from Follow the Money

The US imported too loose a monetary policy from the world, and now exports too loose a monetary policy to the world

May 23, 2008

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That more or less is the conclusion of this week’s Economist.

I agree.

Back in 2003 when the dollar started to depreciate, many emerging economies opted to maintain dollar pegs and follow the dollar down. The resulting increase in their reserves -- and holdings of US Treasuries -- altered the monetary transmission mechanisms in the US. The dollar was stronger than it otherwise would have been, notably against the Asian currencies. And US rates were lower than they otherwise would have been.

Moreover, long-term rates didn’t rise when the Fed started raising rates, keeping financial conditions looser than they otherwise would have been. And as the revised data from mid-2004 to mid-2006 comes out, it is increasingly clear that ongoing central bank purchases of Treasuries and Agency bonds are part of the explanation for the persistence of low long-term rates. The Economist:

"Emerging economies shared some responsibility for America’s housing and credit bubble. As Asian economies and Middle East oil exporters ran large current-account surpluses, they piled up foreign reserves (mostly in American Treasury securities) in order to prevent their currencies from rising. This pushed down bond yields. At the same time, cheap imports from China and elsewhere helped central banks in rich economies hold down inflation while keeping short-term interest rates lower than in the past. Cheap money fueled America’s bubble."

The housing bubble and residential construction boom obviously have ended. The US economy has slowed sharply. And the US has cut rates.

The result is that a host of emerging economies are now importing both a weak currency and loose monetary policy from the US. Countries that peg to the dollar can easily have a looser monetary policy than the US -- higher rates of inflation and the same nominal interest rate can produce lower real interest rates -- but have difficulty maintaining a tighter policy. Raising rates while maintaining a de facto dollar peg would tend to attract speculative capital inflows. Ask China.

Loose monetary policy globally has helped to offset the US slowdown. Much of the emerging world is booming on the back of negative real interest rates. But it also has pushed up inflation globally. The Economist reports that the average global real interest rates is negative ("global monetary policy is now at its loosest since the 1970s: the average world real interest rate is negative") largely because of very high rates of inflation in the emerging world.

The recent acceleration in the rate of inflation in the emerging world reflects -- I suspect -- the enormous acceleration in reserve growth among the world’s emerging economies that took place last year. Such reserve growth has been hard to sterilize, so it has bled in very rapid growth in the monetary supply of many emerging economies. The Economist:

Even if the Fed’s interest rate suits the American economy, global interest rates are too low. In turn, the unwarranted stimulus to demand in emerging economies is further pushing up commodity prices; so too is speculative buying by investors seeking higher returns than from bond yields, which are still being depressed by the emerging economies’ build-up of reserves. This stokes inflationary pressures in America and Europe and makes life difficult for rich-country central banks.

The rise in inflation in those countries that have built up the most reserves suggests that the US might just be a bit too big for the emerging world’s central banks to save. At least too big to support without significant costs.

The Economist recognizes the risks of status quo.

Loose money in America and rigid exchange rates in emerging economies are a perilous mix.

But this week’s Economist also -- following an Economics Focus column of two weeks ago -- notes that moving off a peg is hard, a lot harder than some (unnamed) proponents of floating (a group that I suspect includes me) sometimes suggest.

Admittedly, exchange-rate appreciation is not as simple a remedy for emerging economies as some claim: a rise in interest rates and the expectation of a further appreciation in the exchange rate could, perversely, exacerbate inflation by sucking in more capital; and setting the exchange rate free risks massive overvaluation.

I do not disagree. Small and incremental moves invite additional speculative inflows that -- unless effectively sterilized -- add to money growth and inflation. Moving suddenly to a float, by contrast, risks a large and disruptive upward move. Exiting from a peg is hard.

But the fact that so many countries waited so long to start moving away from dollar pegs -- and in China’s case moved very timidly in 2005 and 2006 -- has only made the ultimate exit harder. The gap between a true market exchange rate and the current nominal exchange rate of many key emerging economies (think of where a freely floating Saudi riyal would trade with oil at $130 ... ) is now quite large.

The easy options disappeared when many key emerging economies didn’t take advantage of the dollar’s 2005 rebound to start to move off dollar pegs.

A 10 or 20% revaluation wouldn’t necessarily end speculation on further appreciation. And a 10 to 20% move was far more than either China or Kuwait were willing to consider.

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