With the dollar collapsing to nearly $1.38 for a euro, many have been left asking, “What happened?” One month we’re doing great and talking down to Europe; the next, the dollar is back to pre-Greek crisis levels. While many factors are responsible, I wanted to touch on just one, expectations of long-term U.S. rates.
In the financial news, central bank watchers seem to divide themselves into three groups: those who follow economic textbooks, those who study Bernanke, and those who view the central bank as almost unpredictable.
The first group follow their college economics textbooks word for word. They ignore the personal opinions of the central bankers, the political situation, and the individuality of every recession. These analysts assume that central banks will always follow a prescribed pattern. Every economics student should know the drill. If the economy weakens, lower rates. If it’s overheating, raise rates. If a recovery begins, increase rates slowly.
These central bank watchers never fear inflation. They believe that Bernanke will always take the appropriate action in response to any threat. However, in reality, central banks deviate from the set game plan. And that’s when problems arise.
The majority of commentators fall into this category, and they have good reason for doing so. Historical precedence is an important compass for the future. After all, certain central banks around the world appear to be following the textbook.
These central banks slashed rates, and now with more stable economies, the rates are rising. Gold-based economies such as Canada and Australia could even keep their rates lower. In fact, higher gold prices could give them leeway for lower rates. Nonetheless, they’re following the textbook. As a result, their currencies have appreciated against the dollar in the past few months. Investors expect them to play by the book and keep raising rates. Positive expectations have real value on foreign exchange markets.
The second group are the Bernanke watchers. According to their view, you don’t play the cards; you play the man. It’s certainly a smart way of looking at the situation. After all, take 20 leading economists and ask them about their macroeconomics views, and you will receive 20 different answers with general similarities. Economics is not a strictly defined hard science. Economists have the luxury of coloring outside the lines.
Bernanke’s academic days do yield some important information. First, he’s scared to death of deflation. He would likely prefer 4-5% inflation to the slightest degree of deflation. Second, Bernanke believes in preserving financial institutions. His academic articles on the Great Depression focused on the damage caused by bank failures.
In the 1930s, credit information wasn’t easily available. Your local banker knew who was creditworthy and who wasn’t. He couldn’t simply type your name into a computer and get a credit score. When the local bank went bust, permanent information about the creditworthiness of the community was lost. Hence, it was difficult to restart the financial system with many bank failures. The new banker in town had to learn everyone’s reputation from scratch. In turn, this slowed the flow of credit and, as a result, the recovery too. This analysis is Bernanke’s claim to fame in the Great Depression literature.
Could this academic study infer that Bernanke would bail out the banks, no matter what? Maybe. However, the current situation is quite different from his papers.
The last group see the central bank as largely unpredictable. Forget the textbook, and forget Bernanke’s academic papers. Interest rates are not following either pattern. Just take interest rates month by month as they come. With the Fed’s last meeting, more analysts may be switching to this point of view. With a small market recovery, the textbook said to raise rates, but instead Bernanke promised more quantitative easing. Even a small rate hike would have sufficed to keep the dollar in place, but Bernanke went the opposite way. That means the textbook viewpoint is out the window. Bernanke’s interest rates are off the regular evening menu.
Further, the textbooks can’t tell us much about near-zero interest rates. It’s largely uncharted territory. Many free-market types blame Bernanke’s Neo-Keynesian school of thought for the current rate policy, but this is inaccurate. Even Neo-Keynesians didn’t suggest near-zero interest rates prior to this recession. Sure, most would support extremely low rates, but not that low. The majority of economists recognize that Japan’s near-zero interest rate policy has been a disaster.
Hence, Bernanke is adlibbing here. He’s completely off script. Can he keep rates low for an extended period of time and just raise them back with little harm to the economy? No one knows. There are simply not enough historical precedents to predict the outcome.
Bernanke has indicated that he’s sailing this ship into unknown waters. Hence, more analysts are becoming uncertain about the future of rates. As a result, the future of the dollar looks hazier too. Though Canadian, Australian, and Norwegian rates are low relative to the long term, their trajectories are predictable. Their ships navigate with a compass and map in hand. But with the Federal Reserve, long-term rates are murky.
Bernanke tried his hardest to create a predictable environment of low rates. He succeeded. However, at the same time, he has made the timing of higher rates highly unpredictable. And when investors can’t see a clear picture of future rates, they will discount the U.S. dollar in favor of more predictable central banks. Something to think about.
