Monday, December 27, 2010

An overview of the fall of 2010- for the Fed and China

The recent history of monetary policy in the U.S. and China were reviewed in two WSJ articles today.  These articles basically gave the answers to two questions on my fall final exam.

Starting with the article on the U.S.:

Summary: In November, the Fed went on another buying spree known as QE2 (quantitive easing 2).  This time around the Fed is buying more long term U.S.securities. The Fed's goal is to bring down long term interest rates to spur investing and spending.

However, 10 year Treasury yields reached their current 52 week low in Oct 2010 (at 2.33%) in expectation of the program, and have been trending up ever since. The 10 year Treasury opened at 3.4% today (12-27-2010).

Why did rates go up - exactly opposite of the Fed's goal? One possible explanation is that people think there will be much more inflation in the future, so they will pay less today for an IOU for a future amount (i.e. rate goes up). Another possible explanation is that fewer people want to buy U.S. long term securities right now - other investments are starting to look better (fewer buyers leads to lower price of bond, i.e. rate goes up).

It is easy to read too much into the recent movement in long term rate; rates are still at historically low levels, and would probably be higher had the Fed not acted.

So what did the Fed accomplish? According to the article, fears of deflation are falling - but some now fear inflation.  Evidence does not suggest inflation will be a problem any time soon, but perception matters. The Fed is paying a heavy price politically - and not just to domestic doubters.

Which leads us to international doubters:

WSJ 12-27-2010 "China Says It Can Subdue Prices" by Jason Dean

Summary: China is struggling with rising prices, particularly for food and housing. As a result they are raising interest rates and banks' ratio of reserves to deposits (reserves = cash which can't be lent out). China's goal is to slow down borrowing and growth - and hence prices.

An extra challenge for China is that they are raising rates while the U.S. is trying to lower them. This draws more investment funds or "hot money" into China. All those investors buying yuan to invest in China puts upward pressure on the yuan.  However, China is reluctant to let the yuan strengthen because its goods would then cost more in the U.S., and its exports would decline.

From Dean, "Chinese officials have openly criticized the Fed's quantitative easing, in part because they say it burdens emerging economies with potentially excessive capital inflows that could fuel inflation."

China may impose capital controls to keep "hot money" out and to make it easier for China to maintain the current yuan exchange rate. The article does not delve into which capital controls China is likely to impose but possibilities include: transaction taxes, exchange controls (limits on quantity of currency that can be exchanged), and controls on purchases of various financial assets.

Capital controls used to be frowned on by mainstream economists, but after the Asian crisis there is a begrudging consensus that capital controls may be a valid policy tool in some situations.

From Dean, the official inflation target rate in China has been raised from 3% for 2010 to 4% for 2011.

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