More on Competitive Currency Devaluations

There is nothing preventing the Federal Reserve from buying up any financial asset it so chooses with money it creates out of thin air. In fact, I seriously doubt that the vaunted bond market vigilantes would be able to cause US interest rates to go up if the Federal Reserve decided to target long-dated Treasuries for purchase. Bruce Krasting made just this point yesterday using Ben Bernanke’s own words. (hat tip Scott)

The Fed could stimulate spending by lowering rates further out along the Treasury term structure. There are at least two ways of bringing down longer-term rates:

(I) Fed could commit to holding the overnight rate at zero for some specified period.

(II) A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt. The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities.

–Ben Bernanke as quoted by Bruce Krasting

This quote is from Ben Bernanke’s famous helicopter speech from 2002 in which the present Chairman of the Federal Reserve Board also says:

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

My point? Ben Bernanke, if one takes him at his word, is committed to preventing deflation in America by all means necessary. This includes:

• Quantitative easing: flooding the economy with money (done)
• Zero-Interest Rate Policy (ZIRP): Holding short-term interest rates near zero percent to make saving less rewarding and debts less costly (done)
• Credit easing: buying up dodgy non-government paper to provide liquidity when banks do not (done)

There are a few other policies that the Fed has taken on as well. What the Federal Reserve has yet to do is target long-term interest rates directly by buying up long-dated government paper.

Here’s the thing though. In our monetary system, the Federal Reserve controls short-term interest rates through open market operations. Bank reserves normally serve this purpose. If the Fed wants a higher Fed Funds rate, it drains reserves by selling financial assets and buying up reserves. If the Fed wants a lower rate, it adds reserves by buying up financial assets – usually Treasury bonds, but more recently it has taken to buying other assets. The quantity of reserves, of course, is irrelevant; the interest rate is what counts for the economy. [Scott Fulwiler reminds us that the Fed doesn’t actually change the quantity of reserves; it just announces a new target, and stands ready to "defend" the target via repos/reverse repos if the market doesn’t move to the new rate. With a large quantity of excess reserves and the target rate set at the remuneration rate, the Fed just changes the interest rate on excess reserves.]

Now, if the Federal Reserve has absolute control over short-term rates, why isn’t it reasonable to assume it also has absolute control over long-term rates too? After all, I just showed you how long-term interest rates are really a series of short-term rates smashed together. The real reason that the Federal Reserve would lose control over short-term interest rates is because the economy was operating at full capacity and creating inflation which provoked an increase in rates.

–MMT: Market discipline for fiscal imprudence and the term structure of interest rates

But, of course, the Federal Reserve wants inflation. It is deflation that Ben Bernanke is worried about. Now, if all of this doesn’t work, Ben Bernanke has already said he is willing to get people to spend by buying up long-dated Treasury securities until those rates come to heel – just as short-term rates do. To prop up asset markets, the Fed could even buy equities; it already has bought mortgage-backed securities to prop up the housing sector and we know the Japanese bought equities during their bouts with deflation.

The point is the dollar is a fiat currency and the government controls its creation.

As I have been saying for some time, the issues in the US and the UK are not ones of interest rates or national solvency but of currency depreciation and inflation. I hope the paragraphs above illustrate why. But, clearly, if the Federal Reserve takes on a policy of buying up assets with printed money, it will cause the US dollar to weaken.  But isn’t that the point?  Unless, the Europeans do the same, we have a de facto beggar thy neighbour currency devaluation policy.

But, of course the Europeans are looking to depreciate their currency too. This is already having an effect in China and Japan. UBS’ Andy Lees writes:

Japan’s May trade figures showed a slowdown in exports for the 3^rd consecutive month, down 1.2% m/m. “Exports grew at a slower than expected pace apparently due to the effects of China’s tightening” of banks reserve requirements according to the Norinchukin Research Institute in Tokyo, which also expects the weaker euro to impact because of the resulting loss of Chinese competitiveness; “Europe’s debt crisis is also expected to impact China’s exports to Europe in the coming months as the euro’s drop hurts Chinese firms competitiveness. This in turn is likely to prevent Japan’s exports from recovering fully”. What it seems to be saying is that the model of outsourcing to China and then onward export has lost its competitive edge against Europe given the euro fall. This follows the Herald Tribune report earlier in the week, quoting BIS data, suggesting that Chinese competitiveness has fallen to its lowest level since 1994. As far as direct exports to Europe go, they rose 17.4% y/y (+2.4% m/m) due to demand for auto parts, electronic parts from Germany and other capital goods such as chemicals and metal products registering double digit gains.

The only positive note here is that Germany’s gain translates into some "increased demand for Japanese parts and materials" as Lees quotes Itochu Corporation as saying. Question: How long does it take before the Chinese get sick and tired of the Europeans and the Americans depreciating their currencies to try and export their deflation onto the backs of others? Hopefully, we won’t find out as we are a long way from the Fed buying up long-dated Treasuries. The global economy is still growing right now at a decent clip, thank you. Still, it makes you wonder.