Wednesday, October 7, 2009

Let's follow the Aussies, please

Australia's central bank earlier this week surprised the industrialized world by raising its target interest rate—they were the first major central bank to effectively declare an end to the financial crisis that plunged the global economy into recession in 2008. Australia already had by far the highest target rate of any of the major industrialized economies, with the next highest being the ECB with a 1% target rate, followed by the Bank of England with 0.5%, Canada with 0.5%, and the Fed with 0.25%

Meanwhile, our Federal Reserve has gone to great lengths to assure the world that short-term interest rates will stay very low for a very long time. The Fed worries that raising rates too soon might jeopardize what many view as a fragile and tentative recovery.

The Aussies, by contrast, have taken the bull by the horns, as it were, and raised rates. This proved to be good for the stock market, and good for the currency. Note in the first chart that the Aussie central bank first decided to stop following the Fed's lead in 2002, by raising rates instead of lowering them. They have subsequently kept their rates higher than ours consistently. As a result, as the second chart makes clear, the Aussie dollar has appreciated by an almost unbelievable 80% against the U.S. dollar. Australia has kept its interest rate higher, and for much longer, than the U.S., and as a result its currency has surged. And with its latest move, the Aussie central bank has once again asserted its independence of political considerations, preferring to protect the value of its currency above all else.

As a supply-sider, I believe that a strong currency is always better than a weak currency. Strong currencies are strong because a) they are well-managed by their central bank, and b) the world's investors have confidence in them. It's a supply and demand thing: the central bank is cautious about supplying its currency to the world (which usually means keeping interest rates a little higher than might be called for by the politicians), and investors and corporations that use the currency prefer to hold it instead of weaker currencies because they trust the central bank and they like the prospects for the currency's economy, both political and economic. Strong currencies are like magnets for investment (as is anything that consistently holds its value), and because they attract investment that helps keep them strong. Lots of investment means a productive workforce, a growing economy, and rising standards of living. It's a win-win for everyone.

So I have one request of Mr. Bernanke: won't you please follow the lead of the Australian central bank? Higher interest rates are not always bad, and in fact they can be very good. If the Australian economy and currency can cheer an interest rate of 3.25%, surely the U.S. economy can support a much higher rate than we currently have. Artificially low interest rates are a fool's game in the end, since they only weaken a currency and discourage investment.


REW said...


Thanks for your many brilliant postings. As a supply-side proponent (I am self-taught by reading Jude Wanniski) I second your comments about a strong dollar. I would only caution, as Jude would, that manipulation of the Fed Funds rate is a poor tool for monetary policy. I agree we should encourage the Fed (and the entire administration) to support a stronger dollar, but encouraging the use of a broken mechanism is short sighted. Sooner or later, the Fed will raise rates too high or cut them too far again. The interest rate lever goes hand in hand with Phillips Curve thinking and needs to be abandoned.
Please keep up the great work.

Public Library said...


Good piece over at Calculate Risk about the housing tax credit.

I think there is hardly any doubt speculation funded by the FHA has exploded like wildfires.

But much like the cash for clunkers program, the post credit fallout could ignite another down leg in housing similar to the pulled demand from autos.

The biggest problem will be the ability of the FHA borrowers to absorb another down leg in prices or hiccup in the economy.

The FHA only requires 3.5% down and does not look at credit quality. On top of that, the FHA is already under water and their loan portfolio is deteriorating.

I know you are recommending real estate with reckless abandon but this story is far from playing itself out.


The tax credit is simply motivating some renters to become homeowners (not reducing the overall number of excess housing units). This is pushing up the vacancy rent, pushing down rents and leading to more commercial real estate (CRE) defaults and foreclosures - and will lead to more losses for lenders. The additional defaults associated with lower rents will probably be higher than the cost of the tax credit. From the WSJ: Fed Frets About Commercial Real Estate

# Motivating some renters to become homeowners has increased demand at the low end and pushed up house prices (more demand). However when the tax credit eventually ends (it will someday), the price-to-rent ratio will equalize, applying downward pressure on home prices.

# Many of the additional sales in 2009 were to buyers who used the tax credit as their downpayment. These were marginal buyers who haven't proven the ability to manage their finances and save for a down payment. The default rates will probably be higher for these buyers than for other buyers.

# The housing tax credit raises the risk of deflation. Falling rents will probably already push core CPI close to zero in 2010. An extension of the housing tax credit will probably push rents down further (as those 383,000 additional home buyers move from renting to owning), and that will probably mean core CPI will be negative in 2010. Not only will this impact any program adjusted by CPI (like Social Security), but this could lead to a deflationary mentality for consumers - with consumers holding off purchases waiting for lower prices.

Scott Grannis said...

REW: I had many arguments with Jude about this. My point was that yes, using an interest rate target is not the best way to manage monetary policy or keep the currency strong. It's fraught with problems. But trying to get the Fed to change that is probably next to impossible. The Fed could use its interest rate tool in the context of a gold standard, could it not? Specify its targets, such as a range for gold and commodity prices, and then raise or lower rates depending on how prices vary relative to their targets. Why wouldn't that work?

Scott Grannis said...

Public: I'm aware of all the criticisms of the FHA, but I think they may be exaggerated. FHA Commissioner David Stevens had a very interesting letter to the editor in yesterday's WSJ which makes some legitimate points that are overlooked by critics. My point has been that insuring new loans at today's much lower housing prices is far less risky than the same activity was a few years ago. Underwriting standards are tougher today, prices are lower, and interest rates are lower. The risks therefore are lower. And if the Fed succeeds in creating just a little bit of inflation, the FHA's balance sheet is going to look pretty solid.

Jay Norman said...

To change the subject a bit, do you have any thoughts about why the shares of gold mining comapanies are lagging way behind the metals. These companies have a great deal of wealth underground. As always, thank you,


Scott Grannis said...

Jay: I'm not an expert on gold vs. gold stocks, so I can't answer your question. A good, supply-side, and investor-focused friend of mine, Michael Churchill, does have an answer however:

"In reality, only some gold companies are cheap relative to the gold price. Others are expensive. Goldcorp, Barrick, et al are not interesting, even at $1,055/oz. gold. They are still probably trading at 25x earnings. Even many of the mid-tiers such as Minefinders, Jaguar and Northgate have gotten somewhat pricey and are no longer interesting.

Where the real value lies now is in the juniors. There are dozens of companies out there with defined, NI 43-101 compliant resources of 1 million to 10 million ounces that are trading for $6-25/oz. in the ground. That compares to $250-450/oz. in the ground for the majors. This is where the opportunity lies. A couple weeks ago I did an interesting exercise: I went through about 60 gold-specific company Powerpoint presentations. I then pulled off 10 that I found interesting, sent questions to managements and followed up with phone calls. From the list I identified four juniors that I thought were particularly attractive (all with sub-$100 million market caps).

That’s pretty much what you have to do to find winners, I think – plow through company after company to find the cheap ones with good stories. Even at $1,055/oz. gold plenty of gold stocks are rather a yawn here …"

Here is his website:

REW said...

Thanks for the follow up. I do agree: A gold price target, addressed via FFR machinations would be much better than our current mess.

Jay Norman said...

Scott:I appreciate the info on gold. Thank you, Jay

Public Library said...


I think you seriously overestimate the FHA's ability to manage credit quality.

As I have said before, a friend of mine with TERRIBLE credit got a 3% down 400 dollar loan for purchase of a condo in Dana Point, CA.

Through the FHA, anyone can qualify so long as they have income coming in ...