JOHN MASON: Stand-off with the Fed, the worlds' Central Bank
Stand-off with the Fed, the worlds' Central Bank
The Federal Reserve System, the central bank of the United States, although not recognized as such, has really become the central bank to the world.
One can really get a glimpse of this in the book written by Ben Bernanke after he retired as the Chairman of the Board of Governors of the Federal Reserve System on January 31, 2014. Bernanke’s book is titled “The Courage to Act: A Memoir of a Crisis and Its Aftermath.” In several chapters Mr. Bernanke gives a detailed descriptions of what the Federal Reserve had to do during the crisis to help other central banks weather the storm.
The world has changed in the last sixty years and the global financial community is highly connected and banking systems are closely intertwined. And, with the United States dollar playing such an important role in the world, both in terms of world trade and in terms of being the primary reserve currency in the world, the Federal Reserve System, the central bank behind the US dollar, has, de facto, a role to play globally.
The actions of the Federal Reserve cannot help but impact events going on throughout the world.
Just take the current crisis concerning Turkey, Turkey’s currency the Lira, and world financial markets.
Over and over again, analysts and people in the press are claiming “It's All the Dollar's Fault!”.
The value of the dollar, it is argued, is too strong. This is causing investors to flee the Lira and to flee the low interest rate debt issued by emerging market countries like Turkey. The fear is that other emerging market countries, like Argentina and South Africa, will also be affected by the strong dollar and there will be a contagion of fear in financial markets.
But, this raises a conflict because the Federal Reserve must still focus on the United States economy. And, right now, the Federal Reserve is in the process of raising its policy rate of interest so as to bring it back up to a more normal level.
A more normal level of interest rates is desired because it will give the Federal Reserve more room to conduct monetary policy in the future, especially if a new recession is to occur.
Furthermore, the Federal Reserve is attempting to reduce the size of its securities portfolio, a size that was reached during three rounds of quantitative easing the Fed used to help the US economy out of the Great Recession. This movement also concerns international markets.
As a consequence of these concerns, money is leaving Turkey, the Lira is dropping in price and the value of the US dollar soars as “risk averse” monies leave Turkey…and other debt-ridden states…and moves to “safe havens” like the United States.
Mohamed El-Erian suggests that either Turkey must deliver a circuit breaker, a policy response that will stop the fall in confidence in the Turkish government correct the disequilibrium that now exists in the economy, or, contagion will grow and the world could find itself in another cumulative currency crisis.
The problem is, as seen by Turkey’s President Recep Tayyip Erdogan, the United States is responsible for much of the present condition of his country and, therefore, should bear the burden of adjustment.
After all, it was the United States that had the historically low longer-term interest rates that attracted Turkey…and other countries…into financing so much the country’s debt in dollar-denominated bonds. If these longer-term rates had not been so low, for so long, countries would not have taken advantage of them and gotten themselves into their current position.
This is the dilemma that a central bank like the Federal Reserve now finds itself. Because of it position of the world’s central banker and because of the openness and fluidity of international banking and financial markets, what the Federal Reserve does impacts others and can result in some very out-of-equilibrium situations.
But, other countries must also recognize that the Fed cannot deal with all out-of-equilibrium situations and so must, themselves, be careful about how they respond to the conditions that exist within the United States. In other words, other countries must be aware of the role the Federal Reserve is now playing in world markets to the same extent that the Federal Reserve must be aware of the role it is now playing in the global economy
The Federal Reserve did not “cause” the historically low longer-term interest rates. Central banks have little or no “control” over longer-term interest rates. Longer-term interest rates are determined as a function of perceived risk, expected economic conditions, and expected inflation.
A central bank can impact longer-term interest rates as their actions impact expectations, but a central bank does not “control” longer-term rates in the same was as they can influence short-term interest rates.
In this respect, the Federal Reserve helped to end the Great Recession in the United States and get the economy growing again. Its policies helped create the foundation for a sustainable nine-year economic recovery. And, this put the United States is a completely different position than much of the rest of the world.
As a consequence, in the 2010 and 2011 period, substantial amounts of risk averse funds started moving to the United States…and a couple of other safe-haven countries…and this had the result that longer-term interest rates…because of the perceived risk factor…dropped in the United States to historic lows. Since then, there have been other periods…like the current one in Turkey…where risk averse funds have moved to the United States, keeping these longer-term interest rates around 3.00 percent or below.
The situation arose, as discussed by John Authers in the Financial Times, several times over the past decade, so these longer-term rates in the US remained low as these international funds remained in the states.
That is, the lower longer-term interest rates created by the movements of risk averse funds came around to be available from time-to-time to help finance the dollar-denominated debt of emerging market nations. A cumulative effect, if you will.
That is what, as Authers describes, we are facing now.
But, what does the Federal Reserve do? Well, the Federal Reserves seems to be intent upon two more rate increases this year with three more to come next year. And, the reduction of the securities portfolio will continue.
And, Mr. Erdogan of Turkey seems resolved. No one seems to be backing off.
Everyone seems to believe that we are still back in a world where the Federal Reserve was only the central bank of the United States.
If policymakers are going to get things right, they must have a more “up-to-date” picture of how the world works. But, unfortunately, these pictures change slowly.