Debt and wealth in a monetary system, part 2: discounted valuation issues in a declining frame with inequalities.

We are presently building up conflicts within the asset price frame:

  • Conflicts between asset values and GDP flows and their growth rates;
  • Between asset prices and return expectations;
  • Between human capital values and the distribution of those values and their impact on the overall wealth equation with respect to future consumption risks as well as asset pricing via increased asset focus of flows due to distribution dynamics;
  • Within portfolio structure and relative to the liquidity and capital security dynamics of liability streams. 

All of this tied to the relationship between frame transitions, emergent properties and structural imbalances and unconventional monetary policy focused overly on asset price support.

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Are debt and wealth really two separate forces in a monetary system? Part 1

I write with reference to a discussion in a recent Bloomberg View article, We’re Still Not Sure What Causes Big Recessions.

Debt/broad money supply is a key foundation of asset and human capital values and their supporting GDP flows.  Because of this, wealth and debt effects (new loans create deposits) on GDP/income flows should not be considered as separate forces. 

Debt in its money supply origination (bank deposits) is a foundation of both GDP flows and asset values and it is when debt, and specifically in the form defined, increases relative to GDP/national income flows that we should pay attention.  And we need to pay attention to all flows, not just income flows on risky assets, for example corporate profits which can squeeze out returns on both fixed interest and human capital during periods of enforced low interest rate policy.

Money leverages many activities, and asset values are always to a certain extent in a form of a bubble, but excess leverage, especially during periods where we have structural imbalances and frame transitions creates instability and risks to the financial system. 

Frame transitions that we need to watch out for with respect to excess asset focused money supply growth are where drivers of GDP growth are in decline (labour and population demographics, productivity and global transitions impacting the same) requiring lower levels of capital or growth rates of capital accumulation resulting in increasing levels of capital depreciation.  In this context monetary frame dynamics should also be contracting or slowing.  Frame transitions can be accentuated by increasing income and wealth inequality, something that may also be an emergent property of economic systems during frame transitions.   This can also leverage asset prices to prospective GDP flows.

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Helicopter drops: feeding the animals in order to keep the zoo in business..

I was reading “Helicopter drops might not be far away” by Martin Wolf in the FT.  By now those interested in macro economics/monetary policy/asset markets should be well aware of the long gradual easing in interest rates, especially since the 1990s.  Lower interest rates did not just encourage people to borrow for consumption, but they also boosted the amount of borrowing for asset purchases with rising asset values also looping back into consumption for a while.   During this period, global money supply growth also became ever more asset focussed. 

For a while this helped stimulate consumption in key economies, also aiding in developing economy growth.   Developed economy consumers became ever more indebted at a time when income growth was also slowing, but given that asset markets kept rising and interest costs kept falling, everything was able “to keep on going for a while”…many felt that this period of low interest rates and rising asset markets was a “great moderation” and few seemed to notice the enveloping divergence. 

While the financial crisis was the bursting of this particular reality, it also marked the onset of a period of unprecedented financial engineering in response, itself a denial of that reality. 

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Interest rates their models and interest rate policy

The natural rate of interest and its determination, especially with respect to when and how the Fed and other world central banks should raise interest rates, is a hotly debated topic.  Many suggest that the only way to get back to trend GDP growth is to push interest rates below ZERO, into negative space, and/or to raise inflationary expectations.

The trouble, as I see it, is that the models used to determine the natural rate, or what the current policy rate should be, focus almost entirely on equilibrium concepts and a restricted set of difficult to define inputs, and can therefore miss key turning points in the domestic and global economic frame.   These are after all, in most cases, simple rule of thumb models. 

From a brief consideration of the subject and given my own historical stance with regard to key developing structural imbalances, I have the following simple propositions on the natural rate/negative interest rate debate

  • Natural Interest Rate models ignore accumulated financial and structural economic imbalances, imbalances that are also likely occasioned and accentuated by transitions and policy responses to those transitions.  Importantly the build up phase (excess) can raise growth (note US consumer debt/consumption expenditure) and mask changes in trend, while the build up itself can serve to push growth lower post crystallisation.  Additionally, point in time models are insensitive to the impact of the power of compound errors: policy that miss changes in trend and accommodate divergence from trend can last as know some time.
  • At critical turning points IR policy may ignore transitions and accumulating imbalances and risks creating significant divergences between the financial and the economic that collapse back through the core financial system as we saw in 2008/2009.  In this case, a deceleration in growth may be viewed as a below trend growth phase (for whatever reason) with policy lowering rates: note the increase in debt and debt relative to income and GDP growth in recent times.   Outsize increases in debt due to lax monetary policy may also impact global structure.
  • The financial and economic shocks that arise from this insensitive IR policy feed back into GDP and key relationships with negative consequences.   Imbalances are accentuated and transition dynamics ignored.  For example a transition to lower growth due to issues of frame may end resulting in a crisis of frame.  
  • The big question is how does IR policy fit into the big picture when we have transitions and accumulating structural economic and financial imbalances not captured by models?  Which problem do we deal with, since we now have more than 1?

In a world of many transitions and imbalances there may be more than one interest rate: one to accommodate financial imbalances and preventing their adjustment in a lower growth frame; another to offset some of the many negative trends impacting growth (thereby risking further financial and structural economic imbalances); another that would better reflect the balance of factors in emergent growth dynamics of a given frame once imbalances had adjusted and transitions completed.   A lower IR is needed for the first 2, a higher for the latter.  Of course, at the moment, our tool box only affords room for one interest rate, so who are you going to throw to the dogs?  I guess the objective is to keep all rates aligned as close to each other as possible and to minimise intervention.

If we ignore imbalances and transitions and assume that deviations from a given trend growth in output are all temporary and due to excess of saving over investment and not any other argument, then we risk more of the same.   Accumulated monetary policy errors weigh on time and are not necessarily washed out by time.

The paradox of monetary policy: reducing IRs below the lower bound is a seriously flawed policy

What we are seeing is a misconstrued extenuation of policy applied to a once rising frame, and indeed it is plausible that we have been following a path of unconventional monetary policy for a much longer time.   What we thought were monetary shocks on the way up were merely reactions to divergences occasioned by overly aggressive expansion of money supply. 

In its recent World Economic Review the IMF nicely, if not completely, summarised many of the world’s economic issues.  One thing clearly communicated was that global economic growth is both slowing down and in transition and that this must have consequences for monetary policy. 

The world has become increasingly dependent on debt (principally new money supply growth originated debt and asset focussed MS’s velocity dynamic within the asset sphere) to finance consumption, investment (and increasingly to a much greater extent, financial leverage), and while this was fine as long as growth barrelled along, incomes rose and populations continued to grow, it all started to go pear shaped as the engine started to wobble.  Lower interest rates designed to encourage consumption and investment, and loan growth financing the two, did just that and more so: in fact one of the consequences of lower interest rates was to increase the asset focus of money supply growth; a secondary consequence was to provide a source of additional expenditure (US especially) via home equity lines of credit drawing off rising asset values, at least until 2007. 

An inversion of many of the factors that had at one time driven growth were reversing at precisely the same time that debt and debt financed consumption expenditure was rising (1990s) and this is well evidenced in Japan.  Well we all know what happened next, ultimately the 2007/2009 financial crisis, but also a string of financial wobbles along the way. 

Slowing growth and rising debt could not coexist within the rising interest rate environment of the mid 2000s and hence we arrived at 2007 and onwards.  In truth, declines in interest rates and growth rates, combined with rising debt, on a global basis, have created a veritable choke hold and “post much greater QE”, one with increasing volatility and sensitivity to changes in monetary flows.  The overall complex whole is full of transitional issues, and these are discussed at length in many previous posts: understanding these various strands impacting demand and supply, loan growth and structural imbalances both domestically and globally is important if you are to be able to translate the many competing nuanced arguments being expounded both for and against unconventional monetary and dare I say it fiscal policy.

That said, we have remained remarkably transfixed on the one size fits all monetary policy to drive growth forward, hoping that low interest rates will spur borrowing for consumption and investment and somewhat erroneously hoping that those with cash will spend it.  Ultimately we are hoping that QE will drive the animal spirits and re awake the growth of good times past.

In the typical economic model with its rationale agent, the agent would be focussed on maximising short and long term consumption/saving from a given income.  Changing interest rates and inflation assumptions would immediately impact key consumption/saving decisions, and so the balance of expenditure between consumption and investment/savings.  But agents on average are neither wholly rationale nor are resources (income and wealth) equitably spread.  Moreover, the resources available for consumption and expenditure are not necessarily constrained to income/capital, but extend to new bank originated loans. 

Indeed the accumulation of imperfect decisions and growing imbalances as well as emergent dynamics (deflating/inflating economic frames and the changes they bring to key economic relationships) can constrain the impact of IRs and money supply on natural adjustment mechanisms.  In other words simple models ignore the actual balance of factors and the impairment of those factors in terms of their sensitivity to policy tools such as interest rates.  

The problem is that as growth slows, the amount of new money supply growth (loan or QE originated) should also decelerate, something which has not really happened.   In a slowing growth environment (one that may be characterised by a declining economic frame: population growth, demographics, productivity, increasing income inequality) we become ever more dependent on a market’s balance and allocational efficiency, that is the relationship between productive capacity/asset and debt values to changes in supply and demand dynamics and the distribution of income/wealth needed to maintain an appropriate balance of consumption and investment in a frame as it transitions.

What we have been doing is increasing money supply growth as growth falters and falls, all the while accentuating many of the imbalances hindering necessary frame transitions.  This has raised debt/equity values as GDP and income growth slows, increasing the sensitivity of the markets and the financial system to growth and changes in growth and raising the latent size of associated future demand shocks.   The solution has been to continually lower interest rates and when interest rates have been as low as they can go to swap debt assets for newly created central bank money.  We now appear to be about to extend this sequence, by reducing interest rates below the lower bound.

What we appear to have confused are the one time solutions to recessions occasioned by monetary tightening, that is to reduce interest rates as activity declines, in expanding frames, to applying the same medicine for a declining growth/deflating frames.  The argument being that the recessions were caused by monetary shocks impacting demand and hence any demand deficiency can be dealt with by monetary stimulus: well, of course, monetary stimulus can of course influence demand, but not without creating imbalances between assets and their value and the frame and capacity, at times, and the growth rate of the frame.    

In short, we do not need more money supply growth as a frame deflates, but an adjustment of the capacity and related capital (debt/equity values) so as to minimise divergences between growth and capital, including debt and its many forms, and hence to minimise shocks to the financial and the economic re maintaining balance between the two.

What we are seeing is a misconstrued extenuation of policy applied to a rising frame, and indeed it is plausible that we have been following a path of unconventional monetary policy for a much longer time.   What we thought were monetary shocks on the way up were merely reactions to divergences occasioned by overly aggressive expansion of money supply. 

I personally feel that arguments to reduce interest rates below the zero bound are seriously flawed, but flaws themselves ingrained into the body economic and financial for too long for many to be able to differentiate the reality of the trajectory. 

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A brief “thought” on debt defaults, asset prices, MS velocity and consumption expenditure risks.

When a private non bank debt collapses the money supply itself is not impacted.  There is however a collateral impact on future expenditure and the velocity of money supply itself.

Asset values are extremely sensitive to portfolio cash allocations.  A given reduction in preferred cash holdings relative to other assets, all other things equal, raises asset prices by a much greater magnitude and vice versa. 

However not all transactions represent closed loops: a disposal of an asset for future consumption transfers asset focussed money supply to consumption focussed money supply.  With money also being transferred in to the asset portfolio the net impact on asset values of consumption related transactions tends to be much smaller.

A default in non bank debt, or loss of any asset, should therefore have an impact on future MS velocity and expenditure while also possibly increasing the asset focus of money supply (all else being equal).  In the event of default, assets/collateral are no longer available for sale in exchange for money for consumption expenditure purposes (and of course investment expenditure purposes) and the potential velocity of money supply falls, specifically with respect to consumption and possibly also with respect to assets. 

Likewise a fall in asset values, especially the significant declines seen in recent decades, also impacts expenditure and MS consumption focussed velocity. Typically asset price declines have been short lived and given the fact that marginal transfers out of the global asset portfolio for consumption purposes has tended to be small in % terms, the impact of price declines etc on expenditure has also historically been small – this is especially so where asset focussed money supply growth has been expanding, demand for assets have been expanding (+ve population growth and demographic dynamics), where there is increasing income inequality (less MS flows out of the asset portfolio etc), but much less so in the reverse scenario.  

QE on the other hand has tended to focus primarily on supporting the financial system and high quality assets with minimal risk of default.   Whether it impacts expenditure decisions depends on the liability profiles of asset holders in general.  In a world of increasing income and wealth inequality asset price support may have only declining marginal benefits for consumption expenditure even though the resulting increase in asset focussed MS has affected a much wider range of asset prices. 

QE and low interest rate policy may well have supported potential expenditure based relationship loops from assets to consumption via asset price support based solely on asset valuations (not re yields) but may also, via increased risk taking within the higher yield/shadow banking asset spectrum, have increased the consumption sensitivity of assets; higher yielding assets are likely to be more consumption sensitive than lower yielding equity type assets.  

QE and lower IRs may well have increased the exposure of consumption and possibly also investment expenditure to future asset price shocks via two routes:

Increased exposure to leveraged loans, emerging market debt, high yield bonds, collateralised debt/loan investments, “wealth management products” (China) etc, exposes future consumption expenditure to higher default based risks, especially in high debt/low growth environments.  This depends on the extent to which QE has pushed investors out of lower risk higher yielding assets into higher risk/relatively higher yielding assets and the changing composition of the market portfolio especially with respect to those investors exposed to higher future liability demands.

Higher asset prices in low growth environments with increasing debt to GDP ratios also exposes consumption and investment expenditure to greater asset price volatility: we have seen quite extreme fluctuations in asset prices since the late 1990s.  As populations age the sensitivity of expenditure to asset prices increase.

The issue of default and asset price shock is compounded by issues of liquidity, especially with regard to many shadow banking products that investors may confuse as being cash like and therefore exposed to greater liquidity risks in risk events.

It is probable given the higher debt to GDP ratios, slower growth profiles and the many transition risks in the global economy, that global asset price consumption risks are not insignificant.  Another reason to support asset prices, another reason for QE and negative IRs, but not necessarily a solution.

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I am not a fan of outsized monetary accommodation in a declining growth frame…but what can you do?

Irrespective, deflation is not the issue, but slowing growth within a complex frame over burdened with financial excess and key structural imbalances. 

A recent speech by Andy Haldane has kept the interest rate/zero lower bound debate “bubbling”.   In this speech, “How Low Can You Go”, Haldane broached the issue of monetary policy in the event of another demand shock.  He is quite right to do so since monetary policy would have little room for manoeuvre with interest rates only a scuff mark away from 0%.  His musings suggested getting rid of cash and bringing in negative rates.

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The China Crisis may be signalling the end of the “rationale” for zero lower bound asset price support.

I do not think that anyone really suspects that we are at the start of an aggressive tightening of interest rates by the Federal Reserve.   A 1/4 point increase in rates would be unlikely to do anything much to growth even at today’s relatively low rate of GDP growth.

In truth, the problems with GDP are not necessarily to do with interest rate costs in the sense that growth is not being held back by the cost of money.  Today’s low interest rates are here pretty much as part of an asset price support operation, as is QE.  The reason why they have remained so low, post 2008 (in the US at least), is because of the increasing importance of asset market stability (given debt levels) to the financial system in a low growth, post financial shock, environment.  

As such, interest rate and monetary policy have been supporting the asset price/GDP disconnect post the financial crisis on the assumption that the shock to growth was temporary and transitory.  Unfortunately the impact of the financial crisis on growth was neither, partly because debt levels were higher than could be supported by GDP growth pre crisis, but also because underlying growth, ex monetary/debt stimulus, was declining, for a number of reasons.

Post crisis, what we have had globally is an increase in debt levels, while pre crisis growth levels have not recovered.  The temporary asset price support operation has lasted longer than expected and has facilitated a further increase in asset focussed MS (increasing instability of the financial system), asset prices and asset focussed debt.

Do interest rates need to rise to prevent inflation surging ahead in the US economy? 

Wage growth remains weak and there does not appear to be material capacity constraints at any level.  The only real concern is rising consumer credit: consumer credit relative to income growth, especially non revolving credit, has been rising at historically high levels post crisis.  This hearkens back to fundamental issues in the structure and distribution of key growth drivers that are independent of interest rate factors. 

Low interest rates/QE have enabled further divergence between assets and debt and GDP and income growth, something that I do not believe was originally intended by Fed monetary policy.   The key decision factor for the Fed is not whether this is the right time to raise interest rates at an economic level, but whether there are other more critical forces restricting growth and, as such, whether it is prudent to continue to juice asset/debt markets.  In a low growth environment a ZLB interest policy is only going to create further divergences between asset prices, asset focussed MS/debt and GDP and other key flows supporting GDP.  

I also believe that China’s current problems are signalling an end to the belief that weak growth post crisis was temporary and that unconventional and unusual monetary policy supporting asset prices/debt was valid and the risks containable.  Otherwise, well, interest policy is no more than a “hope and pray” one that supports the build up of market and financial risks relative to growth. 

Thus the Fed when deciding whether or not to raise rates is ultimately deciding the size and timing of the end game: a greater risk later or a lesser, but by no means small, risk now.  I suspect the Fed realises it has delayed a rate rise for far too long, but I also question whether it wishes to sustain the impression that it can be swayed by short term market movements forever.  Does it want to be looked upon as Sisyphus eternally dropping the interest rate ball?   

Making sense of US employment data and the interest rate decision.

We have relative strength in certain sectors supported by a steady increase in employment and growth in consumer credit. The backdrop is weak domestic productivity and income growth, an unsettling composition of employment growth and global economic weakness, in particular a possible global trade shock centred in China. The US is still growing slowly and while there are signs the labour market is tightening there remains considerable structural slack and remaining structural imbalances of concern.

A rise in interest rates may well be needed in the light of growth in consumer credit, but I have concerns over the fact that wage growth has yet to ignite, that capital investment expenditure remains weak and that the Federal Reserve’s own views of economic growth potential may well be above that which the economy itself is able to produce. Has the US economy returned to the normalcy envisioned by policy makers and with it its interest rate setting policy? I think not, but I also feel that the divergence between income growth and consumer credit growth is a considerable problem and one that may come back to bite the US if China weakens further.

Has demand moved to a level that would generate capital expenditure that many feel is necessary to push growth back to higher levels and would a rising interest rate scenario cut this particular and necessary part of the cycle short? This critical intersect may be a key consideration in any interest rate decision.

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In the context of interest rate decisions you have to ask yourself just what are we waiting for?

I have seen that the IMF has asked the Fed to defer interest rate increases until we see clear signs of wage increases and inflationary pressure.

The request IMO is both scary and rationale given that so much of today’s National Income Accounting Identity (output=C+I+X-M) relies on factors that lie outside of its operation.  I speak of new bank generated loan growth given that income growth/distribution and investment growth still appear to be weak in the scheme of things..i.e. C+I the drivers. 

The last time the FRB delayed interest rate increases we had a debt financed consumption boom in the US followed by IR increases and a de facto financial collapse.   By raising rates we likely restrict one of the few modes of generating consumption growth in the US (note auto loans) and many other countries.  We also likely raise the impact of existing debt burdens on what are to date still historically low rates of income/wage growth.  

As such you have to ask yourself just what are we waiting for?  Well we need higher income growth, but not just higher income growth: we need a more equitable and fair distribution so that economic growth itself becomes less reliant on debt and low interest rates, and less exposed to the scary divergence of asset values. 

But the world is also changing in ways that question whether we can effectively outwait the inevitable: populations are aging and declining.  Areas where the frame can still expand in consumption terms, areas such as China, may be heading into their own period of slow growth and low IR debt support. 

Importantly will the status quo submit to a reconfiguration of the pie and can the world assume a less debt dependent economic raison d’etre?  

So yes, the rationale to defer interest rate rises is both scary and realistic, but it fails to answer important questions: what are we waiting for, how long can we wait, and are our hopes realistic? 

This is just a quick 3 minute post, but the issues are critical!

Re Andy Haldane: my brief comments on deflationary risks and interest rates

This is a quickly penned thought on Andy Haldane’s recent comments on interest rates and deflation:

In a recent speech Andy Haldane of the Bank of England suggested that interest rates may well need to fall as opposed to rise following on from recent falls in inflation.   I would agree that the secondary impacts of price declines need to be seen before we can assess whether or not these price falls could indeed trigger stronger deflationary forces.

For one, price declines may lead to lower revenues (note US retail sales) and lower revenues may impact on wage increases.

Secondly, lower revenues impact cash flows and cash flows impact asset prices, especially for high yield debt in sensitive sectors.   Global markets remain especially sensitive to asset price movements and factors which may impact asset prices.

Thirdly, we are in a complex deflationary frame where aging populations, slowing population growth and relative weakness in corporate investment (note buybacks) is already a significant drag on the global economy.  Falling prices could well trigger latent dynamics in this structure.

And finally, areas of the world which could well create the demand necessary to reinvigorate the frame, for example China where growth appears to be slowing sharply, may also be adding to tensions within the global growth frame.

So yes, interest rates could fall, in the sense of defending asset prices and attempting somehow (I do not quite know how) to reinvigorate or at least support demand, or rather maintain marginal cash flows.

But in reality we do not know because we lack at the moment a measure of the sensitivity of the frame to short term shocks of any financial or economic nature.  We know the frame is weak and has been for some time but as to its sensitivity, we know very little.

The Fed is slowly shaking the tree, but will it start to climb?

Over the last 20 or more years interest rates have fallen, for reasons other than falling inflation, and as interest rates have fallen so has nominal growth in a great many developed economies, and so has inflation fallen further.  On the other hand debt has risen and so have asset prices, quite remarkably so in fact.  But through this period we have also had a succession of financial and economic crisis, with the risk mostly of a financial nature, and in response to these asset price risks, interest rates were either cut or held low for, in my opinion, far too long.

The Fed would now like to raise interest rates, and so too would other seemingly “well on the way to economic recovery nations”.  The trouble is the “economy and our markets” are now more than ever sensitive to changes in interest rates.   The Fed partly knows this, is partly concerned that interest rates lie at close to zero (and unless they want to go negative, a place they probably worry they may never climb out of) would like to see them a bit higher, to allow them to cut interest rates in a subsequent crisis. 

In the last cycle the the Fed Funds rate rose to 5.25 and currently loiters around the 0.11 to 0.12 range.  I would suspect that a Federal Funds rate of 4% was too high for the last upward cycle and would also posit that rates would be hard pressed to rise above 2% in the current cycle before we saw the type of wrenching market reaction…but this all assumes everything else being equal.  Markets are too well worn around the interest rate, money supply asset price equation to lay back and wait for the interest rate cycle to hit economic growth.   The question is though how much of an asset price shock can the “economy take as interest rates rise before that asset price shocks impacts the economy?  I guess that is the question and the Fed is trying to work out just how sensitive the world is to a rise in interest rates.  It just does not know and while the risk of rising rates may be extremely high it may well have figured that “the Fed’s got to do, what the Fed has got to do…”.  

As many other commentators have pointed out, a whole panoply of other risks have started to move out of the closet (namely the many risks posed by a sharply appreciating US dollar), risks that may already constrain the Fed from acting.

Current rates on 5 year treasuries are around 1.5% and stood at some 4% in early 2007.  I would have thought that the peak rate for the Fed rate would be around this level at the current juncture, but just how to get through to it is the question? 

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Calls for higher inflation targets

In a recent post,”There’s nothing left-wing about a higher inflation target”, Tony Yates called for an increase in the Bank of England’s inflation target from 2% to 4%.  Raising the inflation target for some reason would allow for higher interest rates that would provide the necessary leeway to combat economic downturns without being hemmed in by the zero lower bound.

While I do not necessarily agree with the statement I do agree with the dynamics that quite possibly underlie it.   Yes, if the inflation target had been higher central banks may not have been as aggressive keeping inflation under control and possibly inflation may not have fallen to current levels.   Interest rates may therefore not have trended down from the early 1990s to their pre crisis levels.

If interest rates had not moved downwards over this period then it is likely that we would have seen much less asset focussed debt creation and the foundations of the crisis that led to a precipitous immediate drop in growth and weaker growth post crisis would likely  have been somewhat curtailed.   The fact interest rates are hemmed in at the lower bound though has more to do with the dynamics of high levels of debt and their relationship with high asset values amidst the constraints of low economic/income growth.  In other words it is the past that has the greater weight, not the future.  So yes, clearly, without the debt accumulation and with higher interest rates we would possibly not be at this particular chokehold. 

But, interest rates did not fall solely because inflation fell, they fell because growth rates were also falling and because of a number of financial shocks to growth starting in the late 1990s.   In a sense interest rates fell to stimulate growth and anything that stimulates growth also risks stimulating inflation.   That it did not is a very moot point. 

In reality, all other things being equal, where inflation is caused by imbalances between supply and demand, the higher the inflation target you have the lower the interest rate target, and since I believe that lower interest rates have helped foster successive financial bubbles I am concerned over the integrity of higher inflation targets per se given the dynamics.   I would have preferred higher interest rate targets and less monetary stimulus even if this had meant a lower growth trajectory.   I can see little wrong with low inflation within a structurally stable economic framework.   

But let us suppose the argument is one of expectations and by raising the Bank’s own inflation targets so will the general public.  I think if this was the case the article should have clearly expressed it.  I do not personally feel that today’s deflation is led by individuals delaying expenditure in the expectation of lower prices tomorrow, although this does not mean it could not start to happen.   The question is, after all the best efforts of central banks the world over to stimulate growth over the last 20 years have led to the present moment in time of low interest rates and falling prices, how will putting an expectation of higher inflation into CB policy actually raise both inflation and interest rates?

Perhaps by raising inflation expectations we may cause consumers to spend more and save less.   But this assumes that people are spending less than they are capable of (the wealthy “1%” perhaps, but do they need to spend more?) as well as the fact that deflation is impacting the saving/spending decisions of consumers. 

Personally I would rather have seen a higher interest rate framework and reduced asset focussed money supply growth with lower potential inflation implications than the situation we are currently in.  It has less to do with inflation and more to do with structural economic integrity.   Trying to stimulate expenditure via every manner possible has led us into all sorts of problems.

The Geneva report and my points on the debt/asset value/IR chokehold

Many of the points I made in my choke point blog are also reflected in the latest Geneva report, Deleveraging? What Deleveraging?

One thing I would like to touch on before I highlight excerpts from that text is that high levels of debt and misallocations of capital may well be a feature of many a boom, but what makes the current situation much different is the fact that interest rates lie on a lower bound, almost incapacitated by a higher bound debt level, itself tied to highly valued asset markets.   High debt levels and weak growth dynamics are dangerous, irrespective of whether you are undecided as to whether high debt led to growth or low growth to high levels of debt, although I tend to believe that the reality is that weakening developed economy growth dynamics accompanied the debt build up prior to the onset of the crisis.  Beyond that point in time, high debt levels I would say are clearly impacting growth.

Whereas all significant debt misallocations have an impact on subsequent bank lending and new credit growth (the stock of broad MS is tied to these low or non performing loans), not all such instances have occurred at such low interest rate levels.  I think this is key, critical and as the Geneva report suggests “poisonous” intersect, although the report itself strays from emphasising what I consider to be the greater risk of high debt levels at low IRs..

Another point that I have laboured is the present value of future output growth or national income relative to debt is out of balance and this is the first time I have seen explicit reference to this in any other document I have read.

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A debt/asset value/IR bounded endogenous monetary chokehold: Comments on “Patience is a Virtue When Normalising Policy”

The primary interest rate conflict is not between inflation and growth, but between asset prices and a potential asset price shock to growth and the financial system.  Increasing income inequality and weak wage growth keeps the US and other economies within a debt/asset value/IR bounded endogenous money supply chokehold.    A successive series of debt/asset bubbles and interest rate lows are not a succession of unrelated incidents but a tightening of an extremely dangerous grip.

In the most recent Federal reserve Bank of Chicago Missive,  Patience Is a Virtue When Normalizing Monetary Policy, much interesting information was imparted on employment trends…but  there was little comment about interest rates and their relationship with the build up of asset focussed money supply growth……this build up of broad MS was and still is reflected in highly valued asset markets and global debt accumulation.  Its magnitude can be gauged by the large surge in broad MS growth over and above nominal GDP growth.

“With the economy undershooting both our employment and inflation goals, monetary policy does not presently face a conflict in goals;

I foresee a time when a policy dilemma might emerge: Namely, we could find ourselves in a situation in which the progress or risks to one of our goals dictate a tightening of policy while the achievement of the other goal calls for maintaining strong accommodation.

So what happens when a conflict emerges?”

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US debt service ratios

If you look at debt service ratios from 2008 to date you would be led to believe that consumer indebtedness has improved markedly.  In fact you would believe that conditions are the best they have been since at least the early 1980s.  But if you broaden your perspective you find that conditions today have not strayed too much from those conditions which have been in place for much of the last 14 years. 

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US Manufacturing new orders and the Fed Funds Rate…

Total new manufacturing orders rose 1.56% in February following declines in January (1.03%) and December (2%).  Orders are 0.6% below February 2013 levels.   The bigger picture is of the course the more worrying:


And the bigger picture is that historically declines in orders have always been accompanied by declines in the Federal Funds Rate.   I will not need to go too far into the fact that rates have not risen as they usually do.  So why is the Fed tapering?   Well, while asset prices have risen fine and dandy, underlying economic growth has not similarly responded. 

And we see the same picture with respect to producer price inflation:


If QE has not worked and interest rates are as low as they can go and sovereign debt is as high as it can go, where do we go from here?

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