset-price inflation can be harmful in its own right.

“The most obvious way is through a giddying rise and subsequent crash of markets for shares or property. Big swings in asset prices can also lead to a misallocation of resources and so slower economic growth, just as high rates of general price inflation distort economies by blurring relative price signals. For instance, soaring property prices can encourage households to borrow too much and save too little, and can pull excessive resources into property at the expense of other forms of investment.

“More fundamentally, if inflation is defined as ‘change in the value of money,’ then the consumer price index is flawed because it only measures the prices of current consumption of goods and services. A classic paper written in 1973 by two American economists, Armen Alchian and Benjamin Klein, argued that people care about changes in the prices not only of the goods and services they consume today, but also of what they use tomorrow. Because assets are claims on future goods and services, their prices are proxies for the prices of future consumption. If I buy a house — i.e., a claim on future housing services — and its price is higher than a year ago, then surely that should be included in inflation since it reduces the purchasing power of my money.”

In a related article in the same issue (Feb. 24, 2005) entitled “The World’s Giant Money Printing Press,” The Economist takes the central banks to task. The article states first that monetary policies are loose because real interest rates in the United States and other countries are still negative. Moreover, The Economist’s measure of “global liquidity,” which consists of the sum of America’s monetary base (notes and coins, plus banks’ reserves held at the Federal Reserve) and foreign exchange reserves held by central banks around the world, grew in 2003 and 2004 at annual rates of more than 20%. According to The Economist:

“In no other two-year period since 1975 has liquidity increased by so much.

“America’s easy-money policy of recent years has spilled abroad. Low American interest rates have encouraged large inflows of capital into emerging economies, especially in Asia, as investors have sought higher returns. Central banks have then tried to resist the consequent upward pressure on their currencies by buying foreign exchange, mainly dollars. When a central bank does this, it credits domestic commercial banks with deposits (i.e. the monetary base expands), encouraging banks to lend more. Central banks are supposedly the guardians of money. Yet between them, they may have created the biggest liquidity bubble in history.”

Expansionary Monetary Policy: Asset Bubbles around the World

I have to admit that I was very happy to see, in this issue of The Economist, that for the first time, central bankers — and especially the American Fed — are being openly criticized for their extremely dangerous and destructive monetary policies, which have created imbalances and led to asset bubbles all over the world in every imaginable investment class and which, at some point, will lead to some seriously negative economic consequences.

We have discussed the subject of asset inflation a number of times. In particular, I was pleased to read that “big swings in asset prices can also lead to a misallocation of resources and so slower economic growth” and that “soaring property prices can encourage households to borrow too much and save too little and can pull excessive resources into property at the expense of other forms of investment”– such as capital spending, I might add.

This is exactly what seems to have happened in the United States, not only with respect to properties, but also with respect to other asset classes such as equities, bonds, and commodities. In short, easy money in the United States has led to inflation and a colossal wave of speculation in all asset classes, as too much money was chasing too few assets. And who wants to build a new factory and invest in productive equipment when annual gains of around 15% can be achieved by playing the asset-inflation game?

Moreover, as America inflated its price level — and, along with it, the cost of production — it became uncompetitive with China. In turn, this widening cost differential drove investments and industrial production out of the United States and into Asia, especially China. The consequence was then the worrisome deterioration in the net international investment position of the United States after 2000, which came about as a result of a ballooning current account deficit. Of some concern also should be the sharp increase in U.S. net foreign debt.

So far, this net increase in foreign debt has not increased net interest paid to foreigners since 2001, because of the sharp decline in interest rates post-January 2001. But what if short-term interest rates were to rise to a level that approximated The Economist’s broad inflation index, currently around 5.5% per annum (based on calculations by HSBC’s Ian Morris)?

In this case, we would have to expect net interest paid to foreigners to soar and put additional pressure on a worsening current account deficit. Despite declining interest rates since the early 1980s, net interest paid to foreigners rose from 0.4% of GDP in 1986 to around 1.2% of GDP in 2004 (about US$135 billion) and could soar to around 2% of GDP (or to around US$230 billion) if interest rates were to rise to their “natural rate”.

In fact, the problem of lacking U.S. competitiveness is aggravated by the Fed’s easy-money policy. Artificially low interest rates stimulate massive capital spending in China, which lowers China’s unit labor costs far more than if interest rates were high. Declining unit labor costs then lead to a fall in Chinese export prices and worsen the competitive position of the United States even further.

In fact, upon reflecting on the Fed’s monetary policies in the last 10 years or so, I am convinced that they will, in time, bring about serious economic hardship on a worldwide scale. In the United States, the asset inflation will end either with asset prices declining or with a dollar crisis, which will also deflate asset prices — not in dollar terms, but in hard currency terms (probably against gold and Asian currencies). The Asian economies will also suffer because of insufficient demand from the United States. Exports will decline, and Asia — especially China — will suffer from huge overcapacities. But whereas the United States will have consumed the illusionary wealth the asset inflation created, Asia will keep the infrastructure and production capacities that the Fed’s inflationary monetary policies have financed.

Expansionary Monetary Policy: How Will It All End?

As we indicated in previous reports, the external imbalances of the United States are such that currency revaluations in Asia — and specifically in China — will be unable to solve the problems permanently. Only if U.S. consumption slows down or declines (recession) can some modest improvement in the current account deficit be expected. Such a slowdown in consumer spending will be brought about by events that will stop the asset inflation.

Needless to say, it is the recent asset inflation that has created the illusion of wealth shared by American consumers (and, I might add, by some economists who consider the U.S. expansion since 2001 to be sound). (The performance of GM’s stock is a good barometer of the economy’s soundness.) But the events that will bring about the end game will involve a significant rise in interest rates in real terms.

Interest will rise either because the Fed tightens more aggressively or because inflationary pressures force interest rates up massively later. Aggressive tightening by the Fed will be painful for asset markets, but far less so than if the Fed keeps real interest rates negative for far longer.

In addition, if the Fed tightens more aggressively, asset markets — including real estate; equities; commodities; and, to some extent, bonds — will suffer, but the dollar will likely strengthen. Conversely, if the Fed continues its highly inflationary monetary policy, which amounts to timid increases in interest rates that keep them below the rate of inflation, the market will eventually bring about a very nasty dollar and economic crisis and force rates up much further than under an aggressive tightening scenario.

I have to concede that there is some “good news.” However, the good news isn’t favorable for asset markets. It would appear that global liquidity is past its peak and is now decelerating rapidly. If this were really the case, then a brief analysis of the impact of shrinking global liquidity on asset markets and the economy is warranted. Once global liquidity shrinks, commodity prices do ease.

Very clearly, there seems to be a close correlation between Foreign Official Dollar Reserves (FRODOR) growth and, with a 12-month time lag, the CRB Raw Industrial Spot Price Index. Crude oil demand also correlates quite closely with changes in FRODOR growth. Therefore, if FRODOR growth decelerates further, we should expect the upward pressure on commodity and oil prices to ease — at least temporarily — and the U.S. dollar to strengthen.

As The Economist puts it, “Central banks are supposedly the guardians of money. Yet between them, they may have created the biggest liquidity bubble in history.” Moreover, because we live in a world where the supply of goods is more elastic — as a result both of rapid technological advances and new sources of supply from the former communist countries — inflation does not have much of an effect on consumer prices. However, it becomes an issue of “too much money chasing too few assets,” which is exactly what seems to be responsible for the inflated prices of assets around the world.

The American Fed is now confronted with an almost impossible task. Either it tightens monetary conditions and pushes short-term interest rates resolutely above the rate of inflation, or the market will do it later but with far more dire consequences.

If easy-money policies are not abandoned soon, the U.S. dollar will tumble against hard assets and foreign currencies — especially the Asian currencies — and lead to import and commodity price inflation, which will destroy the dollar and bonds. Conversely, if the Fed implements tight money policies now, asset markets will perform poorly and either slow or abort the economic recovery altogether.

In my opinion, investors need to increasingly consider which asset classes will perform the worst — and the least badly — in the environment I have just described. In my opinion, assets that would benefit the most from “free money” (negative real interest rates) and that were excessively leveraged would seem to be particularly vulnerable. In the U.S. financial market, proxies for this excessive leverage would be financial and homebuilding stocks, which we recommend our readers avoid or sell short.

I am also growing more wary of industrial commodity prices. Tighter money could lead to a more pronounced economic slowdown than is expected, or to a recession, which would make them vulnerable.

As explained above, grains look relatively attractive in terms of their depressed prices and fundamentals. Since they have little correlation with economic or liquidity cycles, they might perform even if other assets are under pressure. Gold and silver are also expected to do relatively well.

Near term, I am cautious about emerging markets, as they have benefited greatly from easy money. However, as I indicated, I expect the emerging markets (and also Japan) to far outperform the United States over the next 5-10 years.

The performance of bonds and the U.S. dollar is entirely in the hands of the U.S. Fed. Easy money will totally destroy their value. Tight money will lift the dollar and lead to only a modest decline in bond prices. But how likely is it that the Fed will adopt tight money policies?

Regards,

Marc Faber
April 13, 2005