Economist Brendan Brown answered our questions about interest rates, the carry trade, and why the Federal Reserve won’t fix our inflationary malaise.
The Misesian (TM): Much of your work at mises.org has examined the many ways that monetary inflation creates various types of bubbles fueled by speculative narratives. They’re different with each business cycle, though. What do you see as some of the biggest bubbles out there right now?
Brendan Brown (BB): I think of bubbles as an extreme phenomenon. They are prone to develop in noncore markets under those types of severe monetary inflation where asset inflation, rather than reported inflation in goods markets, is the starkest symptom. (These episodes usually feature strong coincident nonmonetary downward influences on prices). Bubble-like qualities can also extend to some especially hot segments of core markets.
In bubble markets, wild speculative narratives are powerful determinants of asset prices, and there is widespread irrationality in the form of capital gains in the present and recent past that leads investors to expect these to continue in the future. In turn, those gains raise confidence in narratives still lacking hard evidence, and which should encounter healthy skepticism. Under sound money conditions where sober rational assessments of the future are dominant, these wild narratives could not spread.
Examples of bubbles include the tulip bulbs in early 1630s Holland (amid general monetary inflation spurred by the Bank of Amsterdam), the Florida land bubble in the mid-1920s (alongside the general monetary inflation of 1924–28), Bernie Cornfield’s Investors Overseas Services bubble in the mid-1960s (during the great monetary inflation of that decade, in the years before Consumer Price Index inflation picked up sharply and asset inflation was the dominant symptom); golf club membership prices in Tokyo under the Plaza Fed–led monetary inflation of 1985–89, the dot-com bubble of 1999– 2000 during the Greenspan monetary inflation of 1995– 2000, and then the bubbles and busts under the 2 percent inflation standard, including European financial equities (2003–7), commodities (2010–13), some segments of Chinese real estate (2010– 20), and stocks during the pandemic (2020–22).
It is always possible to be more definitive about bubble diagnosis in hindsight than in advance. The degree of corruption of market signals before the bubble bursts remains very much open to question.
The candidates for designation as bubbles which have not yet burst definitively or are still fully intact prominently include segments of the private credit and private equity markets, some AI-related stocks whose prices have variously reflected extreme optimism about the new technology and its monopoly profit potential (some partial bubble bursting was seen in late summer and early fall 2024), and parts of the crypto and art markets. Popular narratives in such bubble areas include the permanence of the vast monopoly power and matching rents achieved by big tech companies, as well as the transformational nature of AI and its potential to create new monopoly profit.
TM: It has now been about two years since the US central bank started raising its target federal funds rate, and market interest rates have slowly been generally rising since then. This came after more than a decade of ultra-low-interest-rate policy. Why did personnel at the central bank feel they needed to let rates rise at that time?
BB: The political pressure on the Fed to raise rates developed over the first half of 2022 as consumer prices continued to rise sharply even though the pandemic had receded. Political opinion surveys revealed that “the cost of living” had become the number one source of unpopularity for the Biden administration, and by spring 2022 the midterm elections (November 2022) were coming into sharp focus with unfavorable prognostications for the ruling Democrats.
No Fed official from the chief downward would admit to making policy under political pressure. Instead, the “pivot to hawkishness” evident in Fed communications from early 2022 rested on the justification that overall spending in the US economy had remained unexpectedly buoyant and the labor market correspondingly tight. Fed forecasts published through 2021 had assumed that without the present policy rate hikes (from close to zero), the goods price rises caused by supply-side shortages would reverse sufficiently once the pandemic receded to mean a big immediate fall in consumer price inflation. This failed to happen as 2022 unfolded.
Why was the Fed so reticent to raise rates immediately and sharply through late winter and spring 2022? It was all talk and little action. Fed official communications did not acknowledge the well-known view in monetary economics that nominal rates are a flawed measure of the tightness of monetary policy.
Perhaps this was all just one big bungle on the part of a well-intentioned Fed. But there is also the suspicion that Fed officials and Congress were in a “conspiracy of silence” about risks. No, not a conspiracy with meetings in the park, but a mutual understanding that there were advantages to silence—meaning no protest or actions designed to reduce the risk of prices rising far above prepandemic levels and staying there.
The unspoken advantage of an “inflation surprise,” as perceived by some powerful members of Congress and Fed policymakers in 2021, was the chance to write off substantial amounts of government debt in real terms. True, the rise in cost of living had so far proved to be unpopular, but surely it might be possible to fool most of the voters into believing that a return to 2 percent inflation (if that indeed occurred within, say, two years) with no recoup of the recent serious losses in the dollar’s purchasing power were a triumph to be celebrated.
TM: You are one of the few who saw the important role of the yen carry trade and how it contributes to monetary inflation. How does this work, and why are rising interest rates a problem in this case?
BB: Carry trades occur both under sound and unsound money conditions. But under unsound conditions, some or, indeed, many of these trades assume a giant size overall, as the investors behind these trades are driven by desperation for yield. They become softened by irrational exuberance, so they underestimate risks and exaggerate possible returns over the long run.
There are four forms of carry trade, with the common characteristic of an investor that takes risk-arbitrage positions between different forms of debt securities (including money) in the pursuit of enhanced yield.
First, there is the currency carry trade, where the trader moves out of a low-interest-rate currency into a higher-interest-rate currency. The bet by the trader is that the interest income on the higher-rate currency will exceed that on the lower-rate currency by more than any adverse exchange-rate move. And in the context of monetary inflation and its corruption of market judgment, participants in fact see the high-interest-rate currency continuing to appreciate indefinitely or at least long enough for a highly profitable exit from the trade to occur.
The yen has been highly popular over the last thirty years as a currency to borrow in the carry trade given its low (sometimes negative) nominal rates and given the strength of monetary inflation in Japan, which stimulates domestic search for yield. The popularity is uneven over time and occasionally gives way to panic retracements when global monetary conditions as led by the US really tighten markedly and when this tightening spreads to Japan.
The second form of carry trade is the credit carry trade from low- or zero-risk debt into high-risk debt; both “legs” (short and long positions) are in the same currency and for the same maturity. An example would be a switch out of, say, five-year Treasury bonds into five-year liquid high-yield dollar paper (issued by low-rated entities). The trader desperate for yield under monetary inflation might underestimate the risk of loss on this carry-trade position, which stems from the possibility of a credit downgrade or an actual default of the long leg.
The third form of carry trade is driven by the attraction of earning extra income in exchange for sacrificing liquidity. The trader counts on the illiquid leg not becoming even more illiquid and correspondingly falling substantially in price during the trade. An example of this liquidity carry trade would be moving funds of equivalent credit risk from the public debt market to the private credit market to pick up the liquidity premium.
The fourth form of carry trade is to move from short-maturity debt paper to long-maturity debt paper—both legs for the same currency and of the same credit risk—in the context of a positively sloping yield curve in the hope of picking up the so-called term premium. The trader expects that any loss on the long leg while this position is maintained will be less than the extra income gained.
Japan, at times the home of the greatest monetary inflation, including in 2022–24, has been the source of much carry-trade business of all types. Also, since the bursting of the real estate bubble and the collapse of the yuan’s nominal interest rates, China has become a source of much business, albeit seemingly concentrated in the yuan-based currency carry trade.
It is plausible that in terms of overall financial and economic risks the noncurrency carry trades in fact weigh more heavily than the currency carry trade considered on its own: remarkably, the much-reported “collapse” or “crash” of the yen carry trade in early August was not accompanied by notable collapses or contractions in the other forms of carry trade—and the level of financial stress globally has remained correspondingly low so far.
TM: What have been some of the other effects of rising interest rates in the global and US economy?
BB: The effects of rising interest rates are distinct from those of tighter money (less monetary inflation). The two are not the same, never mind the near-universal narrative in official monetary statements and in the financial media joining them.
Indeed, it is highly plausible that the Fed’s so-called hawkish pivot in 2022, defined by the intention and then the action to implement higher nominal rates, went along with continuing serious monetary inflation. Whether, and by how much, the near–500 basis point cumulative rise in the federal funds rate during that period meant monetary tightening cannot be read simply from data on monetary aggregates. This is especially true given the total corruption of the monetary base by the payment of interest on reserve deposits and the expansion of too-big-to-fail policies. Disintermediation from the banking system, spurred by onerous capital requirements and other regulations, adds to the blur around the significance of the broad monetary aggregates.
In hindsight we can say that if there was any monetary tightening by the Fed over the last two years, it was in the sense of overall monetary inflation becoming somewhat less powerful. Monetary conditions, however, remained significantly inflationary, as evident from the persistence of asset price inflation.
Decreasing the extent of monetary inflation without reducing it to near zero, let alone entering disinflation territory, leaves asset price inflation generally in place, though the overall signal corruption in asset markets might slow or even pause in some hard-to-assess overall sense. Experience is heterogenous, though, across the whole range of asset classes. Overall reported consumer price inflation has slowed, but that does not indicate that monetary inflation has stopped or decreased markedly, as under sound money conditions prices would be falling substantially overall as pandemic supply restrictions went into reverse.
Some asset classes are vulnerable to a big rise in nominal interest rates even if there is no substantial overall monetary tightening. We should think here of assets which seemed to produce high profits during the period of exceptionally low rates, largely due to the spread between the interest rates and the return to unleveraged equity. In effect, there is considerable scope under monetary inflation with low rates to produce deceptively high profits by increasing leverage and, where possible, applying camouflage. Private equity is a prime example of this.
TM: At the Federal Open Market Committee’s August meeting, Chairman Powell indicated that the committee would start lowering its target rate soon. What is the Fed trying to accomplish by lowering rates? Will lowering rates actually strengthen the economy?
BB: There are grounds to fear that monetary inflation is indeed now receding as cumulative price rises of 15–20 percent since the pandemic combine with some falls in money supply. And there could be an endogenous loss of robustness in the economy as the accumulation of malinvestment and overinvestment weighs on new spending. So, the Fed might envision that some monetary relaxation now will be consistent with low or even no consumer price inflation for a year or two and that it will also reduce the risk of a sudden and/or serious business cycle downturn.
That is the kindest interpretation of the Fed’s intent at this point. The big problem again is that in an anchorless monetary system the extent of nominal rate cuts that translates into any desired degree of monetary relaxation is impossible to conceptualize. It is all trial and error guided by the presumption that a big cumulative rate cut, for whatever reason, goes together with monetary relaxation. Any pretense about policy precision here is bogus.
The Fed’s pronouncements suggest that policy is made differently from this kindest interpretation. It is all about the dual mandate and the inflation target. Implicitly or otherwise, the Fed is projecting that with unchanged policy rates inflation would fall further toward 2 percent inflation, or even meet that target over the next year, while unemployment would continue to climb. Hence, to hold unemployment in a sweet spot the time path for the policy rate must be lowered. Yet forecasts of the state of the labor market are notoriously unreliable, and any connection with the policy rate is very much open to question. As to inflation forecasts, these are based on inertia or overblown versions of the notorious Phillips curve, or both.
Not mentioned in the Fed communications, but surely important, is a concern with reducing the danger of financial crisis that various stress signals in parts of the overleveraged marketplace might be suggesting.
TM: What should the Fed be doing right now, and why won’t it do this?
BB: There are two levels of answer to this question.
First, what should the Fed be doing to achieve its declared aims, which are 2 percent consumer price inflation (which includes no attempt to rebuild dollar purchasing power lost during the great inflation of 2020–23) and a temperate labor market (not red-hot as from 2023 to the first half of 2024, but still strong), all while preempting any outbreak of financial crisis?
This is mission impossible and mission hoax. The 2 percent inflation standard and the so-called dual or triple mandate form the architecture of bad money. Those who manage policy for this bad money are either charlatans, ignorant, or misguided. Good results cannot be expected except from the perspective of managing the political cycle, and much depends on luck. The sound money advocate cannot and should not offer advice to the bad money regime as to how to pilot the policy rate. The advocate should focus on regime change.
Second, what would the Fed be doing if Congress and the president had indeed passed sound dollar legislation?
The Fed, as presently constituted, is not inclined to go down the second path, joining with the advocates of sound money in persuading Congress to sanction this change in direction. The nomination and selection process for Fed officials works so that their mindsets are in line with congressional support for the status-quo monetary regime. If, amazingly, the Fed chief were to announce a belated intention of restoring the purchasing power the dollar lost during the pandemic, he would face a revolt from both Congress and the administration.
In any case, it is far too late in the day for any Fed maneuver on policy rates to preempt huge overinvestment, malinvestment, and excess leverage. All these vulnerabilities are already present. Bold rate cuts now may possibly delay the looming crisis for a short time but not cancel it. A cautious data- and event-driven policy is virtually built into the present rotten monetary system.
