If you stream through the data it is pretty clear that developed economy growth has been slowing for some time and that monetary policy has accommodated this adjustment with lower interest rates and a relaxed attitude towards money supply growth. At about the same time these trends were moving ever closer to their sweet spot on the horizon (because we are not yet at peak of this particular movement) certain developing markets really got going, with the help of a fair amount of their own monetary stimulus but also by a reconfiguration of global supply chains and offshoring in key economies. All factors combined to create a heady and dangerous global financial imbalance, a weak bridge cast across a widening economic divide. No wonder it all came crashing down..but who was to blame? The world’s central bankers who were blindsided into excessively lax monetary policy by a low inflationary world that had become obsessed with laying off and chopping and dicing of risk to those “who could best absorb and bear it”, or some of the finer strings in the mesh? Well, some have chosen to blame excess savings in the emerging/developing part of the world, principally China, but this is all too pat. The “savings glut” theory, if you can really call it “excess savings”, was merely a return of serve of part of the vast ocean of financial and monetary excess that barrelled through the early to mid 2000s.
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.
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?
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.
Once upon a time economic analysis was “relatively” straightforward…growing, slowing, boom, recession…all part of an upward cycle…even if you got it wrong, it never really mattered…most problems appeared consequences of excess growth…
Something changed some time way back and we have been edging in spurts, lunges and various headlong gallops to yet higher precipitous vantage points…the valleys along the way have also yielded some many interesting experiences….whether this change was a structural process that started some way back in the 1980s (secular stagnation and there are indications this could be the case), or the consequence of a misplaced emphasis on maintaining the stability of the business cycle in the late 1990s (LTCM, Asian Crisis..again consequences of this are clear), that saw central banks lowering interests rates to maintain the growth cycle, or the increasing levels of consumption and debt and widening wealth and income inequality that came hand in hand with lower interest rates and more “stable” and longer growth cycles and or financial deregulation, is a part of the overall complexity of the matter.
In a recent blog I touched on issues of definition with respect to savings, debt and money supply. A recent blog by Michael Pettis also touched on excess savings in high growth, debt driven, over extended gross fixed capital investment led cycles…phew. Today Jesse Colombo @thebubblebubble tweeted that “bubbles can form with 100% down payments. Credit is not necessary to form a bubble”.
It is an interesting point. You can get a localised bubble without credit/debt expansion and this is where consumption demand and/or asset focussed demand plonks itself overly on one particular sector of economic activity or asset class. This would draw resources/demand away from other asset classes or other economic sectors. But it would show up in relative demand for other asset classes and other areas of demand. In other words some areas would deflate and others would expand. The damage as the bubble burst would be due to misallocation of resources, if this impacted capital and human investment allocations, or merely a revaluation of asset classes.
Some people seem to think bank loans and savings are one and the same thing..in other words if a bank lends someone $10,000, some believe that this instantly becomes savings in someone’s hands. I do not believe it does. They seem to think that excess savings is synonymous with too much debt…I find this incredible…
Money supply and monetary transmission are important entities and functions within our system. Usually, even broad money supply is well defined, but I was getting to thinking about shadow banking assets and the identities they may have in the minds of those who supply the funds. Shadow banks are not deposit takers so they do not actually hold “money”, but they do hold assets that their investors may consider to be money like, i.e high yielding cash substitutes, within their portfolios.
Now if perceived money supply is actually higher and we have an asset price shock, we also have a monetary shock by default. Now this is just a quick “throw the thought out in the air”, but if the shadow banking system is also messing with identities and virtual money supply, things may well be more complex than we think they are as things start to unravel.
Just 30 second blog….
It may be that the monetary transmission mechanism is impaired through the structural imbalances that have developed within global economies over the last 20 years (+/-). If the transmission mechanism is impaired then we are in a perpetual “Sword of Damocles moment.”
The recent IMF blog, “The New Global Imbalance: Too Much Financial Risk-Taking, Not Enough Economic-Risk Taking” introduces a well known pre existing dynamic as “a new global imbalance”:
Policymakers are facing a new global imbalance: not enough economic risk-taking in support of growth, but increasing excesses in financial risk-taking posing stability challenges
We have been in a declining capital and human investment scenario for some time (discussed in many a recent blog), in many key developed economies, and we have been in a paradigm of increased financial leverage/asset focussed money supply growth. This is not new and is the primary reason why we are pinned to the economic floor with the proverbial boot pressed to our throats. I discussed this also in a recent blog…
The IMF rightly points to the risks posed by the shadow banking financial system:
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.
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?”
I am just parsing through a simple model of QE attempting to bring together the disparate strands and thoughts…
One point that is worth pointing out is the extremely large increases in money holdings in the US economy, especially over the last 12 years with regard to their differential with nominal GDP growth. I dealt in detail with the physics of changes in money supply and its distribution between expenditure and asset portfolios in a document I wrote in 2008.
The blog title is taken from a recent VOX column and an excerpt is noted below. Why am I emphasising this article? Well the IMF has raised the same point about the Canadian economy and the Bank of England seems to be taking the same tack too with the UK. But I have also raised concerns myself about the consequences of such misallocation of capital in the past (and I am not just talking debt but also more structural footprints), so the empirical evidence is interesting:
US Central Bank credit has increased 1.075trillion (End 2008 to 1 May 2013) and reserve balances with the Federal Reserve have increased 958bn over the same time frame – source data H8 and H4.1 reports of the Federal Reserve.
Low interest rates and quantitative easing could deter new capital investment projects. QE is no doubt helping asset prices rise, but it is also forcing down the cost of capital at a time when the return on capital should, arguably, be higher, given the risks. Returns on the different components of the cost of capital equation should justify the risk, and cash and bonds are both important components.
Paul Weller: “I stood as tall as a mountain; I never really thought about the drop; I trod over rocks to get there; Just so I could stand on top; Clumsy and blind I stumbled;…I didn’t stop to think about the consequences; As it came to pieces in my hands.”
The 2008 crisis told us that there was a mismatch between asset values and debt, asset values and future return, and debt and economic growth as well as some rather large structural economic imbalances.
We have tried to delay the eventuality implied by the difference in the hope that the “true” magical economic growth rate should return. Have we built up a bigger monster, and if so, how do we slay the beast?
In the soon to be released IMF World Economic Outlook, the IMF make the following claim:
I have been seeing more and more analysis that “believes” that this could well be the case.
Central banks are a bit like doctors charged with getting their patients back to health armed only with medications, but with little else to influence physical health. But what if the medications are not working, do you just increase the dosage?
The world’s QE bet is all about closing the potential output gap, and for many this accumulated gap, built up over the last 5 years is pretty large. Not large enough however to soak up all that cash the Fed has injected, but the Fed wants to deal with this crisis later.
I am not so sure that such a narrow focus on the monetary base as the de facto cause of current economic problems is a safe way to be conducting monetary policy. Agreed, in a general equilibrium, and in most normal economic scenarios, increasing the monetary base is going to stimulate economic activity – give banks more deposits to lend at an acceptable margin and they are likely to do so – but I am concerned that today’s monetarists have lost the plot.
I am genuinely interested in what he would have said, but not about quantitative easing per se, because he was obviously pro quantitative easing if there were issues about insufficient growth in the monetary base.