There's a lot of discussion right now about the impact of the recent "tightening"
by the Federal Reserve in the United States which moved up the benchmark Fed
Funds rate from 5.25% to 5.5% . The Chairman of the Federal Reserve, Alan
Greenspan, is in the news on an almost daily basis with his diagnosis of the
health of the U.S. economy and sometimes with some prescriptions for his massive
and lumbering patient. Given the byzantine, convoluted and often contradictory
nature of his public utterances, it's no small wonder that the average investor
hasn't got a clue what he's up to.
To top it off, the so-called experts of Bay and Wall streets are pretty
confused themselves and the financial media is rife with conflicting views of
what "tightening" of monetary policy will mean to the U.S. economy and
financial markets. After a healthy economy and rising financial markets for as
long as most investment neophytes can remember, it is currently fashionable
among economic commentators to question if "money matters any more?"
There's lots of great reasons to disparage the impact of monetary policy,
demographics and "downsizing" being popular, but savvy investors know
better. Monetary policy is one of the most potent forces in the financial
markets. Abuse this concept at your own risk!
Monetary policy is the name for the methods that
national governments use to manage a country's supply of money and credit. By
manipulating the availability of money and credit, national governments attempt to influence the overall level of economic activity. In most modern countries,
by law, only the national government can produce currency. This allows
governments to vary the amount of currency and credit, since the creation of
money through the banking system is one of the key determinants of the
availability of loans. All countries also closely regulate their financial
institutions and use their control of a country's financial system to try to
influence their economies.
Experts are divided on exactly what the impacts of monetary policy are for a
modern economy. They also and debate the "transmission mechanism" or
the manner by which monetary policy works. This debate divides economists and
financial analysts into "economic schools" or camps which affects
their way of looking at these issues. This debate might seem a bit dry and
irrelevant to the layperson but it has important ramifications for how an
investor views the effect of monetary policy on the financial markets.
 A Giant Monopoly Game
A good way to think of the effects of monetary policy is to imagine a simple
game of Monopoly. The banker we have chosen is "Big Al", who is the
serious quiet type and seems to get a big kick out of counting out the money and
doling it out to the players. He hands out the money and we start playing the
game. After a while, when the players start to whoop and shout at their
progress in the game, Big Al frowns. " I am disturbed",
he grimaces, "at the rapid price increases in the property values
and the underlying strength in the Monopoly economy. I am going to restrict
monetary policy" , he adds and removes half the money from all of
the players.
We're not too happy with Big Al. People can't afford to buy houses any
more. Prices of the properties begin to fall and people can't pay the rent
when they land on someone else's house. The game isn't fun any more.
We all look at Big Al. "This isn't fun any more",
we say angrily. " We don't know if you should be banker any more!" But Big Al likes being banker. He likes wearing the stately blue suit that
comes with the position. "I am happy with the slowing trend in the
Monopoly economy", he says in his monotone. "I feel
that looser monetary conditions would be more appropriate". He then
hands out twice as much money as we had at the start of the game. Things move
faster. Players can afford to buy houses and pay rent. The price of properties
go up.
"Big Al", we say. "You can be banker
any time you like!" |
Money matters at the extremes
The actual conduct of monetary policy is not that far removed from our
simple game of Monopoly. There is almost universal agreement on the effects of
monetary policy at the extremes. More money means higher inflation and interest
rates and less money means lower inflation and interest rates. Take the runaway
printing presses of the Weimar Republic, or Germany in between the First and
Second World War.
Given the political and economic turmoil in Germany in the 1920s and early
1930s, an almost limitless supply of money was printed. Severe inflation or "hyperinflation"
resulted as the mark rapidly lost its value. All goods and services increased
in value compared to worthless paper currency. Germans had to take
wheelbarrow loads of marks into their stores to buy loaves of bread. Interest
rates soared as investors tried to protect the rapidly declining value of their
marks. People on fixed incomes were impoverished as their incomes were stagnant
in the face of rapidly increasing prices. This experience with hyperinflation is
the reason why the Bundesbank, the German central bank, keeps such a tight rein
on German money supply and inflation to this day.
This story of rapidly growing money supply and hyperinflation has been
repeated many times and is currently the case in the former communist countries
of Eastern Europe like Russia and Poland as well as Brazil. On a happier note,
those countries with high levels of inflation that severely restricted monetary
growth have had their inflation rates drop substantially. This has been the
case in Chile and Argentina, formerly high inflation countries with much lower
rates of inflation with moderate money supply.
What is not so clear is the conduct of monetary policy in non-extreme
situations. In a modern industrial society, it is not obvious what appropriate
monetary policy necessarily is or even what constitutes money and credit. Money
and credit are the very things that monetary policy seeks to control, yet
defining these or even determining their levels is a very difficult task.
What is money supply?
Compared to the simple and obvious money in our monopoly game, there is
considerable argument and confusion over what currently constitutes "money
supply" and what the growth rate of the various aggregates really means.
Economists define money supply according to a liquidity standard, how easily
available the forms of money are. The traditional "narrow" form of
money is called M1 and includes currency, bank deposits, and short term savings
accounts. As modern economies developed new forms of deposits and financial
instruments these were added to a "broader" money supply "aggregates"
called M2 and M3, which include things like money market mutual funds and "sweep"
accounts. Some economists are even adding in stock and bond mutual funds, which
they argue can be spent or used practically on demand, for a measure they call
"MZM".
Monetary aggregates can grow at very different rates and can be taken to
mean very different things. Those with an economic axe to grind can find very
different statistics supporting their viewpoints by selecting their favourite
monetary aggregate as "money supply". In the United States presently
(April 1997), M1 is actually shrinking dramatically, which in years gone by
would have been the precursor to a severe recession. This is due in large part
to the development of money market "sweep" accounts by the banking
industry. Rather than letting money stay in low interest accounts over night,
banks are electronically "sweeping" these funds into special "sweep
accounts" that pay interest based on Treasury Bill interest rates. When
the funds are taken out of the normal accounts, they no longer appear in M1.
When the "sweep account" monies are added back to M1, it shows a
reasonable level of growth. At the same time that unadjusted M1 has been
dropping dramatically, M2 is showing strong growth. Since M2 includes longer
term deposits, which fund lending activity, this could be a sign of monetary
strength which is reflected in high credit growth statistics. Those forecasting
and hoping for a recession, which would bring lower inflation and interest
rates, point to the weakness in M1. Those arguing that the economy is strong
and will inevitably lead to higher inflation and interest rates point to the
stronger growth in M2. The argument won't be "over until it's over",
but it's this argument over the various measures and their interpretation that
leads to investors to throw in the towel and claim that "money doesn't
matter any more".
Now that Mr. Greenspan has thrown his vote towards the "strong
growth/inflation" camp with his 1/4% increase in the Fed Funds rate, we
know that money growth will be purposefully reduced by the Fed to slow the
economy down. Tired of arguing about monetary aggregates, our experts can
debate the timing, implementation and effects of monetary policy. These
arguments basically break down into two camps concerning the "transmission
mechanism" of monetary policy:
- those who believe that it is the level of interest rates that directly
affects economic activity. As rates rise, people making economic decisions
reduce investment and spending as credit becomes more expensive. It is the
actual interest rate increases that matter, not the change in money supply which
is just the manner to change interest rates. This is a "Keynesian"
argument, although most making it don't realize the genesis of their ideas; and
- those who believe that it is actually physical supply of money that
changes the availability of credit and money and makes it harder to conduct
economic activity. The actual quantity of money is their important
variable leading to the term "quantity theory of money". This is the "Monetarist"
argument.
Both Keynesians and Monetarists believe in the effectiveness of monetary
policy. Where they differ is in how it effects the economy. The Keynesians
believe in a smoother world, where interest rates act as a thermostat of sorts.
The central bank sets the interest rate thermostat to a certain level by
manipulating money supply and the economy adjusts its temperature accordingly.
The Monetarists live in a more discontinuous world, where the change in money
supply actually directly affects economic activity by making it harder to find
the money to make loans or spend.
What's all this mean for my precious portfolio, you might ask. It's simple
if you're a believer and this bond manager falls squarely into the monetarist
camp. Think of the monopoly game. More money means happier players. Less money
means unhappy players. If the economy is the total value of all goods and
services produced or alternatively all income paid, less money available will
obviously mean a reduced economic activity.
The withdrawal of the monetary tide also means less money and credit, lower
cashflows and lower asset values. There's not enough money at the best of times
to pay for the supposed value of all assets, both financial and real. Any of
the monetary aggregates is dwarfed by the sheer magnitude of the total value of
investments or the economy. Asset values can expand when the underlying money
supply is on the way up, but will collapse if they're used to their constant fix
of strong money creation. The markets suffering monetary denial are in the
delirium and tremens of valuation withdrawal.
"Financial panics" are recessions by an
older name
Think of the terms we use. "Credit crunch" and "overextension"
are good examples. At the height of the Japanese monetary boom in the late
1980s, a few parcels of land in downtown Tokyo were supposedly worth more than
the entire U.S. economy. When the tide of Japanese money creation receded, real
estate and stock market values have plunged and stayed down ever since. The
Japanese are only now rapidly expanding their money supply, in the hopes of
staving off the effects of collapsing asset values on their frail banking
system. Before the development of modern national accounting, which created
the whole concept of Gross National Product or "GNP" (the dollar
value of all goods and services produced by a country) as "the economy"
we referred to economic setbacks as "financial panics". No neat and
tidy concepts such as the current "two quarters of negative real growth".
Real pit of the stomach, sweaty, blind fear. Of losing asset value. Everyone
for one's self.
You'll be hearing lots of commentary on the positives of monetary
tightening in the months ahead. That it means eventual lower inflation and
should therefore increase stock and bond values. That it ensures a continued
recovery. That long rates will decline even though short rates will rise.
You'll know better. Less money will not be good for financial asset values.
We heard the same arguments in early 1994 just after the Fed tightened. By the
end, we had 30% declines in the value of long term bonds in both the U.S. and
Canada and steep setbacks in both stock markets. Sure we'll get to the other
side of the monetary hill, but we've probably got a long, hard and terrifying
climb ahead of us. Forewarned, you'll be prepared when there is no hope on the
horizon. Knowing that eventually money supply will expand once again, you will
hold on to your long-term assets against the terrifying market retreat that
seems set never to end. You'll also be ready to deploy your short-term money
into very cheap stocks and bonds when no one else is buying. |