The row over US monetary policy
Tuesday, 14 December 2010
Those who find it difficult to understand why an increase in the international prices of rice should raise domestic prices when the country produces more then 90 percent of its consumption will be at a greater difficulty to follow the logic behind the recent spat between the USA and its major trade partners such as Brazil, China and Germany over an essentially US domestic policy. Globalization does spew out problems that are not always easily comprehended.
The recent row is over a fairly standard US monetary policy measure: the Federal Reserve Bank (Fed) has taken a decision on 3rd November 2010 to buy longer term US treasury securities to the tune of $600 billion by the end of the second quarter of 2011 (another $250-300 billion in reinvestment). Such purchases increase reserves and monetary base, and should in principle lead to an increase in money supply i.e. a quantitative easing. The Fed's decision was strongly supported by President Obama as necessary for not only US economic recovery, but also the robust growth of the world economy. Obviously, other countries disagreed.
To understand why these countries are suspicious about the consequence of the US monetary policy on the world economy one must have a clear understanding of what such a policy is meant to achieve.
When the Fed (for that matter any central bank) engages in open market operations to purchase securities by such a large amount, it forces down the interest earnings on them, which over a period of time brings other interest rates down. This is precisely the purpose of open market purchases. The reduction in the interest rates is expected to boost both investment and consumer spending which would promote greater economic activities. The Fed Chairman explains: "To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the committee decided today to expand its holding of securities." (B. Bernanke, Rebalancing the Global Recovery, November 18, 2010.)
Actually, the Fed has been following an easy monetary policy since the last quarter of 2008, but without much success. Reserves rose sharply from only $46 billion in August 2008 to a staggering $1.2 trillion by February 2010. Interest earnings on securities, especially short term securities, fell sharply. While this had some impact on economic recovery, unemployment remained stubbornly high. US policymakers started worrying about jobless growth. The Obama administration had pumped in a great deal of money through various fiscal stimuli, but these failed to boost aggregate demand sufficiently to raise the growth rate to a level that would help reduce unemployment significantly. In this situation, the Fed decided on further quantitative easing through purchases of a massive 600 billion dollar worth of longer term government securities.
However, the interest rates on shorter term securities in the USA have already fallen to near zero by Aug 2010, and the Fed expressly wants to keep them that way. Hence, there is not much to be gained from this bout of open market operations in terms of short term interest rate reductions. Indeed, there is a worrisome possibility that the real interest rates could rise in the event of a deflation, i.e., reduction in the general price level. What the Fed is apparently aiming to do is introduce a large amount of liquidity into the economy through open market purchases in the hope that this would raise the level of consumer spending and investment ignoring the fact that the banking system is awash with excess reserves. This policy of raising liquidity through open market operations the second time has been dubbed QE II (Quantitative Easing II). The Fed Chairman states: "In taking that action [i.e. QE II], the committee seeks to support the economic recovery, promote a faster pace of job creation, and reduce the risk of a further decline in inflation that would prove damaging to the recovery" (ibid).
Whether or not the monetary policy of the USA will succeed in supporting the economic recovery and promoting employment remains to be seen, but the Fed's measures have raised serious concern in capitals around the world, from Brazil to China. And there are good reasons for them to be concerned.
The reductions in US interest rates would make investment in the USA less attractive causing flight of capital out of the country to countries which offer higher interest rates and have stable macroeconomic fundamentals. These are most likely to be the emerging economies such as China and East Asia, Brazil and India. Indeed there have been large inflows of short term capital into the emerging countries since the Fed's first bout of quantitative easing commencing in 2008. Large inflows of capital should move the capital account of some of these countries, and hence, the balance of payments, toward greater surpluses (or smaller deficits).
Such surpluses should, in the absence of offsetting forces, appreciate the value of their currencies. Fed's exchange rate data show that the currencies of most emerging economies including China, Malaysia, Brazil, India, Mexico, South Africa and Thailand have all appreciated significantly since the beginning of 2009, i.e. following the first bout of quantitative easing. Currencies of advanced economies such as Japan, Switzerland, Sweden, South Korea, Australia, New Zealand, Canada and Singapore have also appreciated quite significantly. Such appreciation makes the export and import-competing industries less competitive against the US industries such that global demand may switch in favour of the latter at the expense of the former.
There can be little doubt that the one of the principal objectives of the Fed's policy was to depreciate the US dollar. The USA has been very profligate for a very long time; it has been living beyond its means. This was supported by massive amounts of debt from the rest of the world, especially China and East Asia. China alone hold 0.89 trillion dollar of US debt.
The other side of the profligacy and debt accumulation is that the USA ran large current account deficits, while the other countries matched them by running surpluses. It was just a matter of time that a large correction would be required on both sides; the financial meltdown and the global recession provided the political will and opportunity to confront the problem earnestly.
As it is wont to do, the USA has tried to shift the blame for its poor economic management and performance on the emerging economies. It has identified "incomplete adjustment of exchange rate" of the emerging economies as a principal obstacle to US economic recovery. But why would these emerging countries keep their currencies undervalued? According to the Fed Chairman "… currency undervaluation on the part of some countries has been part of a long-term export-led strategy for growth and development. … [it] allows a country's producers to operate at a greater scale and to produce more diverse set of products than domestic demand alone might sustain, [it] has been viewed as promoting growth … " (ibid).
The emerging economies are caught between a rock and a hard place. It is indeed true that export-led growth has been their development strategy for several decades, and there is no question that it has been spectacularly successful. The USA has been the single-most important destination country for their exports, and hence, a robust growth of the US economy is essential for their own prosperity, at least for some more time. They have little choice but to accept the imposed outcome. The USA had previously abandoned in the early 1970s the responsibility to maintain the postwar gold peg and fixed exchange rates under the Bretton-Woods system when it ran into balance of payments difficulties, and the world had little choice but to accommodate it. The USA is now simply telling them since they have not appreciated their currencies on their own, it will do so for them. And there is little these countries can do without further hurting their own economies.
Another cause for concern is the prospect of large capital inflows increasing liquidly in the emerging markets. Some of these economies, i.e. China and India, are already experiencing inflationary pressures. An injection of more liquidity could worsen these pressures. Excess liquidity could also create asset bubbles with undesirable consequences in the future. These economies will be forced to tighten their monetary policy to partially offset the impact of the accommodative US monetary policy just as the Fed wants. Tightening of monetary policy will inevitably raise their interest rates further widening the yield differentials, and thereby inviting greater capital inflows and currency appreciation.
The appreciation of their currencies and higher inflation will both contribute to reducing the growth of their exports to the USA, while at the same time increasing imports from it. The trade balance will move more in favour of the USA to offset its capital account deficit owing to outflows of capital.
The Fed Chairman has clearly stated the US intention: it wants a global rebalancing of trade and current accounts, which in his opinion is essential for the long run economic and financial stability, and he is imposing it on others by manipulating the capital account. What it means in the near term is slower growth of the emerging economies (especially their exports to the developed world) through tighter monetary policy and appreciation of their currencies, and faster growth of the US (and other developed economies) through accommodative monetary policy as explained above. Not surprisingly these countries are worried.
At a more fundamental level, the balance of payments deficits of the US are the outcome of US profligacy, i.e. a low saving rate, and the willingness of other countries to lend to the USA. The US government has run budget deficits for a long time. The problem worsened during the recent years when the USA got involved in very expensive wars in the Mid-East. Budget deficits ballooned, which were financed by borrowing from overseas since domestic residents did not lend sufficiently to their government. The willingness of other countries to lend to the USA is due mainly to two factors: the strength of the US economy and the US dollar is the key currency in international transactions.
The appreciation of the currencies of countries with which the USA has large trade deficits will not improve the situation much as it only scratches the surface. The USA had imposed appreciation on other countries, especially Japan, in the seventies and eighties, but without much benefit. Japan still runs large surpluses with the USA despite the fact that its currency has massively appreciated since the seventies (348 yen to the dollar in 1971, 227 in 1980, 145 in 1990 and 88 in Oct 2010). As long as the surplus countries' saving ratios remain high and that of the USA remains low, this situation will be maintained although the countries with which the deficits/surpluses are run may differ.
How will the US monetary policy impact on Bangladesh economy? Fortunately, it is unlikely to be directly disadvantageous; indeed there could be some collateral benefits.
The principal channels through which the Fed's purchase of government securities affect other countries, i.e. capital flows and appreciation, are both inoperative in Bangladesh. There are stringent capital controls, and the capital account is inconvertible such that there could be little capital inflows due to yield differentials. Bangladesh Bank has a policy of not allowing the taka to appreciate against the US dollar; in fact, the taka has depreciated marginally against the dollar during the last couple of years. This means that the taka has in effect depreciated against all currencies against which the dollar has depreciated. This should improve the competitive strength of the tradable goods sector. The surge in exports during the post-recession period suggests such an improvement.
Bangladesh's trade relation with the USA is similar to the US-China trade relation: we import only a small fraction of the amount we export to the USA. If the USA makes it a policy to press all countries with large proportionate surplus with the USA for adjustment, then Bangladesh could be caught in the net. This might mean the USA will put some pressure on Bangladesh to increase imports from it. More likely, it will decline to consider any trade preferences beyond what it has already committed citing the same argument that it gave during the Hong Kong Ministerial 2005, i.e. Bangladesh economy is sufficiently competitive not to require any additional concessions. It could even pare away whatever little GSP facility it provides. The review of GSP on sleeping bags, an insignificant import item, should be a wake-up call for our trade negotiators about the mood of the US policymakers. The longstanding strategy of supplication for non-reciprocal advantages may not yield more benefits.
...................................................................
The author, a professor of economics of University of Dhaka, is currently the CEO of Bangladesh Foreign Trade Institute.
E-mail: m_a_taslim@yahoo.com
The recent row is over a fairly standard US monetary policy measure: the Federal Reserve Bank (Fed) has taken a decision on 3rd November 2010 to buy longer term US treasury securities to the tune of $600 billion by the end of the second quarter of 2011 (another $250-300 billion in reinvestment). Such purchases increase reserves and monetary base, and should in principle lead to an increase in money supply i.e. a quantitative easing. The Fed's decision was strongly supported by President Obama as necessary for not only US economic recovery, but also the robust growth of the world economy. Obviously, other countries disagreed.
To understand why these countries are suspicious about the consequence of the US monetary policy on the world economy one must have a clear understanding of what such a policy is meant to achieve.
When the Fed (for that matter any central bank) engages in open market operations to purchase securities by such a large amount, it forces down the interest earnings on them, which over a period of time brings other interest rates down. This is precisely the purpose of open market purchases. The reduction in the interest rates is expected to boost both investment and consumer spending which would promote greater economic activities. The Fed Chairman explains: "To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the committee decided today to expand its holding of securities." (B. Bernanke, Rebalancing the Global Recovery, November 18, 2010.)
Actually, the Fed has been following an easy monetary policy since the last quarter of 2008, but without much success. Reserves rose sharply from only $46 billion in August 2008 to a staggering $1.2 trillion by February 2010. Interest earnings on securities, especially short term securities, fell sharply. While this had some impact on economic recovery, unemployment remained stubbornly high. US policymakers started worrying about jobless growth. The Obama administration had pumped in a great deal of money through various fiscal stimuli, but these failed to boost aggregate demand sufficiently to raise the growth rate to a level that would help reduce unemployment significantly. In this situation, the Fed decided on further quantitative easing through purchases of a massive 600 billion dollar worth of longer term government securities.
However, the interest rates on shorter term securities in the USA have already fallen to near zero by Aug 2010, and the Fed expressly wants to keep them that way. Hence, there is not much to be gained from this bout of open market operations in terms of short term interest rate reductions. Indeed, there is a worrisome possibility that the real interest rates could rise in the event of a deflation, i.e., reduction in the general price level. What the Fed is apparently aiming to do is introduce a large amount of liquidity into the economy through open market purchases in the hope that this would raise the level of consumer spending and investment ignoring the fact that the banking system is awash with excess reserves. This policy of raising liquidity through open market operations the second time has been dubbed QE II (Quantitative Easing II). The Fed Chairman states: "In taking that action [i.e. QE II], the committee seeks to support the economic recovery, promote a faster pace of job creation, and reduce the risk of a further decline in inflation that would prove damaging to the recovery" (ibid).
Whether or not the monetary policy of the USA will succeed in supporting the economic recovery and promoting employment remains to be seen, but the Fed's measures have raised serious concern in capitals around the world, from Brazil to China. And there are good reasons for them to be concerned.
The reductions in US interest rates would make investment in the USA less attractive causing flight of capital out of the country to countries which offer higher interest rates and have stable macroeconomic fundamentals. These are most likely to be the emerging economies such as China and East Asia, Brazil and India. Indeed there have been large inflows of short term capital into the emerging countries since the Fed's first bout of quantitative easing commencing in 2008. Large inflows of capital should move the capital account of some of these countries, and hence, the balance of payments, toward greater surpluses (or smaller deficits).
Such surpluses should, in the absence of offsetting forces, appreciate the value of their currencies. Fed's exchange rate data show that the currencies of most emerging economies including China, Malaysia, Brazil, India, Mexico, South Africa and Thailand have all appreciated significantly since the beginning of 2009, i.e. following the first bout of quantitative easing. Currencies of advanced economies such as Japan, Switzerland, Sweden, South Korea, Australia, New Zealand, Canada and Singapore have also appreciated quite significantly. Such appreciation makes the export and import-competing industries less competitive against the US industries such that global demand may switch in favour of the latter at the expense of the former.
There can be little doubt that the one of the principal objectives of the Fed's policy was to depreciate the US dollar. The USA has been very profligate for a very long time; it has been living beyond its means. This was supported by massive amounts of debt from the rest of the world, especially China and East Asia. China alone hold 0.89 trillion dollar of US debt.
The other side of the profligacy and debt accumulation is that the USA ran large current account deficits, while the other countries matched them by running surpluses. It was just a matter of time that a large correction would be required on both sides; the financial meltdown and the global recession provided the political will and opportunity to confront the problem earnestly.
As it is wont to do, the USA has tried to shift the blame for its poor economic management and performance on the emerging economies. It has identified "incomplete adjustment of exchange rate" of the emerging economies as a principal obstacle to US economic recovery. But why would these emerging countries keep their currencies undervalued? According to the Fed Chairman "… currency undervaluation on the part of some countries has been part of a long-term export-led strategy for growth and development. … [it] allows a country's producers to operate at a greater scale and to produce more diverse set of products than domestic demand alone might sustain, [it] has been viewed as promoting growth … " (ibid).
The emerging economies are caught between a rock and a hard place. It is indeed true that export-led growth has been their development strategy for several decades, and there is no question that it has been spectacularly successful. The USA has been the single-most important destination country for their exports, and hence, a robust growth of the US economy is essential for their own prosperity, at least for some more time. They have little choice but to accept the imposed outcome. The USA had previously abandoned in the early 1970s the responsibility to maintain the postwar gold peg and fixed exchange rates under the Bretton-Woods system when it ran into balance of payments difficulties, and the world had little choice but to accommodate it. The USA is now simply telling them since they have not appreciated their currencies on their own, it will do so for them. And there is little these countries can do without further hurting their own economies.
Another cause for concern is the prospect of large capital inflows increasing liquidly in the emerging markets. Some of these economies, i.e. China and India, are already experiencing inflationary pressures. An injection of more liquidity could worsen these pressures. Excess liquidity could also create asset bubbles with undesirable consequences in the future. These economies will be forced to tighten their monetary policy to partially offset the impact of the accommodative US monetary policy just as the Fed wants. Tightening of monetary policy will inevitably raise their interest rates further widening the yield differentials, and thereby inviting greater capital inflows and currency appreciation.
The appreciation of their currencies and higher inflation will both contribute to reducing the growth of their exports to the USA, while at the same time increasing imports from it. The trade balance will move more in favour of the USA to offset its capital account deficit owing to outflows of capital.
The Fed Chairman has clearly stated the US intention: it wants a global rebalancing of trade and current accounts, which in his opinion is essential for the long run economic and financial stability, and he is imposing it on others by manipulating the capital account. What it means in the near term is slower growth of the emerging economies (especially their exports to the developed world) through tighter monetary policy and appreciation of their currencies, and faster growth of the US (and other developed economies) through accommodative monetary policy as explained above. Not surprisingly these countries are worried.
At a more fundamental level, the balance of payments deficits of the US are the outcome of US profligacy, i.e. a low saving rate, and the willingness of other countries to lend to the USA. The US government has run budget deficits for a long time. The problem worsened during the recent years when the USA got involved in very expensive wars in the Mid-East. Budget deficits ballooned, which were financed by borrowing from overseas since domestic residents did not lend sufficiently to their government. The willingness of other countries to lend to the USA is due mainly to two factors: the strength of the US economy and the US dollar is the key currency in international transactions.
The appreciation of the currencies of countries with which the USA has large trade deficits will not improve the situation much as it only scratches the surface. The USA had imposed appreciation on other countries, especially Japan, in the seventies and eighties, but without much benefit. Japan still runs large surpluses with the USA despite the fact that its currency has massively appreciated since the seventies (348 yen to the dollar in 1971, 227 in 1980, 145 in 1990 and 88 in Oct 2010). As long as the surplus countries' saving ratios remain high and that of the USA remains low, this situation will be maintained although the countries with which the deficits/surpluses are run may differ.
How will the US monetary policy impact on Bangladesh economy? Fortunately, it is unlikely to be directly disadvantageous; indeed there could be some collateral benefits.
The principal channels through which the Fed's purchase of government securities affect other countries, i.e. capital flows and appreciation, are both inoperative in Bangladesh. There are stringent capital controls, and the capital account is inconvertible such that there could be little capital inflows due to yield differentials. Bangladesh Bank has a policy of not allowing the taka to appreciate against the US dollar; in fact, the taka has depreciated marginally against the dollar during the last couple of years. This means that the taka has in effect depreciated against all currencies against which the dollar has depreciated. This should improve the competitive strength of the tradable goods sector. The surge in exports during the post-recession period suggests such an improvement.
Bangladesh's trade relation with the USA is similar to the US-China trade relation: we import only a small fraction of the amount we export to the USA. If the USA makes it a policy to press all countries with large proportionate surplus with the USA for adjustment, then Bangladesh could be caught in the net. This might mean the USA will put some pressure on Bangladesh to increase imports from it. More likely, it will decline to consider any trade preferences beyond what it has already committed citing the same argument that it gave during the Hong Kong Ministerial 2005, i.e. Bangladesh economy is sufficiently competitive not to require any additional concessions. It could even pare away whatever little GSP facility it provides. The review of GSP on sleeping bags, an insignificant import item, should be a wake-up call for our trade negotiators about the mood of the US policymakers. The longstanding strategy of supplication for non-reciprocal advantages may not yield more benefits.
...................................................................
The author, a professor of economics of University of Dhaka, is currently the CEO of Bangladesh Foreign Trade Institute.
E-mail: m_a_taslim@yahoo.com