In financial circles, discussion about the economy often is between people who believe that the federal reserve bank has power to control interest rates and inflation.

Arguments revolve around how fast the Fed should raise rates so as to hold down inflation without choking off business recovery.

For many, it is comforting to assume that the Fed actually determines interest rates and inflation and that the only question is how it should use this power. This reassures the nation that the government is in control.

The Federal Reserve really has power to manage bank interest rates, since banks are subject to the command of the Central Banker.

When the Fed tells bankers to jump, they ask, “How high?”

Bankers are intermediaries in the money game, buying from one side to sell to the other. Their goal is to maximize the spread between two rates — the rates themselves are indifferent. In whatever direction the Fed asks them to adjust rates, they arrange to modify spreads accordingly.

The degree to which banks profit from interest rate changes is suggested by the “savings” line in the commercial bank flow of funds table (”savings” are economist jargon for “profits”).

However, commercial banks are not usually the leading players in bond markets. In Q2 2004, commercial banks absorbed relatively minor percentages of new bond issues:

1. Treasury bonds …0.1%
2. Corporate bonds .. -6.4%
3. Agency bonds … . 14.9%

If commercial banks were not controlling players in the bond markets, who was? In Q2 2004 it was foreign investors and life insurance companies. These sectors absorbed commanding percentages of new bond issues:

                        Foreigners          Insurers
 Treasury bonds            92.0%               1.3%
 Corporate bonds           55.1%              41.4%
 Agency bonds              49.7%              10.6%

In other words, in Q2 2004, foreign investors and life insurance companies took up 96.5% of corporate bond issues, 93.3% of Treasury bond issues, and 60.3% of agency issues.

Insurance companies bought bonds because clients gave them pension money to invest. The amount they invested was based on demographics, pension laws, and past agreements with workers. Insurance companies could invest in bonds, in cash, in equities, or in other assets. The Federal Reserve had little control over what insurance companies could do. Insurance companies are controlled by state, not federal government.

The Federal Reserve has even less control over foreign investors.

In Q2 2004, if foreign investors did not have dollars to invest, there would have been no way that the Federal Reserve could have kept down interest rates and inflation.

The American public was simply not saving enough to absorb deficits that resulted from government spending. The volume of Treasury bonds needed to cover the deficit, without the savings of foreigners, would have driven interest rates through the roof. On the other hand, if the government had tried not to sell Treasuries, issuing money instead, inflation would have spiraled and other bond issuers would have had to pay higher interest to keep investors (like insurance companies) from buying bonds overseas.

The basic motivation of foreign investors was simply to invest money accumulated from selling more goods and services to the U.S. than Americans purchased abroad. Since most of this trading was contracted in dollars, foreigners accumulated dollars. Their motivation was not to buy U.S. bonds, but rather to stock up on the most prestigious international trading currency.

The “dollar franchise ” goes back generations and is based on American industrial and military supremacy in the first half of the 20th century. Since no major country has a currency backed by gold, the prestige of the United States as the super power, with a sound economy and more than two hundred years of political stability creates a competitive advantage for dollars that no other currency can match.

However, the Federal Reserve has little to say about the balance of trade. This is determined by Congress in setting minimum wages, determining rights of labor unions and workers, coddling tort lawyers, and on a federal bureaucracy the spawns millions of regulations controlling domestic industry. None of this can be influenced by the Federal Reserve Board, even through “moral suasion”.

Therefore, during 2002 and 2003, what we should have been watching was not the antics of the Federal Reserve (which mainly influence commercial banks), but the trade deficit, the fiscal deficit, and the position of the dollar abroad.

The Federal Reserve was able to keep interest rates down, while selling record volumes of Treasuries, because foreigners had made the decision to acquire dollars well before the Fed had jiggled bank interest rates. If there was no trade deficit and the government had tried to attract new investment dollars from abroad to absorb these large issues of Treasury bonds, the government would have been forced to raise interest rates.

In this discussion, the basic principles of Capital Flow Analysis come into play.

We need to know the motivation of the foreign investors and the life insurance companies.

It makes a difference whether foreign money comes from the trade deficit or from portfolio investors. The relative size of new funds that each sector has to invest in bonds is extremely important. We may also presume that the motivation of issuers of bonds is dominant over that of buyers.

In determining the motivation of the government in selling Treasury bonds and of foreign investors in buying them, it is important to keep the sequence and timing of events in mind:

Steps leading to the issuance of Treasury bonds

1. The American people elect representatives that promise to give them jobs and free benefits;
2. The representatives of the people enact laws that increase the size of government and government benefits, generally on a permanent basis;
3. An extraordinary event occurs, like a war or natural disaster, that causes the representatives of the people to spend more money than is raised by taxation;
4. The government, in order to avoid raising taxes or inflating the currency, (both actions that could lead to removal from office) decides to issue Treasury bonds to finance the deficit.

Steps leading to the foreign trade deficit

1. A supplier in a foreign country wants to sell goods to a buyer in the United States in order to make use of excess plant capacity, cover fixed overhead, and generate profits. This motivation is backed by the foreign government that also wants to accumulate dollars and a trade surplus to get good marks with the IMF and the World Bank.
2. The American buyer prefers to pay in U.S. dollars to avoid exchange risk.
3. There is competition among sellers and if the foreign manufacturer does not bill in dollars, the buyer may choose another supplier. However, the foreign manufacturer wants to receive dollars because it is a more valued currency than that of the exporter’s country and because bank loans used to finance the transactions are denominated in dollars. Furthermore, by selling in dollars, the exporter can arrange to keep part of the profits offshore, away from local tax authorities.
4. From the point of view of importer and exporter, the choice of dollars as the trade currency is a “win-win proposition”.
5. After the trade is settled, the foreign exporter has a dollar account in a U.S. bank. Over time, the ownership of these dollars changes, through trading on the foreign exchange market. Eventually, some of these dollars end up in the hands of foreign central banks and investors. These dollars can be traded but not destroyed. They can either end up owned by Americans (by purchasing goods or services from the United States) or may roll around indefinitely in the hands of foreigners.
6. The foreign owners of these dollars will seek out appropriate investments. Generally, the leading contenders for this money will be the U.S. Treasury, the issuers of Agency bonds, and investment grade corporate bonds. When the Fed forces banks to lower interest rates, this raises the competitive advantage of fixed income securities, but does nothing to alter the volume of dollars already owned by foreigners and seeking the best return within the dollar bond market.

This sequence shows that although the Fed can alter the rates of bank deposits relative to the bond market, it can do little to alter the volume of dollar funds available as foreign savings.

This has been determined years, even generations ago by long historical and sociological processes.

This entry was posted on Saturday, October 30th, 2004 at 9:42 am and is filed under Treasuries, Open Market. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

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