On 21st Dec 2008, I predicted that the Fed would find it very difficult to reverse its monetary expansion once it had repaired the many punctures of the previous asset bubble. Yesterday's announcement by the Fed partly vindicates my fears but it appears the Fed believes those punctures are not fully repaired. Extraordinary loose monetary policy continues to be the order of the day. Whether this will, as Mr Buffet fears, and as I suggested 18 months ago, result in runaway inflation, only time will tell. My suspicion is high unemployment will delay that eventuality but the Fed will delay a reversal of loose money for even longer.
Inflation aside, there is a bigger problem with the loose monetary policy pursued by many of the world's central banks. Particularly those that seem to have redefined the meaning of "persistent" as has Mr King on behalf of the BOE. There seems to be a somewhat tautological feat being performed by these central banks in keeping monetary policy extraordinary loose as a means for reversing the pain caused by monetary policy which was loose prior to the crash. I suspect monetarism behaves in an unpredictable and non-linear manner when the cost of money reaches levels below classical dimensions as they have today. Just at with physics, some "quantum" effects must come into play which makes loose money not nearly as effective as Mr Bernanke and Mr King seem to believe. One such quantum effect is the behaviour of the consumer as suggested by classical economics. Monetary policy seems to predict that there is a clear trade-off between savings and consumption and that consumption is favoured over savings when interest rates are low. This may not necessarily be the case when the cost of money is hovering just above 0. Ultra-low rates may actually cause the perverse outcome of reducing consumption and increasing savings. This can occur when you consider the vast majority of savers still rely on short term interest rates to provide supplementary income through bank deposits and money markets. When rates are this low they may have to save more to offset the decline in rates. In addition at very low rates, loan spreads to deposits also tend to increase, and banks make hay, thereby compounding the pain to your typical saver who also has liabilities such as mortgages. The "quantum" behaviour of money therefore may actually cause much greater unpredictability in consumer behaviour and help to promote perversely a much a longer period of deflation. Quite the opposite of what central banks are seeking to achieve. How else do you explain the combination of near zero rates in Japan and the lost two decades?
The massive distortion of price of risk assets by the central banks also supports the very wealthy who own the majority of financial assets and also have the ability to invest through far more sophisticated tools than bank deposits. Arguably they have much bigger saving buffers in any case.
Time for central banks to rethink monetary policy and return to more normal interest rates?