On April 20th Paul Krugman published in his Op-Ed-Colum of the New York Times an article with the title that Sweden turns Japanese. He criticizes the recent decision of the Swedish central bank decision to raise its interest rate. The somewhat strange tone to call this decision a sadomonetarist approach to monetary policy is somewhat beyond the tone of Nobel Prize winners in economics, which has been established just by the same bank years ago. The reason given by this to some extent controversial decision of the bank was that the see the risk of a financial market bubble which has to be contained before it is becoming to huge and destructive. This can be interpreted as a kind of forward guidance of monetary policy to financial markets that the Swedish central bank will act timely and vigorously to stop such unwarranted development. How come, that Paul Krugman loses his countenance on this behavior? The answer is simple. It’s the deflation scarecrow, which worries Krugman. He is not alone that he sees an increasing risk of a deflationary spiral emerging around the globe. Leading the crowd of deflationist worriers is the IMF with Christine Lagarde. A close follower along this line is Mario Draghi, who sees the same risk for the Euro area in particular. The key remedy against this development is according to Paul Krugman an anti-deflation policy by keeping interest rates low for an undetermined period of time until hopefully the economy recovers sufficiently to can absorb higher money market interest rates. The only difficulty so far is that monetary policy is operating in a liquidity trap, i.e. central banks have already lowered nominal interest rates close to zero. One instrument applied by the Fed, the Bank of England and the Bank of Japan like many others around the globe was to use Quantitative Easing (QE) to pump additional liquidity into the financial markets. However, this medicine did for some time the trick to lower long-term capital market interest rates in the US in particular; the medicine lost its effect after been applied for such a long time. After QE1 which worked just fine, QE2 already had to face much less success and the last QE3 turned out to be an outright failure. After that Ben Bernanke decided that it was time to stop this policy experiment. The unwarranted side-effects of these programs was that the Fed – like other central banks following this line of advice – became more and more risk takers of financial market assets of government bonds and asset backed securities (ABS) in particular. The Fed like other central banks was acting as bad banks for their respective economies.
For the US this might seem a minor problem because it is the globally dominant reserve currency. The possibility of capital flight from the over exposed central bank; to face default was therefore negligible. Other countries lacking this extraordinary privilege are in a less favorable position. Iceland can tell a story about this. Lender-of-last-resort can only be viable for central banks if they have full or at least sufficiently control of the financial markets and by this over the economy. What works fine in a closed economy with capital controls, is much less efficient in an open market economy with free capital flows. If creditors flee a financial market of one country this will have huge impacts on its exchange rate, i.e. their currency will slump. Currency depreciation could lead to a positive feed-back loop which drives down the respective currency much below its reas0nable level like e.g. the purchasing power parity (PPP). In the Asian crisis of 1998 Thailand, Indonesia or South Korea experienced such an excessive currency slump. Since imports will rapidly appreciate because prices will not compensate this exchange rate shock, the country will face two kind of de facto embargoes. They cannot lend money from abroad and they are unable to pay their bills of import goods as before. For countries deeply integrated in the global economy this leads to a depression, i.e. a shrinking output and high unemployment. That is the logic behind the 1929 Great Depression.
Why rising interest rates are a danger for the global economy?
The current state of the global economy if fragile. Much of the money created by central banks like the Fed has gone offshore to countries like the BRICS. It created there a external debt driven high growth which was fine at a time when the developed economies had to recover from a deep recession. However, it also increases the risk of malinvestments. If long-term interest rates are too low, they lead to investments which become unprofitable if long-term interest rates swing back to a higher level. Since most major investments are not financed by cash reserves of investors but on credit they face the risk that refinancing debt becomes a problem. It might happen that banks cut credit lines which make investors immediately insolvent or they only raise interest payments through higher interest rates. If the profitability of the project was already low the investor cannot take these additional financing costs and goes bankrupt as well. This easily can lead to a complex contagion process spreading through the whole economy. Knut Wickell, a Swedish economist, who formulated this problem of business cycles due to a too loose monetary policy. Through false monetary policies to stimulate excessive growth through credit expansion this process finally created an endogenous credit cycle and financial and real economy bubbles, which sooner or later will burst and turn an economy into a recession or even depression. The Monetarist answer of this maladjustment through too accommodating monetary policies was to stabilize the monetary expansion to the long-term growth potential of the economy. The principle of the Monetarist recommendation was to take a non-activist stance towards liquidity provision. However, in times of crisis monetarists accepted that a too restrictive monetary policy will deepen a recession unnecessary. The idea behind this recommendation was to supply sufficient liquidity to stop the economy from falling off the cliff. However, this is easier said than done. The central bankers should know perfectly well how much liquidity is necessary. Since the endogenous dynamics of liquidity floating through numerous channels into the economic system not only of a national economy but in an open economy far beyond, one has more or less to have perfect insight into all the simultaneous adjustment processes to target the liquidity injection correctly (see figure 1).
Figure 1 – Channels of impacts of monetary policy
There is a high uncertainty that monetary policy will not hit the target properly. Sometime it is too much and sometimes it is too late and too little. Even sophisticated econometric models have not overcome the obstacles of steering the liquidity supply in an efficient or even optimal way.
So, how to overcome the hurdles of optimal liquidity provision to an economy? Monetary policy has tried many of them with ambiguous success. Monetarists first looked for leading indicators as intermediate targets like various versions of money, M1, M2, M2a, M3. However, none of them showed a stable relation towards inflation and interest rates as necessary to control liquidity and credit cycles of an economy. So one moved on to target the overall inflation rate directly. The next step was to introduce the Taylor-Rule. Beside the inflation rate the real growth of GDP should be included by weighting both targets accordingly to find an appropriate compromise between both objectives. The more recent invention of the Fed has been to use the unemployment rate as a monetary policy target. The Fed under Ben Bernanke announced a monetary policy target to consider raising interest rates when the US unemployment rate is falling below 6.5%. As an independent observer one easily comes to realize that all these targets are subject to Goodhart’s Law. They are changed suddenly and unpredictably by those who have proposed them before.
Monetary policy targets are inherently non credible due to the past experience. Market participants have always been caught by surprise from sudden monetary policy shifts. Expect the unexpected is the conclusion from all these exercises. Behavioral economist would claim the central bank suffers from hyperbolic discounting. So I have become a Socratian: I know that I don’t know, but I also know that they don’t know. They always adjust their opinions according to their perceived state of the economy.
What causes Krugmans rage?
I have outlined before that interest rates along the yield curve behave not as predicted by the Fed and other central banks in particular. QE should have had a lowering effect on the interest rates along the yield curve. The most recent empirical evidence discovered was that a QE-Paradox emerged. When QE3 was started to cut back since January 2014 the long-term interest rates started to decline instead to rise. The original purpose has been that QE1 should lower long-term interest rates along the yield curve what it did. Now QE3 was shrinking and the interest rates fell as well. How come?
Another paradox emerged during the QE3 period that long-term interest rates began rising even of massive buying programs of the Fed was still going on. All this is more or less puzzling and still lacks a proper explanation. The capital market interest rates are seemingly out of control of the central bank. They move into directions the Fed wants to avoid or they move in the desired direction when the Fed begins to lower its buying program just implemented to accomplish lower interest rates. Anything goes.
The biggest worry in the US is now that long-term interest rates will rise even after the Fed has announced that the Fed will keep its short-term money market interest rates close to zero for an longer term. What processes are at work? Nobody seems to know.
Looking at the most recent developments of the US-yield curve one notices that the current interest rate , i.e. the darker red-line, is lower in the very long-run of the 20 and 30 years bonds, but higher in the medium-term interest rates of 2 to 10 years than in October 28th 2013, i.e. the bright red-line. There seems to have emerged some reallocation of demand for bonds from very long-term towards shorter time periods (see figure 2).
Figure 2- US-yield curve on 29th October 2013 and 23rd of April 2014
If you are responsible for the monetary policy of the US these findings are no good news. Even the interim results of falling interest rates since early January until February 2014 was not following the Fed predictions what should have happened (see figure 3). It might have been fine that long-term interest rates declined, but one could not explain why?
Figure 3- US-yield curve on 2nd January 2014 and 28th of February 2014
Now this development seems to be over again. The differences between interest rates in January and March have disappeared (see figure 4).
Figure 4- US-yield curve on 31st January 2014 and 12th of March 2014
Market interest rates on US capital markets move in any direction but are not under control of the Fed anymore. This might be a dangerous sign. The only credible commitment the Fed still has left is to keep the Federal fund rate close to zero. However, the transmission process from there to the capital market interest rates is volatile. However, capital market interest rates are what finally matters for the economy. If the interest rate structure moves up sufficiently, this can cause a recession at some point
Now, the Swedish central banks breaks away from the consensus of the major central banks around the world to keep even the short-term interest rates low. Since Janet Yellen has already in January 2014 that rising money markets rates in the US will occur earlier than before expected, this causes additional uncertainty if the commitment of the Fed is credible. Even after Janet Yellen truned down their January announcement afterwards , financial markets have become rather nervous about the future perspectives of the Federal funds rate. Since now, the Swedish Riksbank is becoming the vanguard of rising money market interest rates this might even amplify the already fragile situation in the US.
First, higher interest rates abroad in Sweden might lead to carry trades from the US to Sweden. This puts pressure on the US-Dollar exchange rate, and might stimulate Swedish growth by the external liquidity inflow. Since the Fed is looking for a soft-landing for the US economy they dislike such foreign independent actions which counteract their strategy very much. The Fed did not want to lose their dominant role in the global financial markets. Even respectively tiny economies like Sweden are potentially dangerous. In particular, since Germany with its Jens Weidmann of the Germany Bundesbank will have some sympathies for the Swedish policy move. If the Bundesbank would put pressure on the ECB to stay put, and not to start unorthodox monetary policy experiments like a European QE this would the QE-Exit of the Fed. The BIS has already developed a concept to use global liquidity as a new monetary policy framework. If this perspective is correct, the mopping-up of liquidity elsewhere in the global economy than in the US would constrain their ability to do so themselves. Since there is no real framework of monetary policy coordination in place, independent actions would always have harmful side-effect on others. Raghuram Rajan, who has recently become head of the Indian central bank, started already complaining about the ruthless monetary policy of the developed countries which do not take care of the needs of developing ones like India.
Now even the Fed might feel that they lack sufficient support from Europe from countries like Sweden to follow their own monetary policy objectives. In a more and more interdependent world in particular with global financial markets interlinked by highly complex derivatives the situation is highly fragile. Some like Paul Krugman might be worried about the possible butterfly effect. In a world of high complexity and non-linearity of interconnected financial systems sometimes tiny changes could trigger chaotic or even catastrophic behavior. Since nobody knows for sure when and if this might happen, it is better to stay put. That might be the reason why Paul Krugman became so nervous about the policy move in Sweden. Let’s hope he is wrong.