Brad Setser

Brad Setser: Follow the Money

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The US imported too loose a monetary policy from the world, and now exports too loose a monetary policy to the world

by Brad Setser
May 23, 2008

That more or less is the conclusion of this week’s Economist.

I agree.

Back in 2003 when the dollar started to depreciate, many emerging economies opted to maintain dollar pegs and follow the dollar down. The resulting increase in their reserves — and holdings of US Treasuries — altered the monetary transmission mechanisms in the US. The dollar was stronger than it otherwise would have been, notably against the Asian currencies. And US rates were lower than they otherwise would have been.

Moreover, long-term rates didn’t rise when the Fed started raising rates, keeping financial conditions looser than they otherwise would have been. And as the revised data from mid-2004 to mid-2006 comes out, it is increasingly clear that ongoing central bank purchases of Treasuries and Agency bonds are part of the explanation for the persistence of low long-term rates. The Economist:

“Emerging economies shared some responsibility for America’s housing and credit bubble. As Asian economies and Middle East oil exporters ran large current-account surpluses, they piled up foreign reserves (mostly in American Treasury securities) in order to prevent their currencies from rising. This pushed down bond yields. At the same time, cheap imports from China and elsewhere helped central banks in rich economies hold down inflation while keeping short-term interest rates lower than in the past. Cheap money fueled America’s bubble.”

The housing bubble and residential construction boom obviously have ended. The US economy has slowed sharply. And the US has cut rates.

The result is that a host of emerging economies are now importing both a weak currency and loose monetary policy from the US. Countries that peg to the dollar can easily have a looser monetary policy than the US — higher rates of inflation and the same nominal interest rate can produce lower real interest rates — but have difficulty maintaining a tighter policy. Raising rates while maintaining a de facto dollar peg would tend to attract speculative capital inflows. Ask China.

Loose monetary policy globally has helped to offset the US slowdown. Much of the emerging world is booming on the back of negative real interest rates. But it also has pushed up inflation globally. The Economist reports that the average global real interest rates is negative (“global monetary policy is now at its loosest since the 1970s: the average world real interest rate is negative”) largely because of very high rates of inflation in the emerging world.

The recent acceleration in the rate of inflation in the emerging world reflects — I suspect — the enormous acceleration in reserve growth among the world’s emerging economies that took place last year. Such reserve growth has been hard to sterilize, so it has bled in very rapid growth in the monetary supply of many emerging economies. The Economist:

Even if the Fed’s interest rate suits the American economy, global interest rates are too low. In turn, the unwarranted stimulus to demand in emerging economies is further pushing up commodity prices; so too is speculative buying by investors seeking higher returns than from bond yields, which are still being depressed by the emerging economies’ build-up of reserves. This stokes inflationary pressures in America and Europe and makes life difficult for rich-country central banks.

The rise in inflation in those countries that have built up the most reserves suggests that the US might just be a bit too big for the emerging world’s central banks to save. At least too big to support without significant costs.

The Economist recognizes the risks of status quo.

Loose money in America and rigid exchange rates in emerging economies are a perilous mix.

But this week’s Economist also — following an Economics Focus column of two weeks ago — notes that moving off a peg is hard, a lot harder than some (unnamed) proponents of floating (a group that I suspect includes me) sometimes suggest.

Admittedly, exchange-rate appreciation is not as simple a remedy for emerging economies as some claim: a rise in interest rates and the expectation of a further appreciation in the exchange rate could, perversely, exacerbate inflation by sucking in more capital; and setting the exchange rate free risks massive overvaluation.

I do not disagree. Small and incremental moves invite additional speculative inflows that — unless effectively sterilized — add to money growth and inflation. Moving suddenly to a float, by contrast, risks a large and disruptive upward move. Exiting from a peg is hard.

But the fact that so many countries waited so long to start moving away from dollar pegs — and in China’s case moved very timidly in 2005 and 2006 — has only made the ultimate exit harder. The gap between a true market exchange rate and the current nominal exchange rate of many key emerging economies (think of where a freely floating Saudi riyal would trade with oil at $130 … ) is now quite large.

The easy options disappeared when many key emerging economies didn’t take advantage of the dollar’s 2005 rebound to start to move off dollar pegs.

A 10 or 20% revaluation wouldn’t necessarily end speculation on further appreciation. And a 10 to 20% move was far more than either China or Kuwait were willing to consider.

21 Comments

  • Posted by Twofish

    bsetser: But the fact that so many countries waited so long to start moving away from dollar pegs — and in China’s case moved very timidly in 2005 and 2006 — has only made the ultimate exit harder.

    It’s not so much waiting, it’s the simple fact that you just can’t change currency policies overnight. There is a huge amount of financial infrastructure that has to be built to move from fix to floating rates, and doing so takes time. It took about a decade to move off of Brenton Woods I, and the fact that it has taken China about four to five years to move off of a peg is greased lighting speed.

    Currency policy affects just about everyone and everything, and to get everyone in a room to agree to change currency policy takes time.

    bsetser: As Asian economies and Middle East oil exporters ran large current-account surpluses, they piled up foreign reserves (mostly in American Treasury securities) in order to prevent their currencies from rising.

    And the another reason they did that was that they were also terrified of a repeat of the Asian crisis in 1998 and having to beg and plead from the IMF for emergency stabilization loans. Every emerging market wants huge currency reserves so that in a crisis they can tell that the nice man from the IMF to go to hell.

  • Posted by JKH

    BWS –

    If the US had no current account deficit, other things equal, the difference between domestic saving and investment would be $ 800 billion greater than what it is now ($ 0 versus $ (800) billion). This means an additional $ 800 billion annually would be available domestically to buy the same domestically issued financial assets, other things equal.

    Therefore, on the basis of the flow of funds alone, I don’t buy the argument that foreign reserve accumulation has pushed down interest rates, because the counterfactual puts the same buying power in the domestic US.

    There is an ancillary argument that foreign buying power is concentrated in treasuries and agencies, pushing those rates down. But even then, the counterfactual supplies enough domestic money, less concentrated perhaps but still looking for a home, to buy the same assets.

    I remain somewhat puzzled by the fundamental argument. Is my reasoning above wrong? Any comment?

  • Posted by dmg555

    Brad: David King, in today’s Wall Street journal editorial section, makes the claim that oil is up because the dollar is down.
    I believe the answer is multifactorial, not a single factor with a high correlation coefficient. That was my question concerning the Riyal a few days ago, if the riyal were allowed to appreciate in a free market against the dollar, would not the dollar price of oil go up? I say yes, but because oil is traded in dollars, I’m interested in your answer.

  • Posted by dmg555

    please ignore the previous post, the answer is obviously contained in your comments today

  • Posted by Cassandra

    I think such simplistic explanations smack of trite revisionism. Why is there no talk of more-than-lame US fiscal policy, and complete lack of US energy policy? I just hate it when the victim card is employed to absolve culpability. Despite free capital flows and globalization, numerous policy tools and ways of better coordinating existing policies, have always been available to the US to counter the noxious effects of poor and/or self-serving mercantilist policy elsewhere, even without the benefit of hindsight. I do not believe The Economist is helping matters here.

  • Posted by MMcC

    Twofish: “they were also terrified of a repeat of the Asian crisis in 1998″

    I think this point is worth emphasising, especially if you add in the common belief in China’s finance ministry (and elsewhere in Asia) that it was revaluation which tipped Japan’s early-90s problems from bad to irrecoverable. Having a currency that’s only semi-substitutable, backed by an Everest (ok, Qomolangma)-sized mountain of dollars is worth enduring the current problem set for, in the minds of many MoF and PBoC officials. The somewhat newer question in those bodies is: are we now overinsured against a speculative attack on the Rmb? I think this parallels the questions bsetser was asking many posts ago about how many quarters worth of import cover need to be in the reserve… The answer is moving slowly to yes but, as Twofish points out, you need near-unanimity on that yes before even China’s very nimble peg-adjusters can go to work.

  • Posted by bsetser

    US fiscal policy directionally got better from 04 through 06 (starting point wasn’t great) — and the resulting fall in treasury supply likely contributed (given strong CB demand) to lower long-term rates and the strong bid for housing debt. the policy that was available was higher short-term rates to impact central bank demand at the the long-end, but that ran into the fed’s doctrine of not pre-emptively trying to pop bubbles.

    Fully agree that there was/ is a lot more the US can/ should do on energy policy.

  • Posted by Moe Gamble

    If the Economist is writing about loose money, it’s safe to start betting on tight money.

  • Posted by RebelEconomist

    I agree with Cassandra, Brad. I would be interested to read your views in more detail about what the US should have done and should do in future to deal with official capital inflows. But perhaps you have an eye to working in a future Democratic administration and wish to avoid (a) being critical of the US and (b) expressing any firm policy views that might become a hostage to fortune?

  • Posted by Spectator

    Unbelievable, this bit of revisionist history that ignores the obvious! The elephant in the room is Fed coddling of Wall Street speculation via low rates, low margin requirements, ridiculous leverage, baby step rate increments, and outright moral hazard.

    In a world where the Fed is supposed to squash excessive speculation whenever it rears it’s ugly head, the Fed has taken upon itself to serve this group at every turn. The outsize credit bubble enabled by this asymmetric policy has created the greatest liquidity binge ever.

    I find your pussyfooting around the real issue quite distressing. I say this only because you’re one of the few unbiased economists around.

  • Posted by koteli

    Sorry, Brad,

    Cassandra made a very clear comment.

    “US fiscal policy directionally got better from 04 through 06 (starting point wasn’t great) — and the resulting fall in treasury supply likely contributed (given strong CB demand)…” is not a real answer.

    “Fully agree that there was/ is a lot more the US can/ should do on energy policy.” It isn’t either.

    Spectator is right, totally right.

    I think it’s about the time for real USamerican economists like you, to start to speak your mind about military profligacy and Wall Street speculation right away.

    Obama or Clinton or McCain will need some real advice about this mess.

    I think that you and Nouriel have the e-mails of lots of economists: Krugman, Stiglitz, Baker, Klein, Rodrik, Chinn…

    You are a lot and the bests!

    Couldn’t you all speak your mind all-toghether about this mess?

    Or you don’t think this is a crisis?

    Please, read “Dear Mr Activist…” by Cassandra.

    That’s where we are going…

    Yesterday answer to Calculated Risk was good…, but good enough?

    You could do it better.

    The Economist reads your posts, but you don’t need them. Don’t take land in their airport!

    Thank you, anyway.

  • Posted by algernon

    “The Economist reports that the average global real interest rates is negative (”global monetary policy is now at its loosest since the 1970s: the average world real interest rate is negative”)…”

    This statement implies to me that global inflation is just beginning & provokes me to ask again if there is a decent measure of global money supply.

    I have previously cited the IMF stat that the world’s total foreign exchange holdings had more than quadrupled in the last 10 years as world GDP had roughly doubled. To my question as to whether these ‘reserves’ were a decent proxy for global money supply, Dr. Setser noted that some reserved were sterilized. Previously I think it was indicated that China tends to sterilize about half its reserves, which still leaves pretty massive creation of fresh money.

    A measure of global money supply growth strikes me as eminently useful. Excessive money/credit creation seems a more probable explanation for widespread negative real interest rates than a ‘savings glut’.

  • Posted by bsetser

    Algeron — I don’t have a number for global money supply growth available, but no doubt one exists (sum up nat’l data in a common currency and look at the rate of change). Negative real rates in the emerging world clearly reflect monetary policy choices — and an aversion to nominal appreciation. The gulf has effectively chosen a policy of real appreciation through inflation, a policy that implies negative rates. Negative real rates should encourage domestic investment and thus tend to reduce the savings glut.

    Spectator. We all have our biases, myself included. The Fed — especially the Greenspan fed — never believed its mission was to crush excessive speculation. it argued instead that you couldn’t tell a priori what was “excesssive” speculation and what was natural market exhuberance in a dynamic economy. Moreover, the point I made above isn’t necessarily in contradiction with an argument that the Fed was too loose (both in terms of its interest rate policy and its approach to regulation) during the buildup of the loosing policy. The point above was simply that for any given Fed policy path, ongoing reserve accumulation outside the US meant the policy was effectively more stimulative than it otherwise would have been b/c of non-market/ reserve based demand for treasuries which helped hold Treasury yields down.

    Dollar pegging impacted the US by holding long rates down and keeping the exchange rate up — and thus made the interest rate monetary transmission channel stronger.

    There is always a tendency to argue that noting this shifts blame away from the US. That may be the effect, but it is not the intent. The intent is simply to recognize how the widespread decision to peg to the dollar impacted the US during the 02-06 period. I don’t think it makes sense to try to deny that there was an impact, or that the direction of that impact was to stimulate interest-rate sensitive sectors of the economy. The modality the PBoC choose to stimulate Chinese consumption was to stimulate the housing sector of the US by buying up massive quantities of US Agency bonds.

    Finally, i strongly believe that the US isn’t responsible for the rise in inflation globally. A set of countries have by their own choice continued to peg to the $ even as their economies boomed and the US slowed. They could adopt a different exchange rate policy, one which would allow them to adopt a monetary policy more suited for their domestic conditions.

  • Posted by Spectator

    Brad – thanks for your response. I honestly feel you’re among the best resources on the web for insights into the global economic picture.

    While there’s no consensus on a smoking gun to explain global inflation, I go back to “always and everywhere a monetary phenomenon.” The US credit bubble, entirely the fault of the Fed, is the primary cause of global inflation. Credit here is spent on imports, which result in money growth overseas and inflation. Many other countries have poorly chosen to keep their currencies suppressed and promote inflation in their economies. But global inflation is primarily a dollar phenomenon. Stronger currencies in China and India may limit their internal inflation, but will only increase global inflation.

    And in my opinion there is an ongoing myth about long rates being caused by FCB demand. Long bond rates were low only because the Fed made their short rates always predictably low. When clear short rates would never rise dramatically, long bond holders cannot expect high rates to compensate for that risk. This was an extraordinary era of liquidity, brought to you by an Fed that promised helicopter money. With extreme leverage and this Fed guarantee, speculators could confidently buy long bonds at very low rates. Why would long rates go up with such a backdrop?

  • Posted by Spectator

    Correction:

    With extreme leverage and this Fed guarantee, speculators could confidently borrow short and lend long at very low rates. Why would long rates go up with such a backdrop?

  • Posted by David Heigham

    The language in which we discuss the problem of inflation is changing. The change shows here, in the academic debate, in the Finacial Times as well as in the Economist. This time round, we are trying to think about inflation as a world problem, not the problem of separate national economies. I am sure this is right for one half of our current problem; even though we have no global measure of inflation, no real idea yet of what is global money supply, and still less of what might constitute a useful global monetary policy.

    The other half of the problem is the part caused by changes in the balance of supply and demand for goods, causing higher relative prices for those goods. This half of the problem needs continued attention from all of us. It remains a national problem; if one that may have never been satisfactorily resolved in practice. Only national governments have the powers to force acceptance of the relative price changes – so minimising the damage from sustained inflationary pressure – or to delay acceptance with the increased ultimate damage that implies. Forcing accaptance requires a national political bargain; a bargain which may compensate some losers, but can only do so at the expense of winners and/or those with less political clout. The only clear point is that compensation must not attempt to work through price controls or subsidies directed at the goods whose real price has risen.

    Attempts to blame speculators for either half of the problem are just scapegoat hunting; and should be despised accordingly.

  • Posted by RebelEconomist

    I agree with Cassandra and Spectator. Instead of urging other countries to unpeg from the dollar, I would welcome more analysis of what the US could have done better to deal with the resulting official capital inflows (so that the US can do better if it gets into the same situation again) and what it can still do. But I could understand why this might be difficult if you have the ambition to serve in a future Democratic administration and are reluctant to (a) criticise the US and (b) make firm policy proposals that turn out to be politically difficult.

  • Posted by RebelEconomist

    Sorry, I forgot I said that yesterday…..I thought I had a feeling of deja vue when writing!

  • Posted by acorcos

    Is it time for a global currency?

  • Posted by bsetser

    Spectator — the very predictable path of tightening was a factor for a while, but there also was an extended period when long-rates were lower than short rates, i.e. the curve was inverted. I think that is hard to explain as a byproduct of a predictable tightening path + an assumption that if the us hit trouble, the fed would ease.

  • Posted by algernon

    Spectator, you may be right to say “The US credit bubble, entirely the fault of the Fed, is the primary cause of global inflation” in the sense that US monetary looseness required loosen on the part of the pegging countries in order to peg. But the Asian & petro-state central banks’ insistence on pegging was their individual decision & undoubtedly has contributed to global inflation.