Economic theory and central banks

My daughter Diana has just started A level economics, so we’ve been discussing some of the principles of ‘supply and demand’, and as part of the luggage of economic theory, there’s the premise that a market participant can’t seek to set both the price and the quantity of an economic variable unless as a supplier they have a near monopoly position, or as a buyer they have a monopsony position.

With this in mind, we could argue that over recent months, that the supply of money within the global real economy has operated as if there’s a monopoly, with central banks able both to influence nominal price through their usual management of short term interest rates and to set the quantity of money in the system through their asset purchases, with this reality reflecting the near absence of money creation by commercial banks. Indeed over recent weeks the problem seems to have become worse, with US commercial banks shrinking their credit books, principally by shrinking their trading books and amount of repo lending in response to regulatory changes, but also by continuing to contract their mortgage books and more recently by reducing their level of lending to the commercial sector as well. These actions have reduced the level of liquidity within the US economy – and we may suspect in the global economy also.

However, this has not (until last week at least) resulted in a decline in overall liquidity growth within the economy because large asset purchases by the Federal Reserve and others have been able to more than offset the contractionary influence that has been emerging from the commercial banks.

Whilst the Fed has become the setter of both the price and the quantity of money and credit in the US system, if it does now begin to taper bond purchases, as seems likely, it will explicitly be creating less liquidity outside the banking system, and thereby exerting less direct control over the quantity of money in the economy – although we may well expect that it will continue to create plenty of new liquidity within the banking system.

It has been suggested in some research notes and commentaries that tapering does not represent true monetary tightening since the Fed will still be setting – and potentially even reducing – rates at the front end of the yield curve. However, if this were true, it would then beg the question as to why tapering is contemplated in the first place if it is not going to change anything – and tapering does imply that the Fed will be reducing or letting go of control of the quantity of money in the system and shifting back to focusing on short-term price setting. This represents a major shift in the Fed’s stance and modus operandi.

Ordinarily, if any system receives less supply of something relative to the demand for that ‘commodity’, the price of the commodity in question will tend to rise and this is of course what has been happening in the bond markets over recent months. Markets are simply re-pricing US dollar liquidity because the supply of this liquidity is coming down.  Although, the Fed is of course still capable of controlling short term nominal interest rates (and may even attempt to enhance control with a possible new form of reverse repo facility), as the Fed begins to reduce its impact on the quantity of money in the system, so markets regain control of nominal prices of longer term interest rates within the US, along with the external value of the dollar and of course the price and availability of dollar liquidity to foreign borrowers such as Emerging Markets (EMs).  It is in these areas that the ‘price of dollars’ has of course increased of late.

Moreover whilst the Fed may be able to control nominal short-term interest rates in the US, it cannot control real interest rates, and if EM currencies continue to weaken and world trade prices continue to fall in response to any Fed tapering, then inflation rates will likely drop and hence even real short-term interest rates could rise regardless of the Fed’s wishes.

The other critical issue that we need to watch is what now happens with the commercial banks because in the real economy, where people want to borrow mortgages and consumer credit, companies want to borrow commercial loans or issue corporate debt instruments, and most may want to hold deposits, the quantity of these variables is set rarely by the size of the monetary base but rather by the attitudes and practices of the commercial banks.  The net result is that central banks are important but by no means the only determinant as to what lies ahead.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla