The recent softening in some economic indicators prompted market players to conclude that the Fed is unlikely to pursue its tighter interest rate stance further. The reason for this view is that slower economic activity will cool off consumer demand and, consequently, the rate of inflation as measured by various price indices will follow suit.
With this model in mind, many market players have concluded that the present stock market has fallen enough and it is a “great buy.” For instance after reaching 4696.69 at the end of February the Nasdaq Composite share price index closed at 3400.91 at the end of May, a fall of 27.6%. The Dallas Federal Reserve president further reinforced this view saying that the recent correction in stock prices may help prolong the current economic expansion.
This way of thinking, however, could be wrong. A general rise in prices of goods and services cannot be quickly suppressed by a high interest rate policy. The effects of monetary tightening proceed gradually, while the effects of a previous expansion are not subject to central-bank control.
After falling to a yearly growth of 1.6% in May 1996 the yearly rate of growth in the money base climbed to 15.2% by December last year. Historically, the lag effect from changes in the money base to changes in the consumer price index is about two years. This in turn means that one should expect a further acceleration in the momentum of prices and therefore further tightening by the Fed.
Against this long lag, the effect from a rise in interest rates to real economic activity is much shorter; historically, about one year. This means that there is a growing likelihood that a fall in economic activity will be accompanied by rising price inflation, which is to say there is a risk of inducing stagflation (the combination of inflation plus recession that Keynesians once claimed could not exist). This nasty cocktail could be bad news for financial markets in general and the stock market in particular.
Now, even if the Fed decides not to raise federal funds rate target further, the effect of the previous six increases cannot be undone. Most analysts while agreeing that the economy will slow down do not envisage a severe recession. It is held that the Fed would know how to navigate the economy towards the path of stable growth and moderate inflation.
This is however totally unfounded. It is based on the view that the Fed sits outside the economy and by means of a magic wand can push the economy towards the desired path. However, this navigation and pushing by the Fed requires resources. From where does it obtain this funding? Contrary to what some analysts suggest, printing money cannot create more real funding; it merely redistributes the existing pool of real funding.
The size of the pool of funding sets a brake on the implementation of more productive but longer stages of production. Trouble erupts whenever the banking system makes it appear the pool of funding is larger than it is in reality. When a central bank expands the money stock, it does not enlarge the pool of funding. On the contrary, it gives rise to the consumption of goods, which is not preceded by production. It leads to less means of sustenance.
As long as the pool of funding continues to expand, loose monetary policies give the impression that economic activity is being boosted. That this is not the case becomes apparent as soon as the pool of funding begins to stagnate or shrink. Once this happens, the economy begins its downward plunge. At this point, the central bank’s monetary policy becomes ineffective. The most aggressive loosening of money will not reverse the plunge. Paper money cannot replace production.
Between the January 1980 and May of this year, the US money base has risen by 234%. We suggest that all this has generated massive consumption of real wealth that is not backed up by a corresponding production of real wealth. Consequently it is quite likely that the US real pool of funding is close to being stagnant or even might have started to fall. For instance the personal saving flow has almost disappeared. Thus in April 1992 the personal saving rate stood at 9% against the present rate just above 0%.
Most economists downplay the importance of savings, arguing that the rising stock market will compensate for this shortfall. However, higher stock market valuations have nothing to do with the real pool of funding. All that high valuations describe are people’s views regarding the real pool of funding or the real pool of wealth. As a result of monetary pumping people’s perceptions regarding the facts of reality gets distorted thereby giving rise to inflated valuations. Once the FED adopts a tighter stance the money illusion tends to fade away and the unpleasant facts of reality are surfacing. This in turn brings stocks market valuations back to earth.
What we are currently observing in the US already took place in Japan in the 1980s. On average, between 1980 to 1990 the Japanese GDP rate of growth stood at 3.9% while the average unemployment rate stood at 2.5%.
Furthermore, Japanese exports were roaring and the international trade balance displayed massive surpluses. Moreover Japanese were seen as a major contributing force to the emerging information technology. In addition to its massive and sophisticated industrial base Japan was busy developing a strong banking industry, with Japanese banks surpassing by a large margin big American banks.
The Bank of Japan (BOJ) was partly credited for the impressive economic performance. Between the 1980 and 1988 the money base increased by 105% while the inter-bank call rate fell from 12.7% in July 1980 to 3.2% by May 1988.
Against the background of these economic facts it surprised very few experts that the Nikkei share price index zoomed to a record levels. Thus at the end of January 1980 the Nikkei share price index stood at 5,994 while at the end of 1989 it climbed to 38,916--an increase of 549%. Most experts at the time couldn’t see any reason as to why this up-trend couldn’t last for an indefinite period of time.
The performance of the economy appeared to be so good that the BOJ decided to “immunize” it from various negatives, by raising interest rates. This, it was hoped, would keep the economy on the track of a healthy economic growth with no inflation (sounds familiar). So between the period 1989 to 1990 the BOJ lifted the official interest rate from 3.8% to 8.2%.
Instead of keeping the economy on the path of stability and prosperity the tighter interest rate stance plunged Japanese economy into a severe economic slump. How is it possible, that an economy, which held as the model for the rest of the world, had collapsed in response to a tightening in the interest rate policy?
Granted, that it is possible that the BOJ had miscalculated and had lifted interest rate far too much. But since the beginning of 1991 the interest rate policy was completely reversed. Nonetheless, despite bringing the official interest rate to almost nil by September 1995, and despite aggressive monetary and fiscal policies, the economy has been in a depressed state for the past 10 years.
In other words for some “strange” reasons loose interest rate policy couldn’t bring the economy to the path of economic prosperity. It seems that the BOJ lost its navigational powers--whilst the economy appeared to be reacting to a tighter interest rate stance it continued to disregard the easier stance.
The main factor behind this failure of the BOJ to steer the economy is the collapse in the real pool of funding. (The aggressive monetary stance boosted consumption without the corresponding production thereby severely eroding economy’s real pool of funding, the driving force of economic activity.) The real pool of funding shrank despite the fact that Japanese consumers are regarded as good savers, implying that the pace of wealth destruction was of a massive dimension. In response to this the Nikkei share price index lost 66% of its value between December 1988 and September 1998.
The Japanese experience should serve as a warning about an undeniable reality of central banks: they cannot control the stock market and they cannot control the macroeconomy. The power to manipulate interest rates is an awesome power, but the laws of economics are even stronger in the end.
