The Fed’s ‘Hotel California’ Problem

The Liberal Democratic party’s election victory in Japan has given equity bulls something to cheer about the start of this final full trading week of 2012, as has news that the Chinese government is scrapping the US$1 billion ceiling on investments into China by foreign sovereign wealth funds and central banks. Chinese regulators hope that this move will encourage investment in Chinese shares (down 60% from their November 2007 highs), though funds will still have to make an application to invest over $1bn. As Reuters notes, currently around just 1% of Chinese market capitalisation is accounted for by foreign investment.

Shinzo Abe’s election victory in Japan is piling pressure on the yen, which is now down to 20-month lows. Abe is calling on the Bank of Japan to “act this week” – by which he means print more yen in an effort to weaken it, and so help Japanese exporters. Given Abe’s determination on this, it’s looking bullish for gold priced in yen.

Across the Pacific, Dallas Federal Reserve President Richard Fisher made an interesting observation last Friday about the problem the Fed faces when it tries to exit from its “accommodating” monetary policy. In his words: “We are at risk of what I call a ‘Hotel California’ monetary policy, referring to the Eagles’ song, where we can check out any time we want from this programme, but we can never leave”.

As Robert Wenzel comments, this is because currently around $1.4 trillion of bank money is sitting at the Fed in the form of “excess reserves,” reserves that earn just 0.25%. Any effort to prevent dramatic inflation in the event that banks start lending these funds out could mean a dramatic rise in market interest rates – and thus another serious crisis.

Thus the problem with unconventional monetary policy: unconventional problems.