27 Aug 2019
On 31 July the Fed lowered the Fed funds rate by 0.25% to 2.0-2.25%. Subsequently on 7 August New Zealand’s Reserve Bank cut rates by 50 basis points to 1%, while Thailand and India have followed with smaller cuts to 1.5% and 5.4% respectively.
Probably not.
In the US the Treasury yield curve, having first inverted in December last year, has become more inverted with the 2-year Treasury rate rising above the 10-year rate.
In the language of the markets, the central banks are “behind the curve”.
More broadly, the entire developed world – and parts of the emerging world – are caught in a low interest, low inflation trap, but it is not the “liquidity trap” made famous by John Maynard Keynes’ analysis of the downward-sloping “liquidity preference function” that every economist learns in class.
The problem with the Keynesian analysis is twofold.
First, it is does not apply in the real world.
In fact, the true relationship is the exact opposite of that shown in the standard economics textbook.
Diligent students of the liquidity preference function will tell you that the downward-sloping curve implies that lower rates lead to faster money growth, and conversely higher rates lead to slower money growth.
But anywhere you look around the world today, the opposite holds true.
Venezuela, Argentina and Turkey have high interest rates not because they have been holding money growth down, but because they have been printing money rapidly and the result is high inflation.
Equally, Japan, Switzerland and the Euro-area have very low rates not because they have been printing money, but because money growth has been too low for too long and deflation risks predominate.
In other words, the relationship is from money to interest rates, not from interest rates to money; the relationship is the exact opposite of the Keynesian paradigm.
Yet almost every central bank model of the economy features lower interest rates as the key driver of economic recovery and higher inflation.
Financial market participants and central banks seem obsessed with pushing rates down in the hope that somehow the economic outlook will improve.
Second, the relationship between money and interest rates is not – as implied by Keynes’ curve – monotonic.
That is to say, changes in money growth do not have a unique, uni-directional impact on interest rates.
If broad money growth accelerates for a sustained period of several quarters, interest rates do decline – at least for a while.
But then, as asset prices improve, economic activity strengthens and the demand for credit increases, interest rates rise.
Moreover, they will continue to rise as inflation picks up.
In other words, interest rates fall initially, but the more important, more permanent relationship is that interest rates rise in response to faster money growth – exactly the opposite of the Keynesian doctrine.
Conversely, if broad money growth decelerates for a sustained period of several quarters, interest rates will first rise.
But then, as asset prices fall, economic activity weakens and the demand for credit declines, interest rates fall.
Moreover, they will continue to fall as inflation drops.
In other words, interest rates rise initially, but the more important permanent relationship is that rates fall in response to slower money growth.
This means not only that interest rates are a bad measure of the stance of monetary policy, but that we need to distinguish carefully between the two stages of the impact of money on interest rates.
Specifically, do the low interest rates in Japan and the Eurozone represent the first stage of an easy money policy or the second stage of a tight money policy?
In my view a strong case can be made that both regions are experiencing the second stage of a tight money policy (i.e. a money growth rate that is too low), not the first stage of an easy money policy (i.e. a money growth rate that is too fast).
For almost three decades Japan has been suffering economic malaise and near-deflation.
Ever since 1992, and despite a plethora of fiscal stimulus programmes in the 1990s, quantitative easing (QE) in 2001-06, “Abenomics” and qualitative and quantitative easing (QQE) from 2013 to the present, broad money (M2) has grown at an average rate of only 2.5% p.a. - too low to achieve the 2% inflation target.
A simple calculation shows that Japan needs roughly 5-6% annual M2 growth to achieve BoJ Governor Kuroda’s 2% inflation target.
Yet time and again the central bank has failed to implement monetary policy in such a way as to guarantee this outcome.
Incremental interest rate cuts in the 1990s and expanding the BoJ’s balance sheet are not the same as ensuring faster growth of money (M2) in the hands of the public.
The same diagnosis applies in the Euro-area since 2008.
Before the global financial crash, average annual M3 growth in the Eurozone was 7.7% p.a. (1999-2008); since the crisis the growth rate has more than halved to an average of just 3.1% p.a.
Like the BoJ, the ECB has tried several ideas: LTROs (long-term refinancing operations), Targeted LTROs, and a QE programme that has expanded its balance sheet from 1.4 trillion euros in September 2008 to almost 4.7 trillion today.
But all this has done little to grow M3, or money in the hands of the public.
In the Euro-area annual M3 growth also needs to be roughly 5-6% to achieve the ECB’s target of “below, but close to 2% inflation”.
Yet instead of purchasing assets from non-banks in order to boost the money held by firms and households, the ECB has either lent to banks (through its LTROs and TLTROs) or purchased securities from banks.
In both cases the funds stayed with risk-averse banks and have not been loaned out in sufficient quantities to ensure faster money growth.
Low money growth and the central banks’ obsession with interest rates is also the fundamental reason why Japan, the Eurozone together with Switzerland, Denmark and Sweden economies have negative interest yields in their bond markets.
The best and only way is to ditch the Keynesian liquidity preference function and go back to Irving Fisher who showed in the Theory of Interest (1930) that the level of interest rates follows money; it does not precede it.
Central banks need to ensure that broad money growth is adequate to meet their inflation goals.
In Japan and the Eurozone they have been falling short.
Such a money-growth strategy will gradually eliminate negative rates and ensure a broader economic recovery not only in Japan and Europe, but more broadly.
It will also restore the health of banks and insurance companies whose business models are being undermined by negative rates, and reward ordinary savers with meaningful interest rates.
If the US wants to avoid the same fate -the low interest, sub-target inflation/deflation trap that Japan and the Eurozone have fallen into - then the Fed had better start paying attention to broad money growth, not obsessing about interest rates like the BoJ and the ECB.
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Important information
Where John Greenwood has expressed opinions, they are based on current market conditions, may differ from those of other investment professionals and are subject to change without notice.