Will a lower currency prevent a big rate cut?

Over at Tumeke, Tim Selwyn states:

Not even our high interest rates are enough anymore (to keep our currency elevated) – that’s why I can’t see our Reserve Bank slashing rates on the 29th as aggressively as some people think they should

Now Tim raises a relevant point – a lower dollar both increases prices and stimulates activity for exports, as a result you would expect an exogenous fall in the value of the New Zealand dollar to constrain the size of any rate cuts in New Zealand.

However, the current value of the TWI (53) is broadly in line with where it was when the RBNZ cut rates by 150bps – and at the time they said that they believed that any further declines in the currency would “help” not hinder monetary policy.  My impression is that this is because the Bank is interested in loosening as quickly as possible – without loosening “too far”.  If the exchange rate is willing to adjust to a deterioration in New Zealand’s external position, then this is of great help to the Bank, and allows them to be more “conservative” by cutting in 75bp and 100bp chunks rather than heading straight for and OCR of 1% 😛

As a result, I doubt that the current level of the TWI would prevent a large scale cut of the OCR by the RBNZ at its next meeting.

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  • Peter Brown

    I just found this blog, and so I hope you get this.

    The more you cut the Official Cash Rate the more the CPI ought to (and is shown to) fall. The NZD ought to also be stronger in foreign exchange in the longer term too.

    The Japanese Yen is a good example of this at the moment. This is the reason it’s considered safe – because of the long end of the yield curve and the pro-growth nature of low interest rates.

    Lower interest rates precede upturns, and not because someone is ‘printing’, infact, many central banks make sure they don’t print because the market knows immediately and growth slows to that extent, or the rise in stocks is less spectacular, or there’s a fall in stocks (1970s).

    You’d be amazed to know, and I’d like to inform you, that lower interest rates bolster currencies in foreign exchange, lower price inflation rates, lower the cost of production and increase the demand for non-interest bearing money balances (money leaves the wallet and moves into an 8% bank account when interest rates are high) – which increases the demand for money.

    Also technically the natural rate of interest is the 3-month T-bill rate, so if the 3-mo T-bill is 0.04% and the Fed Funds Rate is 1%, Fed interest rates are artificially high, and slowing growth.

  • Hi Peter,

    I’m not sure I agree with your claim, let me just state down my views on your claims:

    “The Japanese Yen is a good example of this at the moment. This is the reason it’s considered safe – because of the long end of the yield curve and the pro-growth nature of low interest rates.”

    I thought that the reason people were running to the Yen was the large CA surpluses and strong international financial position – not because their cash rate is low.

    “You’d be amazed to know, and I’d like to inform you, that lower interest rates bolster currencies in foreign exchange, lower price inflation rates, lower the cost of production and increase the demand for non-interest bearing money balances (money leaves the wallet and moves into an 8% bank account when interest rates are high) – which increases the demand for money.”

    The first two claims appear to be conjecture, although the third and fourth claims are true. Yes lower interest rates do lead to an increase in the quantity of money demanded (as the opportunity cost of holding money is lower) – but I’m not sure why you are telling me this.

    Would you please be able to elaborate on this?

    “Also technically the natural rate of interest is the 3-month T-bill rate, so if the 3-mo T-bill is 0.04% and the Fed Funds Rate is 1%, Fed interest rates are artificially high, and slowing growth.”

    The Federal Funds rate helps to set the 3-month T-bill rate – as a result I don’t think we can quite make the conjecture you are making. Furthermore, the Fed funds rate is 0-0.25% not 1% at the moment.

  • Peter Brown

    @Matt Nolan
    The Fed raises interest rates to fight economic growth, and in particular, to cause a recession (a reduction in output), particularly when the Fed raises interest rates above the 10-yr.

    Most economists, and fed officials, as per the Phillips curve, believe high economic growth rates (a trend of lower unemployment rates) causes price inflation, and therefore, while usually screaming that the economy is supposedely growing ‘too fast’ or is ‘overheated’, raise interest rates to trash growth – which they certainly do.

    As a recession takes place, the supply of loanable funds surges as investors invest in cash equivalents – pushing the least riskiest end of the yield curve to -0.02% in terms of the U.S. 3-Mo T-bill at one point during this recession – if I remember correctly around the time of the Emergency Economic Stabilization Act of 2008’s ($700bln) passing – a deleterious exogenous shock to the supply side – a sell signal on the stock market (which fell over 20% in the following week). The Fed actually follows the 3-mo T-bill.

    Most economists do not properly understand Open Market Operations. They also completely misunderstand interest rates as if interest rates were the abudance or scarcity or money – or even worse – the ‘cost’ of money.

    They also do not understand how the Fed works. The Fed is only stealing wealth when the System Open Market Account increases, the expansion of its balance sheet outside of the SOMA (such as TAF, TSLF, toxic mortgages, etc) is purely a function of the Fed operating a loan portfolio on its own reserves on a fractional basis (over 20x+) and not a function of money creation.

    On lower interest rates, the cost of production falls in aggregate.

    The common belief that raising interest rates fights price inflation is the modern equivalent of the flat Earth. If you want to understand more on this I recommend Say’s law and the New Classical School’s Real Business Cycle Theory (even the wikipedia page on RBCT is really good).

    The empirical data on CPI correlations to interest rates, gold, oil and home capital values is undeniable – particularly if you understand and follow bond markets. Ask any researcher at a central bank, they know what they’re doing (stealing) and those type of employees are very frank.

    Trades balance, there’s no such thing as a current account. If I accepted Keynsian economics, I’d have one huge trade deficit with my grocer – and he’d have to come get some personal portfolio analysis to the tune of thousands of dollars.

    In a normal financial market, the capital value of the Japanese Yen is related to the ¥/gold ratio, which often increases at a larger rate than the $/gold ratio, with the denominator in both ratios retaining their purchasing power – arbitrage pricing theory dictates that the objective value of the Yen in the long run is less than the dollar – one also must consider the high corporate tax rates in Japan as well as the protectionist nature of the Japanese government and its disastrously enormous welfare statism.

    The only way to directly measure inflation is the currency/gold ratio, that, and the long-run trend of a currency towards increased economic freedom (such as Europe and the effective axing of border controls, as well as collective budget deficit limits of the EU agreements, axing 12 arbitrary values for 1 arbitrary value, etc) – there’s also incoming exogenous shocks and anticipatory probabilities (of events happening) that is determining the Dollar Yen rate, which has been highly correlated to U.S. economic performance (Japans economy is always more stable) and gold over the last year.

  • Peter Brown

    I’m sorry I meant to say the ¥/gold ratio is less volatile and generally less than the $/gold ratio.

    To learn more about the $/gold ratio, take 1/$700 an ounce and divide it to figure out the gold (tangible-asset) component of $1. Then find a time series such as the ratio move from last years 1/$670 to 1/$850, find the differences with some math – then apply the lag to the $/oil ratio – which usually moves the same % a month or more later. Then do some $/gold time series analysis using the lag, and watch the 1:1 unfold as gold moves from $670 to $1020 by X% and oil moves from $70 to $X by X%, then as the ratio falls from $1020 to $690, start forecasting an oil price fall of Y% from $147.

    The financial sector forecasts commodity price moves this way, as long-run commodity price swings are a function of the value of the numerator (fluctuations in the monetary unit).

  • “The Fed actually follows the 3-mo T-bill.”

    I was under the greater impression that the 3mo T-bill followed expectations of Fed movements – as Fed movements are transparent, it “leads” Fed movements.

    “Most economists do not properly understand Open Market Operations. They also completely misunderstand interest rates as if interest rates were the abudance or scarcity or money – or even worse – the ‘cost’ of money”

    The “interest rate” is the opportunity cost of holding money. I completely agree with you that a recessionary environment can lead to an increase in money demand – but that doesn’t change this fact.

    “The common belief that raising interest rates fights price inflation is the modern equivalent of the flat Earth. If you want to understand more on this I recommend Say’s law and the New Classical School’s Real Business Cycle Theory”

    Being an economist I do know about Say’s law and RBC theory 🙂

    Nonetheless, both rely on the notion that prices adjust instantaneously such that demand and capacity meet. If this was the case, then “inflation” would only be growth in the money stock. The fact is that reality isn’t that simply: and so models that include stick prices, and inflation expectations, are required to understand the movement of aggregate variables.

    In this case, the role of interest rates as the “opportunity cost” on money, and as a factor that can influence “demand” in the economy come into play.

    “The empirical data on CPI correlations to interest rates, gold, oil and home capital values is undeniable”

    Correlation not causation my friend. There is a difference because there are contemporaneous variables that explain the movement in both – namely the movement of expectations.

    Note that the Central Bank lifts interest rates BECAUSE activity is past capacity. As a result, because of lags, a peak at the data will make it look like higher interest cause the very inflation that they are knocking now.

    “Trades balance, there’s no such thing as a current account. If I accepted Keynsian economics, I’d have one huge trade deficit with my grocer – and he’d have to come get some personal portfolio analysis to the tune of thousands of dollars.”

    You seem to be comparing bilateral trade deficits (which I agree are rubbish 🙂 ) with general current account deficits. Now current account deficits do exist – for example, I have a current account deficit (and a stock of debt of about 200% of my personal GDP at the moment 😉 ) . This merely states that I spend more than I earn. I don’t think current account deficits are very scary – but they do exist.

    “The only way to directly measure inflation is the currency/gold ratio”

    Well, if the relative price of gold never changed then it could be used as a numeraire. However, I wouldn’t say this is necessarily the case – especially given changes in the relative value of everything else in society.

    Peter I believe there are a lot of interesting facts that you have put forward – however, I don’t agree with the lens of analysis you are using to understand them. I hope what I have said has made my position a bit clearer 🙂

  • Peter Brown

    @Matt Nolan
    The 3-mo T-Bill indicates the general level of prevailing interest rates in a prolonged reduction in aggregate economic output (recession). As the risk-free asset it takes the role of cash, its yield is more or less the closest thing you’ll get to a pure, natural rate or intersection of the supply and demand of aggregate loanable funds. The exact level of the interest rate is determined by exogenous shocks to the supply of Capital (loanable funds). As investors buy T-Bills, saving in a recession surges and with that the supply of Capital.

    Interest rates take into account, and yet have nothing to do with, the money supply, interest rates reflect Capital, not money, i.e., they reflect tangible wealth or real loanable funds. Capital markets keep their eye on arbitrary power and are not fooled by government intervention. An interest rate, properly, is a price determined by Capitalist-entrepreneurs for which, judging by the facts of reality, they’ll charge a borrower for borrowed Capital. Government expropriation of tangible wealth through a central bank is filtered by the capital markets in the level of interest rates and commodity prices, among other things.

    Markets clear with a lag.

    A common smear by market-failure types is the assertion that those who believe in efficient markets necessarily ascribe to the fallacy of instantaneous clearing. In my view liquid markets clear extremely fast however. The best example of this was the crash of 1987 after U.S. Treasury Secretary James Baker signaled an extreme desire to see a weak U.S. dollar in foreign exchange. The tech stock sell off after United States v. Microsoft in early 2000 is a more recent example of speedy market clearing. Far from market failure, crashes are great demonstrations of the efficient operation of markets.

    There’s no dormant inflation that’s creeping in the system, there’s no asserting that it takes years for inflation to show up, there’s no “inflation is just around the corner”, “over the mountain” “about to come through from thirty seven years ago”, “if it’s not here now it’ll be coming soon” or “the true impact of inflation takes years” — etc etc.

    Even if you empirically account for these nonsensical assertions by the majority of economists, the data shows raising interest rates boosts and reflects price inflation. Direct causal relationships are well established truths in financial markets, just not to pundits on TV and in the intellectual-academic realm (which is dominated by statist, demand side economists mind you).

    As for me I’d rather listen to stock and index futures traders who recognize, properly, that lowering interest rates closer to the natural rate (which is usually far lower than the Fed Funds Rate in a downturn [i.e., recently the 3-mo T-Bill was -0.01 when the Fed Funds Rate was 1%, constituting insanely artificially high Fed Funds Rates that slow the economy and are pro-growth to the extent they cut close to the T-Bill rate (which, again, they follow)]) decreases the cost of production and increases the demand for non-interest money balances (increasing the demand for money-tender – a stronger currency).

    On Fed Rate Hikes..

    The Fed’s war on inflation: impact or impotence?
    http://www.hcwe.com/vSignup/Archive_Publications/Interest%20Rate%20Outlook/1999/IRO%2012-99.pdf

    There’s no such thing as current account deficits, what you describe is a budget deficit – the current account includes bilateral trade and is a fallacious idea based on protectionism. It also seemed to me you were talking about the trade deficit. When it comes to the U.S., remember that a contracting trade deficit is bearish, and accelerating U.S. trade deficits are bullish.

    With regard to gold, annual mining only increases the above ground stock by roughly 1%, furthermore gold is accumulated rarely consumed. Gold retains its purchasing power and is stable precisely because of this. In the intermediate and long run, $/gold ratio changes, or the price of gold in U.S. dollars, reflects only a change in the objective value of the numerator (the U.S. dollar), the denominator is essentially static. There are also moves in the short run, they’re very genuine and reflect changes in the numerator only — i.e., if there’s an exogenous shock (such as major market news that pushes gold up $50 in a day).

    The supply of gold consists of its entire above ground stock, gold mined out of the ground for over 60 centuries. The vast majority of this supply is in the hands of investors who dump gold when they anticipate disinflation or deflation, both bullish for financial assets – causing the $/gold ratio to fall – and demonstrating an objective increase in the value of U.S. dollars – as these investors buy U.S. dollar denominated financial assets.

    When investors anticipate inflation, they buy gold again, pushing up the gold price.

    Market participants, acknowledging that the U.S. government, whose proper role is to protect individual rights and private property, sold U.S. financial assets and bought gold earlier this decade. The reason was that investors, having observed the U.S. non-response to 9.11, the complete misidentification of the enemy as a tactic (terrorism) and the total lack of annihilating the threat (the Islamic Republic of Iran and Saudi Arabia, the ideological and financial fountainheads of Militant Islam [the actual enemy]), forecasted prolonged, rather than temporary, warfare and welfare state building in dunk pestholes such as Iraq and Afghanistan. Currently the $/gold ratio at $890 discounts the U.S. government, years out, paying 40-45% interest on its own debt every yearly budget (currently 9-13%). In other words $/gold discounts hyperinflation, but in my view, this is out of line, especially when one clears that the United States will no longer be building welfare states in Iraq and Afghanistan sometime soon.

    I’m discounting that the $/gold ratio falls as investors buy financial assets in the post-recession recovery, and that the $/gold ratio falls below $690, this move will affect the price of commodities, such as the $/oil ratio.

    I hope you see from my post that the subject is political economy, or the production, distribution or consumption of wealth in relation to custom, law and government — not math-physics engineering.

    The science of political economy is fundamentally absolutist, like 2+2=4, low taxes, low regulation, sound money and free trade is conducive to production and it is especially that – production – and the conditions that foster it – that all economists ought to be focusing on.

    Economists who assert that this is not a normative subject don’t know what they’re talking about, and fail miserably in debate. In political economy, value judgments are integrated from positive facts, and theory is integrated to practice, is to ought, fact and value.

    ** I oppose gold bugs, especially when they begin with their conspiracy theories about government ‘manipulating’ gold prices.

  • Hi Peter,

    The official cash rate helps to determine the market rate of interest – given that it signifies a certain, risk free, return for banks. Furthermore, it sets a floor on the cost of credit for banks (up to the level that the central bank is willing to loan to banks). These other factors are definitely very important in setting the interest rate on loans – but the OCR is part of the story.

    “Even if you empirically account for these nonsensical assertions by the majority of economists, the data shows raising interest rates boosts and reflects price inflation”

    No it doesn’t. Economists do use data and I have seen studies that show interest rates have a negative impact on inflation. Now I agree that a increase in interest rates often pushes up the price level – but it reduces growth in the price level, which is what economists term inflation.

    “There’s no such thing as current account deficits, what you describe is a budget deficit – the current account includes bilateral trade and is a fallacious idea based on protectionism. It also seemed to me you were talking about the trade deficit. When it comes to the U.S., remember that a contracting trade deficit is bearish, and accelerating U.S. trade deficits are bullish.”

    The current account deficit is largely the trade deficit, but it also includes net transfers and net investment/factor income. In NZ the investment/factor income section is very important – because we have a large stock of foreign debt.

    The current account deficit does exist – however, it doesn’t have to be seen as a bad thing.

    Peter, I am not sure what exactly you are trying to argue here. There are a number of places you mention facts but they don’t seem relevant to what I initially felt you raised as the argument – namely that a high OCR increase inflation.

  • Peter – A fascinating exposition. I am heartened that there seems to be a school of thought out there that finds substantial flaws in mainstream economic thinking. I will follow up on some of your references.

    Some comments. You don’t address the dual challenge of national security. If I want the Islamists and owners of energy (oil & gas) to stop bombing me and aiming for the caliphate I need to bring their people to capitalist democracy so their people share in prosperity rather than being manipulated to fight our system.

    The owners of energy are the enemy. How do you resolve that.

    Gold is simply a metal. It has been valuable historically but cannot produce more of itself. A US T Bill is a call on the economy of the US. The US can dilute that call through inflation but that is the path to self destruction. Would you rather be the debtor owing China & Japan trillions or the owner of that debt. Those T Bills can buy productive US assets.

    The owner of that debt & of energy can control the entire productive capacity of the US. Surely far more valuable in the long run than a simple metal?

  • Put another way in case I was not clear and overstate the power of Chinese holdings of T Bills. Which would you prefer in the long run. To own Berkshire Hathaway at current market capitalisation or the equivalent in Gold. You go first and I take the other, but neither of us can sell. Who will have more wealth & income in 50 years time?

  • Hi guys,

    “I am heartened that there seems to be a school of thought out there that finds substantial flaws in mainstream economic thinking”

    I have to admit – I don’t see the flaws you guys are discussing. You both seem to be listing facts, facts that don’t contradict the implicit economic model I have in my head – what exactly are you guys critiquing?

    If I know that I would be more use in discussing the issue.

    Also, why the obsession with gold? (which is what the focus on gold indicates) I agree that there are correlations – as gold is viewed as a numeraire. But gold prices do not “cause” anything – they just move around with things.

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