"As I have already suggested, the rapid pace of financial innovation in the United States has been an important reason for the instability of the relationships between monetary aggregates and other macroeconomic variables.14 In response to regulatory changes and technological progress, U.S. banks have created new kinds of accounts and added features to existing accounts. More broadly, payments technologies and practices have changed substantially over the past few decades, and innovations (such as Internet banking) continue. As a result, patterns of usage of different types of transactions accounts have at times shifted rapidly and unpredictably.
Various special factors have also contributed to the observed instability. For example, between one-half and two-thirds of U.S. currency is held abroad. As a consequence, cross-border currency flows, which can be estimated only imprecisely, may lead to sharp changes in currency outstanding and in the monetary base that are largely unrelated to domestic conditions.15, 16"
As if to underscore this point, we got John Authers' Short View Column in today's Financial Times on "Tracking Bank of Japan"(subscription needed). Here he writes about the role of the yen-carry trade, the Japanese Central Bank and global liquidity.
"The question arises because much money is now riding on what is known as the “yen carry trade” – borrowing money in yen, where the BoJ’s base rates are still only 0.25 per cent, and placing it in a much higher yielding currency, such as the New Zealand and Australian dollars.
You lose money only if the yen suddenly appreciates. That could quickly wipe out all your gains. But the weight of money making this bet has helped to keep the yen relatively cheap. Volatility, which hurts the carry trade, has also been remarkably low. It may also have contributed to excess liquidity – or a “bubble” to some – elsewhere in world markets, by providing a source of cheap money.
Tim Lee of pi Economics says carry trades are “at the heart” of the “current bizarre economic cycle”, and that “carry trade mania is a key factor in the weak yen”. Stephen Jen of Morgan Stanley argues that the evidence does not support this, and points out that of all global cross-border loans, only 5 per cent are yen-denominated.
But there is circumstantial evidence that the yen carry trade matters a lot. During the sharp world equity market correction in May this year, traders complained of a liquidity crunch. That correction coincided directly with a sharp appreciation of the yen, which moved in days from Y118 to Y110 to the dollar. This temporarily removed the carry trade. Liquidity has returned, and equities rallied once more, as the yen has slipped back towards Y120. This is consistent with the belief that the yen carry trade is the source of a global liquidity bubble.
The BoJ has reason to dislike carry trade activity. If next week’s Japanese GDP figures are as bad as some expect, then it may be difficult for the BoJ to raise rates straight away. But it is well to pay a lot of attention: little or no risk of a tightening by the end of the year is priced into the market. Judging by May’s experience, a surprise from the BoJ could knock over a lot of dominoes."
So, what is U.S. monetary policy?
The globalization of money and credit has apparently confined policy to divining a rate that sustains the Fed's anti-inflation credibility yet maintains growth while letting everyone in on the plan. Policy has gone from a gold standard to monetary growth targets to "trust me, we know the right rate". The groundwork for this trust in today's Fed comes from when Volcker reestablished central bank credibility by essentially setting reserve growth and then allowing the market to decide the level of Fed funds. Believing we know the right rate to meet growth and inflation targets, especially in a world of free flowing capital and goods, is the kind of hubris that got us to needing Volcker in the first place.