How many years have passed with US interest rates of almost 0 or 0%? Since December 2008, as a dramatic slowdown in the US economy manifested clearly, the Federal Reserve reduced its target for the federal funds rate to nearly 0%. It was intended to provide stimulus to household and business spending to support economic recovery.
Unfortunately the hope for sustainable recovery was in vain, except in the rise of the capital markets.
In the fight for economic recovery the central banks in the US, the European Union, Japan and some other countries made great efforts through their monetary policies. But because the lowest bounds of the interest rate has been attained, the Fed used an unconventional monetary policy by purchasing the Mortgage Backed Securities, providing liquidity to the market. In some economies the real interest rate has been in the negative territory.
The Fed conducted large-scale asset purchases, also often referred to as quantitative easing (QE). It was a monetary tool firstly deployed in 2001 by the Bank of Japan after the double crash of 1990 and then used more widely since the financial crisis by other advanced countries.
The following excerpt shows how the rising prices in stock and property markets in Japan was attributable to an accommodative monetary policy and especially to a low interest rate.
The BOJ official discount rate dropped from 5% before January 30, 1986 to 2.5% between February 1987 and May 1989.
A decrease of interest rates will induce a hike in asset values, like stocks and property. The Economist reported in 1989 that the value of property in the Tokyo Large Area was equal to the property value of the whole US.
In 1984 the Nikkei moved between 9,900 and 10,600, but a major surge occurred in 1986 as the Nikkei 225 gained close to 45% within a year. The trend continued throughout 1987, when it touched as high as 26,029 by early August before being dragged down by the NYSE Black Monday. The strong rally pushed up the Nikkei 225 to get another new record high at 38,957.44 on December 29, 1989.
Hence, there is a counter-movement between the level of interest rates and the asset prices. The rise of prices in capital markets and property both entailed huge financial wealth. After the crisis of 1990 both the stock prices and urban land prices fell significantly.
As financial wealth dropped, the economy fell into depression. The economic drop induced Japan to employee a QE policy, resulting in very low interest rates without economic recovery, but a partial recovery of the financial market did happen.
The significant drop of the bubble prices in the stock market and property sector was considered as an act of reckoning for Japan’s wrong monetary policy of before 1990. Now people talk about the “lost decades” in Japan.
The Japanese experience was a predecessor to the US in modern times where a huge drop of financial wealth was followed by a crisis.
It seems that the length of the ensuing weakness in the economy is in line with the magnitude of the fake wealth created by a false economic policy.
During the booming phase in the US property sector the phenomena of wealth effects were manifested in the consumption behaviour of households because of the rising value of their houses.
The availability of refinancing mechanisms for mortgagors enabled them to cash in the capital gains of their houses, called housing equity withdrawal. The proceeds were used for whatever they liked and mostly resulted in the raising of consumption.
But they were also more indebted. When the crisis broke, the prices of houses dropped, but alas their debt in the bank-books was even higher because of a compounding interest formula, leaving households more and more indebted, many ending in foreclosure.
China’s devaluation of the yuan on August 11 was triggered by a weakening economy and a drop in exports. Several consecutive days of capital market rout ended in the Black Monday on August 24.
At least two suspected factors were behind the mini-crash, namely the slowing growth of China’s economy and the next hike of the US Fed’s funds rate.
The next day the central bank, the People’s Bank of China, issued a series of monetary policies, including an interest rate cut of 25 basis points and a decrease of the required reserve ratio of 50%.
China’s policy directly reversed the course of the stock market from negative to positive territory. But it seemed insufficient. Volatility became violent.
To the surprise of many Black Monday happened in spite of the yuan devaluation. The monetary policy of China has triggered the capital market to engage in a yo-yo movement. China’s government does not want the yuan to be too weak, fearing a capital flight by foreign investors, which has happened several times.
Above all, China wants to position the yuan as a global currency and establish it as a component of the Special Drawing Rights. Strengthening the yuan by buying it by using its huge foreign exchange reserve is a visible alternative.
Selling US treasury bonds is equivalent to counter the QE programmes. China amassed FX reserves since 2003 without letting the yuan appreciate significantly.
There is a conflict of interest between China and the US. It happens at the time of friction between the two giant states relating to several geopolitical issues in the South China Sea and with Japan.
Most of the Fed’s balance sheet was expanded during the QE programmes, achieving US$4.4 trillion (RM19.13 trillion) while China’s FX reserve in 2014 was around US$4 trillion.
The accumulation of the big reserve was conducted by managing the exchange rate to the benefits of China’s trade and economic growth.
The fast-growing China was highly indebted in the amount of US$28 trillion. The slowing economy makes it harder for China to pay off its debt. Overly ambitious construction of infrastructure, building for commercial or for residential purposes, cities and so on have been underutilised.
The philosophy of easy money and easy credit contributed to the high demand, leading to high prices and then a highly inflated value of wealth. These are the sources of the problem loans that are dragging the economy.
It seems that most of the advanced economies were infected by inflated wealth value, supported by low interest rates, but also by unusually high sovereign and private debt. If history provides a lesson, this could be ending in crisis. The bigger the fake wealth created, the more severe and longer the crisis will be. We pray that it will not happen. – Jakarta Post, September 10, 2015.
* Djamester Simarmata is a lecturer at the University of Indonesia’s School of Economics, Jakarta.
* This is the personal opinion of the writer or publication and does not necessarily represent the views of The Malaysian Insider.