Makin, Mischief, and Central Banks

John Makin provided a scathing assessment of the Fed and the Bank of Japan in the weekend edition of the Wall Street Journal. His criticism titled “Monetary Mischief” was focused on the raising of interest rates in Japan with inflation being at approximately zero and with the Fed not raising interest rates with inflation above the suggested target of 1-2%. Wile his criticism is well taken for those who believe that central banks should only worry about inflation and inflation targeting, it misses the point that central banks have multiple objectives. For those who have to forecast interest rates and central bank behavior, understanding the competing demands of the central bank is essential to any analysis. This positive view makes no value judgment concerning central bank behavior only an analysis of what will occur and what are the implications.

The Bank of Japan is currently worried about exchange rates and external effects. Raising interest rates from 25 to 50 bps will not change the overall easy money stance of the BOJ. Granted, reserve growth have fallen, but even with a euroyen rate at 50 bps and inflation at zero, the real euroyen rate is below the current long-term growth rate for the Japanese economy. Real rates are less than one percent with growth showing some signs of strength. A rate raise sends a signal that loose monetary conditions will not be tolerated forever and provides a reason for exchange rate changes to be less one-sided. Central bank policy fears concerning exchange rates are often focused on creating liquid two-sided market which are not subject to excessive swings. This is consistent with the longer-term goals of the G7 finance ministers. The increase is rates in Japan albeit small is a signal that the exchange rate will not be tolerated to move to extreme low levels. There is limited harm with the BOJ’s actions and it at least temporally restores some balance in the global markets.

The lack of Fed action at their last meeting only tells the market that the Fed is willing to delay further increases in interest rates as they assess the recent economic information on housing. This makes sense given the strong declines in stocks associated with sub-prime lending and the issues with potential housing declines. The Fed has a clear requirement to look beyond inflation regardless of the talk from many hawkish Fed presidents. There will be enough information over the next quarter for the Fed to reassess their current position. Is the Fed providing a “Bernanke put” on the housing market? Hard to say, but a postponement in raising rates is a premature signal.