The basics of monetary policy are relatively simple to understand.
Simply put, central banks exist to defend the integrity of money, which is why interest rates are raised above neutral levels when inflation rears its ugly head. The higher cost of borrowed money is supposed to slow down economic activity and deflate the upward pressure on prices that can build up when good times spawn a seller’s market.
Lowering interest rates below neutral for a controlled period of time, on the other hand, can supposedly be a good way to fight a faltering economy, jump starting job creation and GDP growth by making it cheaper to borrow. This is expected spurring consumer spending, which is will then lead to business investment.
Naturally, politics can make central banking an exasperating endeavor. Unlike hawkish central bankers, the vote-buying crowd doesn’t worry enough about the price pressures created by juicing the economic system. That’s why there is typically considerable pressure to keep rates at historically low levels during tough times, even when inflation starts to rise or when it make little long-term sense to encourage consumers to increase debt.
That political pressure is why many countries have taken steps to make their central banks independent of the government of the day, but central bankers can also be their own enemies. After all, when it comes to shifting gears on monetary policy, they like to think they have the ability to perfectly time a rate change. This is difficult though, and as a result, monetary policy is often a crap shoot when there is political demand for loose money and inflation starts to signal that the genie is leaving the bottle. This is where Canada is today.
On July 20, markets will know if Bank of Canada Governor Mark Carney is ready to increase the BoC’s benchmark rate, which has sat at a stimulative 1% since last September thanks to external risks to the economy that have put local monetary policy in a holding pattern.
Carney might try to buy time yet again by standing pat and talking tough about his readiness to adjust rates upward when the need arises. But inflation isn’t like a currency speculator who can be scared off a nation’s currency by monetary threats. Inflation is a lagging indicator of pricing pressures that already exist. In May, Canada’s overall inflation rate hit 3.7%, which is well out of the so-called comfort zone. Core inflation, which excludes volatile items such as gas, rose to 1.8%, not far from the BoC’s 2% preferred ceiling.
When looking at these numbers alone, an armchair economist could easily decide to cool things down by raising rates. But moving economies is like steering a battleship, and Carney does not want our boat to be on the wrong course if a sovereign debt default by Uncle Sam or an EU PIIG (Portugal, Ireland, Italy and Greece) creates another global financial crisis or the global economy simply loses steam and does the dreaded double-dip recession dance.
The only bright light for Canadian central bankers these days is that the choices they face are not as tough as the ones that must be made by their American cousins. In the United States, U.S. Federal Reserve Chairman Ben Bernanke has done everything in his power to stimulate job growth. In addition to serving up rock bottom interest rates, he has been printing money via a controversial asset-buying policy known as quantitative easing, which basically creates more money that can be used by lenders.
Inflation hawks fret over the day of reckoning that could come from flooding the economy with dollars. In June, however, unemployment in the world’s largest economy rose to 9.2%, continuing its upward trajectory after falling to 8.8% early this year. Bernanke is now expected by some to turn on the printing presses for a third time since the start of the so-called Great Recession and hope for the best. This option may be popular with the interventionist crowd. But U.S taxpayers are not being paid to take the risk, insists Bob Eisenbeis, chief monetary economist with Florida-based Cumberland Advisors.
In a recent analysis of QE published by the Washington Post, columnists Allan Sloan and Doris Burke claim the U.S. Treasury has made huge gains from the interest the Fed earned on assets acquired through QE1 and QE2. They estimate US$102 billion has been returned to the Treasury by the Fed in 2010 and conclude US$85 billion more may be returned this year.
Unfortunately, as Eisenbeis writes in a related commentary, the authors have played fast and loose with numbers. “They have ignored important unreported costs of the bailout and, most importantly, they have misrepresented the true nature of Federal Reserve transfers of earnings to the Treasury.”
Eisenbeis, a former research director with the Federal Reserve Bank of Atlanta, worries historical revisionism is being used to obscure the true costs of QE. He notes the Fed has essentially printed money by issuing one form of government debt to purchase Treasuries from government-backed mortgage giants Freddie and Fannie. And when Uncle Sam pays interest to the Fed on those assets, the funds are being transferred back to the Treasury. As a result, an expense “is magically transformed into revenue.”
Eisenbeis insists QE revenues are simply an intergovernmental transfer that results from printing money. “It is like writing a check to your wife,” he says, “and when she gifts it back, you count it as income. The process makes Bernie Madoff’s Ponzi scheme look like chump change.”
Indeed, if managing economies was as easy as America’s QE crowd wants people to think, the Fed could simply buy up as much debt as possible and the U.S Treasury could use the interest payments gained to reduce the deficit to zero. Unfortunately, the inflation pressures created by printing money are the real deal.