Total assets down $30Bn: the biggest weekly decline since May 1, 2019, and down $27Bn from peak on Jan. 1, 2020. All of the decline is on the back of repos, down $43Bn on the week, and 70Bn from peak. At $186Bn, repos were last time here in mid October 2019.
On the liability side, bank reserves declined by $64Bn. But the liquidity dropped more because both the TGA and domestic reverse repos rose by $31Bn and $15Bn respectively. At $412, TGA is at its highest level over the last 12 months. On the other hand, and as expected, FRP continues to decline and at $250Bn is close to the low end of the 12m period. Currency in circulation also dropped for third week in a row, posting the biggest cumulative decline from its peak over the last 12m. The decline in FRP and currency in circulation cushioned the otherwise drop in overall liquidity.
Going forward, there is no doubt that the bulk of the central bank’s increase in balance sheet is behind us for the moment, ceteris paribus. The Fed will continue shifting from repos to T-Bills and probably coupons (especially if it hikes the IOER/repo rate next week). The effect on liquidity will depend on the liabilities mixture, though. Expect TGA to slowly start decreasing ($400Bn has kind of been its upper limit, rarely going above it by much).
FRP has a bit more to go on the downside but I think it will struggle to break $200Bn, probably settle around $215Bn.
That should help liquidity. If the Fed buys more securities than the decline in repos, under that scenario, bank reserves/liquidity go up. If not, it really depends on the net effect of the change in autonomous factors.
If you are trading Fixed Income, expect a bit more pressure on the curve to continue flattening. If you are trading equities, none of this matters to you. At the moment, the only thing the equity market cares about is the size of the gamma cushion.
I am late in this debate, at least in writing, because at first, I thought it did not matter; it is all semantics. Last week I read John Authers’ article in Bloomberg in which he referenced a chart from CrossBorder Capital that showed that the Fed had recently injected the greatest liquidity boost ever. That got me really curious, so I did some digging in the Fed’s balance sheet and I concluded, notwithstanding that I am not privy of how CrossBorder Capital defines and measures liquidity, it is unlikely that the Fed’s actions led to the ‘greatest liquidity boost ever’. And then yesterday Dallas Fed President Kaplan said he was worried about the Fed creating asset bubbles. This pushed the ‘old’ narrative that CBs’ liquidity/NIRP/ZIRP is creating a mad search for yield and a rush in risky assets out of the woodwork again on social media. So, that got me thinking that whatever the Fed did since last September, whether it is QE or not, actually matters.
So, just to refresh, since September 2019, the Fed’s balance sheet increased by about $400bn, of which more than half came from repos, the other from mostly T-Bills, with the increase in coupons more than offset by the decline in MBS. On the liability side, there was a similar breakdown: about 50% came from an increase in bank deposits, the other 50% came from an increase in currency in circulation and the TGA account. This 50/50 in both assets and liabilities is important to keep in mind.
During QE1, the increase in securities held was more than 3x the increase in Fed’s total assets. That was mostly because loans and CBs swaps declined to make up the difference. On the securities side, the Fed bought both coupons and MBS. T-Bills remained the same, while agencies declined. However, 75% of the increase in assets came from a rise in MBS (from $0 to almost $1.2Bn). The Fed had begun to extend loans to some market players even before September 2008, but immediately after Lehman Brothers failed, the Fed extended loans to primary dealers (PD) as well as asset-backed/commercial paper/money market/mutual fund entities to the tune of about $400Bn. These were very temporary loans, pretty much making sure that no other PD or any other significantly important player failed. By the time QE1 finished the loans had gone back to almost pre-Lehman-time sizes. In a similar fashion, the Fed had already put in place CBs swaps even before September 2008, but immediately thereafter, the CB swap line jumped to more than $500Bn, and by the time QE1 finished it had gone to $0. Finally, repos actually decreased during QE1. Bottom line is, as far as Fed’s assets are concerned, September 2019 had absolutely no resemblances at all to September 2008.
On the liability side, the differences were also stark. Unlike 2019, during QE1 bank reserves contributed to 95% of the increase. The FRRP account remained pretty much flat for the full duration of QE1, while the TGA account was unchanged but it did exhibit the usual volatility during seasonal funding periods.
QE2 was much more straightforward than QE1. The Fed’s assets increased only on the back of coupon purchases (around $600Bn), while the Fed continued to decrease its MBS and loans portfolio. On the liability side, bank reserves continued to contribute about 95% of the increase. The rest was currency in circulation. Bottom line here again, really no resemblance to 2019.
QE3 was similar in the sense that Fed’s reserves increased 100% on the back of securities purchases (around $1.6Tn), but this time split equally between coupons and MBS. On the liability side, at 80% of total, bank reserves contributed slightly less towards the overall increase. The rest was split between currency in circulation and reverse repos. During QE3, unlike QE1 and QE2, less of the Fed’s balance sheet increase went towards higher liquidity (bank reserves), but still nothing like in 2019. For one reason or another, the market was willing to give some of the liquidity back to the Fed in the form of reverse repos even before the Fed started tapering (reverse repos were prominent after QE3 when the Fed stopped growing its balance sheet but before it actually started tapering it).
No, you can’t call whatever the Fed has been doing so far, starting in September 2019, QE. There are simply no comparisons with any of the previous QEs: The largest increases on the Fed’s balance sheet in 2019 was T-Bills and repos; the Fed never bought T-Bills or engaged in repos in any of the previous QEs – the asset mix was totally different. On the liability side, while in the QEs almost all of the increase went directly into bank liquidity, in 2019 only 50% did. FRRP was more or less unchanged, at around $100Bn between QE1 start and the end of QE3 – by September 2019 it had tripled! TGA averaged around $60Bn before the end of QE3; thereafter the average increased 4x!
As to the second issue of how much of the Fed’s liquidity injection since the crisis has boost asset prices? Not much.
According to the Fed’s own flow of funds data, real money has been a net seller of equities and buyer of risk-free assets since the 2008 financial crisis. If there is a rush into risky assets, it is not obvious from the data. There is also this argument that the Fed’s consistent boost of liquidity, combined with low interest rates, provides the proverbial put for prices and, therefore, the search for yield can be implemented by selling vol/gamma. This could indeed be the case. The problem is that I have not seen any data which shows exactly what the $ notional (in cash equities) equivalent of that vol selling flow is.
Moreover, given that both ECB and BOJ have engaged in even bigger balance sheet expansions, plus their interest rates are negative, the case could be made for a similar exercise in Europe and Japan. However, both European and Japanese equity markets have been languishing for years, underperforming US equity markets. Finally, even if this indeed were the case, the more likely explanation for the reasons people would be selling vol is the relentless bid from corporates engaging in share buybacks. This would also explain the underperformance of equity markets abroad relative to US ones despite higher CBs’ liquidity boosts there.
But how much liquidity did the Fed provide since the 2008 financial crisis?
Equities bottomed in March 2009. Fed’s assets increased by about $2Tn thereafter. But only 37% of that increase went to bank reserves. 40% went towards the natural increase of currency in circulation, 14% went to TGA and 9% went to the FRRP (drawing liquidity out). It is slightly better if one does the comparison since QE1, but even there, at most, 50% went directly to bank reserves.
Finally, one has to take into account that banks’ reserves needs have also substantially increased since the 2008 financial crisis on the back of Basel III requirements. According to the Fed itself, the aggregate lowest comfortable level of reserve balances in the banking system ranges from $600Bn to just under $900Bn. At $1.6Tn currently, there is not much excess liquidity left in the system. In fact, banks Fed deposits were already at around $800bn in March 2009. Given that most of the regulations were implemented thereafter, one could claim that no additional liquidity was really added to the banking system since.
According to John Authers at Bloomberg, data from CrossBorder Capital, going back to January 1969, shows that we have been recently experiencing Fed’s greatest liquidity boost ever. I have no reason to doubt CrossBorder Capital or their proprietary model of measuring liquidity. But there are many ways of defining, as well as measuring, liquidity. So, I decided to simply look at what exactly the Fed has done since it started expanding its balance sheet in September last year.
Fed has indeed been doing more than $100Bn worth of repo operations on a daily basis recently, but those operations are only temporary, i.e. they can not be taken cumulatively in ascertaining the effect on liquidity. In fact, the Fed’s balance sheet has increased by $380Bn, and only 55% of which came from O/N and term repo operations ($211Bn). The other 45% came from asset purchases. On the asset purchases, the Fed bought mostly T-Bills ($182Bn), some coupons ($55Bn) while letting its MBS portfolio slowly mature (-$81Bn).
However, not all of that increase went towards interbank liquidity. In fact, only about 50% of that increase ($198Bn) went towards bank deposits. The TGA account increased by $167Bn; that drained liquidity. Reverse repos decreased by $20Bn (FRP by $17Bn and others by $3Bn), which added liquidity. Finally, $37Bn went towards the natural increase in currency in circulation.
Fed actually started increasing its T-Bill and UST portfolio already in mid-August, three weeks before the repo spike. Part of that increase went towards MBS maturities. But by the end of August, Fed’s balance sheet had already started growing. By the third week of September, also the combined assets portfolio (T-Bills, USTs, MBS) started growing as well, even though MBS continued to decrease on a net basis.
Fed’s repo operations started the second week of September. They reached a high of $256Bn in the last week of December. At the moment they are at the same level where they were in the first week of December ($211Bn).
On the liability side, the TGA account actually bottomed out two weeks before the Fed started buying USTs and T-Bills, while the FRP account topped the week the Fed started the repo operations. Could it be a coincidence? I don’t think so. My guess is that the Fed knew exactly what was going on and took precautions on time (we might find eventually if it did indeed nudge foreigners to start moving funds away from FRP).
Finally, while currency in circulation naturally increases with time, bank deposits also bottomed out the week the Fed started the repo operations in September, but strangely enough, they topped the first week of December (for the time being).
So, while the Fed’s liquidity injection since last September was substantial relative to both the decrease in liquidity before that (starting in 2018 when the decrease in the Fed’s balance sheet became consistent) and, to a certain extent, since the end of the 2008 financial crisis, it is difficult to make a claim that this is the greatest liquidity boost ever. The charts below show the 4-week and 3-month moving average percentage change in the Fed’s balance sheet. The 4-week change in September was indeed the largest boost in liquidity since the immediate aftermath of the 2008 financial crisis. The 3-month change though isn’t.
The Fed pumped more liquidity in the system during the European debt crisis. In the first four months of 2013, not only the growth rate of the Fed’s balance sheet was higher than in the last four months now since September 2019, but also the absolute increase in Fed’s assets and US bank deposits. Moreover, there were no equivalent increases in either the TGA or the FRP accounts.
Final note, if the first week of January is any guide, it might be that a big chunk of the Fed’s balance sheet increase might be behind us, if only for the time being. Fed’s balance sheet decreased by $24Bn, which is the largest absolute decrease since the last week of July 2019, i.e. before the start of the most recent boost in liquidity. I actually do expect the Fed’s balance sheet to keep growing but at a much smaller scale and mostly through asset purchases rather than repos.
“For a little reflection will show what enormous social changes would result from a gradual disappearance of a rate of return on accumulated wealth.”
~ John Maynard Keynes
Lately, not a day passes by without someone commenting on the pernicious effect of negative rates and how they are an aberration which cannot and should not be ‘allowed’ to continue. Reality is slightly more nuanced.
To start with, low interest rates are the norm, not the exception throughout history. Second, while indeed a rarity, negative rates have existed in the past, and, depending on circumstances, have lasted longer than initially expected. Third, to ascertain their effect, we must first understand their cause and purpose. All these will eventually allow us to forecast how long they would be around. Still, even then, we must be cognizant that a switch to higher rates will most likely only happen after the economy has first gone through one or a combination of: social unrest, debt jubilee, large increase in the money supply or natural disaster.
Negative interest rates are a result of past accumulation of surplus capital (and its mirror image, large stock of debt) combined with previous persistently high interest rates on that debt relative to the growth rate of the money supply (new money).
The forces that could push rates structurally higher, therefore, would logically be either a reduction of the surplus capital/debt, or a massive increase in the money supply. As neither of this has happened yet, negative interest rates are effectively the market’s response to this status quo: on a long enough timeframe, they reduce the debt stock and they allow the money supply stock to outpace interest payments on the debt and have some left for economic growth.
Considering that interest rates measure the cost of capital, when capital is abundant, ceteris paribus, interest rates should be low. For example, normally, periods of peace bring about an accumulation of surplus capital, either directly because money is not spent on wars, but more importantly, indirectly, as people innovate and bring about technological advancements which increase efficiency and reduce the need for more capital in general. As a result, interest rates trend lower. That’s exactly what happened, indeed, during the almost century of peace in the time of Pax Britannica in the 19th century.
Source: BeyondOverton, BOE Three Centuries of Data
At the same time, wars, conflicts, or even big natural disasters, deplete the capital stock and force interest rates to rise. Sometimes, when these negative supply shocks turn out to be ‘one-off’ occurrences (the 1970s oil crises), we could get just a spike in interest rates; sometimes, if the conflict persists, the increase in interest rates can last much longer (the Cold War).
On a long enough timescale, one would then expect to see periods of low interest rates inevitably followed by periods of high interest rates in a kind-of mean reversion pattern. Actually, that is not the case. In fact, according to Paul Schmeizing, real rates have been falling for over 500 years on a variety of regression measures:
“…over the entire timeframe 1313-2018, I find 19.7% of advanced economy GDP experience negative long-term real rates on an annual basis…the general trend of an even higher frequency of negative rates is independent of the establishment of central banks and active monetary policy.”
Mean reversion of interest rates is not a given from a historical point of view largely because certain events, the so-called paradigm shifts, have such a profound effect on the production function that no war or natural disaster can easily reverse. For example, the Agricultural Revolution ushered the first large (and ‘permanent’) resource surplus which lasted humanity indeed a long time. We came close to depleting it during the centuries of the Dark Ages in Europe but, with the help from the Renaissance, the Industrial Revolution couldn’t come soon enough to change the paradigm shift once again. After that, Aggregate Supply (AS) had been consistently running above Aggregate Demand (AD).
While on the face of it, an imbalance of this sort, AS > AD, is much better than the reverse, managing it, has proven quite difficult over the years. Especially in the more modern times when the changes affect both the production function and the mode and nature of consumption (from a physical to a digital medium – more on this later).
Feudalism, socialism, capitalism, etc., are all examples of how society is designing an institutional framework to help distribute these surpluses in the most optimal way. However, because of the inertia of the past and the numerous vested interests, such institutional changes may take much longer than the production breakthroughs to feed through. Therefore, as the capital surpluses keep adding up while their distribution mode remains the same, the economy becomes even more imbalanced.
If capital does not flow naturally through the income channel to raise the purchasing power of the majority, aggregate demand starts to lag. Debt becomes then the lever which transfers purchasing power, in a way substituting for rising wages. However, as debt comes with the additional burden of positive interest rates, it pushes up inequality to an unsustainable level thus closing even that avenue of balancing the economy. Therefore, AS continues to increase at the expense of AD, and a deflationary spiral ensues. A temporary solution to this problem in the past has indeed been a form of negative rates, called demurrage money.
Demurrage money is not unusual in history. Early forms of commodity money, like grain and cattle, were indeed subject to decay. Even metallic money, later on, was subject to inherent ‘negative’ interest rates. In the Middle Ages in Europe coins were periodically recoiled and then re-minted at a discount rate (in England, for example, this was done every 6 years, and for every four coins, only three were issued back). Money supply though, did not shrink, as the authorities (the king) would replenish the difference.
In 1906, Silvio Gesell proposed a system of demurrage money which he called Freigeld (free money), effectively placing a stamp on each paper note costing a fraction of the note’s value over a specific time period. During the Great Depression, Gesell’s idea was used in some parts of Europe (the wara and the Worgl) with the demurrage rate of 1% per month.
The idea behind demurrage money is to decouple two of the three attributes of money: store of value vs medium of exchange. These two cannot possibly co-exist and are in constant ‘conflict’ with each other: a medium of exchange needs to circulate to have any value, but a store of value, by default, ‘requires’ money to be kept out of circulation.
Negative interest rates solve this issue by splitting these two functions. The problem though is that negative rates are not a very efficient tool for reducing the capital surplus because the whole process takes a really long time. Absent any other changes in the institutional framework, the general pattern of the past has therefore been for a military conflict, either a revolution or a war, to literally obliterates the capital surplus.
As mentioned before, indeed, the Industrial Revolution was followed by the century of peace of Pax Britannica during which neither low rates nor the gold standard managed to close down the inter-country economic imbalances, thus we got two very violent world wars. The period between the end of WW2 and now is considered one of general world peace. And indeed, relative to the horrors of the war which preceded it, it was.
But despite the fact that there were no major traditional global wars after 1945, the Cold War was a major global war of ideologies, in which few shots were fired, but one which caused a large capital outlay (military build-up, but also huge government investments in space exploration, and in general, technology). In addition, there were a lot of proxy wars (Afghanistan, Korea, Vietnam) and conflicts (for example, the 1970s oil crises were a result of such a proxy conflict). It is not surprising then, that during that time interest rates tended to stay high.
(Incidentally, it is with sadness that I heard of the passing of Paul Volcker the other day, but reality is that he presided over a Fed which orchestrated the largest aberration in the history of interest rates since Babylonian times. In my opinion this was totally unnecessary and a complete overkill.)
Source: Business Insider; original data from ‘History of Interest Rates’ by Homer and Sylla
By the end of the Cold War, when it was clear that capitalism had gained the upper hand as the main institutional framework of the time, interest rates started to subside. It also became obvious that the USA was to become the undisputedly dominant global power. In addition, all these (mostly government) investments of the Cold-War time started to pay off, eventually ushering the Digital Revolution which is still ongoing. To a certain extent, one could think of this period as Pax Americana, in reference to the global dominance of Britain during most of the 19th century.
The Digital Revolution has heralded a similar paradigm shift to the Agriculture and Industrial Revolutions in the past. Indeed, the resulting capital surplus has not only completely reversed the previous spike in interest rates but has brought about a strong disinflationary environment pushing real interest rates in negative territory.
This period is called by some the biggest and longest bond bull market in history. It is probably the biggest because interest rates have gone down from double digits in the 1980s to almost 0% now. But it is certainly not the longest. As seen in the chart on page 1, interest rates in Britain trended down from 6% to 2% for almost 100 years in the 19th century. And it doesn’t yet look like there is an end to this bull market as there are no signs that anything is being done on the institutional side to take into account the changing modes of production and consumption caused by the paradigm shift of the Digital Revolution.
Moreover, low/negative interest rates are only really applicable to the government sovereign market. In the current debt-backed system, the majority of money is still loaned into circulation at a positive interest rate. Even in Europe and Japan, where base interest rates and sovereign bond yields are negative, the majority of private debt still carries a positive interest rate. This structure inherently requires a constantly growing portion of the existing stock of money to be devoted to paying solely interest. Thus, the rate of growth of the money supply has to be equal to or greater to the rate of interest; otherwise more and more money would be devoted to paying interest rather than to economic activity.
Source: BeyondOverton, US Federal Reserve
This is indeed problematic if one considers that the long-term average growth rate of US money supply in modern times is around 6% (chart above), which is only slightly higher than the average interest rate on US government debt but it is below the average interest rate on both US household and corporate debt. To reach this conclusion, I used the US Treasury 10-year yield as the average yield on US government debt (the average maturity of US debt is slightly less than that), and allowed very generous estimates for both US corporate debt and household debt.
In addition, I have not included the much higher yield on US corporate junk bonds which comprise a growing proportion of overall corporate debt now. I have not used either credit card/consumer debt, which has a much higher interest rate, or student loan debt, which carries approximately similar interest rate to auto loans rates used in the calculation. Just like for BBB and lower rated US corporates, credit card and student loan debt are a much higher proportion of total US household indebtedness now compared to before the 2008 crisis.
Finally, I estimated the long-term average economy-wide interest rate as a weighted average of government, corporate and household debt – with the weights being their portions of the total stock of debt. With the caveats mentioned above, that average rate since the early 1980s is about 7% – higher than the average money supply growth rate.
Over the last four decades, US money supply has not only not grown enough, on average, to stimulate US economic growth, but has been, in fact, even below the overall interest rate of the economy. Needless to say, this is not an environment that can last for a long time. It is surprising it did go on for so long.
Indeed, if one calculates the above equivalent rates for the period 1980-2007 only, the situation would be even more extreme (see chart above). In fact, until the late 1990s, money supply growth had been pretty much consistently below the economy-wide interest rate. Only after the dotcom crisis, but really after the 2008 crisis, money supply growth rate picked up and stayed on average above the economy-wide interest rate.
What is the situation now? The current money supply growth rate is just above the average economy-wide interest rate: above the government and corporate interest rates but below the household interest rate (data is as of Q1’2019, chart below). It is also still below the combined average private sector interest rate.
So, even at these low interest rate, US money supply is just about ‘enough’ to cover interest payments on previously created money. And that is assuming equal distribution of money. Reality is that new money creation is only just ‘enough’ to cover interest payment on public debt. Moreover, money distribution is very skewed in the private sector: corporates have record amount of cash but that cash normally sits only in the treasuries of few corporates. The private sector, overall, can barely cover its interest payment, let alone invest in CAPEX, etc.
Seen from this angle, negative interest rates may not be a temporary phenomenon designed just to spur lending. On the opposite. It is almost counter-intuitive from what we learn in economics where we are accustomed to think that a rising GDP is associated with higher interest rates because of the need to suppress potentially inflationary pressures. Reality is that a rising GDP also produces more excess capital which tends to naturally put pressure on interest rates lower. If this increase in AS is not fully offset by a rise in AD, inflationary pressures may not develop and interest rates may not rise. In fact, they may start falling if the debt build-up becomes excessive. In that regard, the purpose of negative interest rates may be to help reduce the overall debt stock in the economy and to escape the deflationary liquidity trap caused by the declining marginal efficiency of capital.
Could they work? Sure, they could, but unless they are deeply negative, it will take a really long time and, most likely, the fabric of society would come apart either way. So, what could cause this massive bull market in rates then to reverse?
Well, it is unlikely to see those signs of reversal in any economic variable on the demand side, like lower unemployment or even higher wages, as the surpluses are just too large. At least not from a structural point of view: for example, a pop in real wages could see a pop in real rates but that will quickly reverse as the supply side will adjust almost ‘instantaneously’. Instead, we should look for signs of any pressure on AS which would come about from institutional changes. Anything that suddenly reduces the capital/debt surplus, such as a debt jubilee, or permanent increases of the money supply, such as ‘helicopter money’.
In the absence of such changes, we could either see a prolonged period of negative interest rates to address the above imbalances or, in the worst-case scenario, for example in the US where there is strong institutional pushback against them, social unrest. The process of de-globalization, which started already with Brexit and Trump’s US tariffs, is another supply side force which would take its time but could eventually erode the global resource surplus.
In the end, if all else fails, nature would have the final say as climate change could cause a massive natural disaster, leading to such a destruction of capital, that interest rates would be bound to go much higher from there!
 Eight Centuries of Global Real Interest Rates, R-G, and the ‘Suprasecular’ Decline, 1311-2018, 24 Nov. 2019
 For corporate debt I used the average yield on Aaa and Baa bonds and for household debt I used mortgage debt and auto loans
Credit impacts the real economy in a different way depending
on whether it is to households or to corporates (see Atif Mian’s work, also his
Very generally speaking, credit to households affects the economy directly
through the demand-side channel, while credit to corporates – through the
supply-side channel directly, and only then, potentially, indirectly through
the demand-side channel.
Household debt to GDP was flat for two decades between mid-1960s and mid-1980s; and then it doubled; corporate debt for GDP, on the hand, was flat also for two decades after the S&L crisis, and even now it is only a few per cents higher. But the demand-side reduction from the household debt channel post 2008 is rather unique.
Given that the US was running a negative output gap for most of the period post 2008 (and it might still do, even though official estimate is for a small positive), it was the demand-side that needed some catching up to. Instead, the opposite was essentially happening: credit to households was decreasing relative to credit to corporates. As far as credit was concerned, it was primarily the supply side that was getting stimulated (of course, the question is how much stimulus was really created given that a lot of the corporate debt went to share buybacks).
The other theory, one to which I subscribe, is that the modern economy is essentially always experiencing a demand gap. When real wages stopped growing in the 1990s, post the the financial liberalization of the 1980s, household credit experienced a massive run-up. The demand gap left from the stagnation in real incomes was filled with household debt. Until the sudden stop in 2008.
Household debt to GDP did not grow between 1960s-1980s but real household income did, so there was no demand gap either. Post 2008, though, neither of these two options were available which left the US economy in a demand insufficiency. The ‘stimulus’ provided was mostly through the supply side with very little follow through into the demand side which meant lackluster economic growth.
The bottom line is that the type of credit creation matters.
The central bank affects directly only the supply of credit (and in some cases,
even less so) thus, it has limited ability (none?) to decide on whether credit
goes to firms or households. We may get a lot more from lower interest rates if
policy makers start thinking more holistically about the whole process of
credit creation. Banks do not care where credit goes
(why should they?) as long as they get their money back.
But with overall debt in the economy climbing higher and higher, it is essential to think how we can get the most out of it. And if the market can’t do that (it can’t), someone else should step in.
All this does not mean that US households should get even more indebted! On the contrary, the decline in household debt to GDP is good news only if it were also followed by a similar rise in real household income. And it the private market can’t do that either (it seems, it can’t), then we need to rely on the official sector to take on that burden.
Really interesting the divergence of monetary policy in Norway and Canada, and now possibly, Sweden with the rest of the DM/EM world in the last 12 months*. While pretty much every other central bank in the world has turned dovish, Norges hiked four times since September last year, while Bank of Canada has hiked 5 times since mid 2017. And last week, against all odds and expectations, Riskbank also surprised by pretty much guaranteeing a hike at its December meeting. It’s questionable whether hikes in either country was/is warranted looking strictly at economic activity.
Despite a spike in core inflation in early 2019, something which Norges had actually expected to be temporary, inflation is back below 2%. Both Canada’s and Sweden’s inflation spiked up in mid 2018 and have recently retreated back below 2%. Growth in all three counties has actually been more elevated than in neighboring Europe or US but growth was never the reason their respective central banks cut rates before, so it does not seem to be the reason they are now hiking. In fact, looking at weakening domestic demand and rising unemployment rates in Sweden, there are probably more reasons to cut than hike now.
So why are they hawkish? One theory is that the central banks are worried about rising household leverage with private debt to GDP in each close to the highest in the world. The thing is, other countries in a similar situation have chosen to go the opposite way. Australia, New Zealand, Korea, which also have high household debt ratios, tried to be ‘hawkish’ but have been aggressively cutting over the last 12 months on the back of slowing global demand.
The problem with hiking rates when over-indebtedness is high is that you are ‘inviting’ financial instability and when that is one of your mandates, it is probably not such a wise choice. Is that why the Riskbank has said it would hike only once and stop at 0%?
Another theory is that the Riskbank is
preparing to introduce the e-krona and does not want to be dealing with the arb
of negative rates. I find that a poor excuse to hike as well.
And finally, some people are looking for a symbolic meaning of Sweden going back to 0% after being the first modern central bank to go below, 10 years ago. I don’t know. My guess is that it is more likely to be part of the experimentation process, but that ultimately it would turn out to be too early not to be a policy mistake.
*In Israel, the UK and the Czech Republic the last interest rate moves were a hike. However, Israel hiked only once, in November last year (from 0%) and with inflation at 0.5% and below the target range of 1-3%, the central banks has removed any prospect for a further rate increase and confirmed inflation is in a downward trend. UK is a special case of Brexit and deserves a post on its own. The Czech Republic, I have to admit, is a proper outlier here with both growth and inflation bucking all trends in Europe and, therefore, also deserves its own blog post.
In the current debt-backed system,
the majority of money is still loaned into circulation at a positive interest rate.
Even in Europe and Japan, where base interest rates and sovereign bond yields
are negative, the majority of private debt still carries a positive interest
rate. This structure inherently requires a constantly growing portion of the
existing stock of money to be devoted to paying solely interest. Thus, the rate
of growth of the money supply has to be equal to or greater than the rate of
interest, otherwise more and more money would be devoted to paying interest
than to economic activity.
The long-term average growth rate of US money supply is around 6%, which is only slightly higher than the average interest rate on US government debt but it is below both the average US corporate interest rate and US household debt. While I have used the UST 10yr yield as the average yield on US government debt (the average maturity of US debt is slightly less than that), the estimates for both US corporate debt and US household debt are very generous. For the former, I used the average yield on Aaa and Baa corporate bonds, and for the latter I used a weighted average interest rate between mortgage debt and auto loans (I have used 2/3 and 1/3 weights). I have not included the much higher yield on US corporate junk bonds which comprise a growing proportion of overall corporate debt. I have also not used credit card/consumer debt, which has a much higher interest rate than auto loans, and also student loan debt which carries approximately similar interest rate to auto loans. Just like for BBB and lower rated US corporates, credit card and student loan debt are a much higher proportion of total US household indebtedness compared to before the 2008 crisis.
I estimate the long-term average economy-wide interest rate as a weighted average of government, corporate and household debt – with the weights being their portions of the total stock of debt. That rate currently is about 7%, still higher than the average money supply growth rate since the early 1980s. Over the last four decades, US money supply has not only not grown enough, on average, to stimulate US economic growth, but has been, in fact even, below the overall interest rate in the economy. Needless to say, this is not an environment that could have persisted for a long time.
Indeed, if one calculates the above
equivalent rates for the period 1980-2007, the situation would be even more
extreme (see Chart below). In fact, until the late 1990s, money supply growth
had been pretty much consistently below the economy-wide interest rate. Only
after the dotcom crisis, but really after the 2008 crisis, money supply growth
rate picked up and stayed on average above the economy-wide interest rate.
What is the situation now? The current money supply growth rate is just above the average economy-wide interest rate; respectively above the government and corporate interest rates but below the household interest rate (data is as of Q1’2019).
It is also still below the combined average private sector interest rate.
So, even at these low interest
rate, US money supply is just about enough to cover interest payments on
previously created money. And that is assuming equal distribution of money.
Reality is that it is only enough to cover interest payment on public debt. And
even in the private sector, money distribution is very skewed: corporates have
record amount of cash but it is only in the treasuries of few corporates. The
private sector, overall, can barely cover its interest payment, let alone
invest in CAPEX, etc.
The deeper question is whether money creation should indeed be linked to debt at positive interest rate. In fact, we have already answered that question, and gone beyond, with some portion of money creation in Europe and Japan actually happening at negative interest rate. In effect, the market is trying to correct for all those decades when money creation substantially lagged interest payments: money there is starting to decay.
Demurrage money is not unusual in history. Early forms of commodity money, like grain and cattle, was indeed subject to decay. Even metallic money, later, on was subject to inherent ‘negative interest rates’. In the Middle Ages, in Europe, coins were periodically recoiled and then re-minted at a discount rate (in England, for example, this was done every 6 years, and for every four coins, only three were issued back). Money supply though, did not shrink, as the authorities (the king) would replenish the difference to find his own expenses. In 1906, Silvio Gesell proposed a system of demurrage money which he called Freigeld (free money), effectively placing a stamp on each paper note costing a fraction of the note’s value over a specific time period. During the Great Depression, Gesell’s idea was used in some parts of Europe (the wara and the Worgl) with the demurrage rate of 1% per month.
The idea behind demurrage money is
to decouple two of the three attributes of money: store of value vs medium of
exchange. These two cannot possibly co-exist and are in constant ‘conflict’
with each other: a medium of exchange needs to circulate to have any value, but
a store of value, by default, ‘requires’ money to be kept out of circulation. Negative
interest rates in effect split these two functions.
Seen from this point of view, negative interest rates may not be a temporary phenomenon just to spur lending. On the opposite, negative interest rates may be here to help reduce the overall debt stock in the economy and to escape the deflationary liquidity trap caused by the declining marginal efficiency of capital.
the Fed can do to alleviate the potential repo squeeze (apart from the usual
suspects already discussed in great detail by both saleside/buyside research
and in Twittersphere):
1) hike the interest banks pay on TT&L ‘notes’ accounts from EFF-25bps to EFF, or to make it even simpler, equal to IOER. That could encourage funds to move from the TGA account back to TT&L accounts and ‘release’ reserves.
When the Fed started paying IOER, the opportunity cost for the Treasury to keep money on deposit in the banking system (TT&L accounts) rose. The Treasury thus started using the TGA at the Fed.
2) cut the fee on daily uncollateralized overdrafts from the current 50bps, adjust the net debt caps, decrease the penalty daily overdraft fee of 150bps. That could encourage better use of the existing Fed intraday liquidity option.
The Fed made major changes to its daily overdraft operations in 2011 spurred by some inexplicable desire to limit its credit exposure. This was probably on the back of political pressure from the legacy of the 2008 crisis during which the Fed indeed took massive credit risk.
Before 2011, the majority of the Fed’s daily overdrafts were uncollateralized. The new rules discouraged uncollateralized ‘repos’ by raising their fees and introducing collateralized overdrafts for free. After those changes, majority of the overdrafts became collateralized. The problem arose when during the most recent repo squeeze, the mechanics of obtaining collateral became complicated.
In any case, Fed’s action was strange given the fact that only a few months before that, in 2011, it had changed the accounting rules which pretty much ensured that the central bank can not go bankrupt (no negative equity) even in theory.
Should the Fed, actually, be providing free intraday liquidity with no collateral to eligible institutions? I think so. Because:
-that liquidity is needed for transaction (retail 24/7), not consumption or production purposes (Pfister 2018)
-the central bank can create money at zero cost, while the opportunity cost of holding money should be equal to the social cost of creating it (Friedman 1969)
-the central bank would be simply accommodating Basell III regulations
These two solutions are not groundbreaking: the Fed would be either going back to the way things were before 2007 (uncollateralized Fed daily overdrafts), or taking into account new developments (the emergence of IOER).
Both make people’s lives
unintentionally difficult and complicated by having changed the system in the
1970s but continuing to insist on following the same old rules.
In 1970, Myanmar General Me Win
changed the direction of traffic in the country (literally overnight) from left
to right. Such a sudden decision would have been a precarious change even in
the best of circumstances, but in the case of Myanmar which, having been a
British colony, traffic had been on the left with a right-hand drive steering
wheel, it was truly extraordinary given that all the cars continued to be with
a right-hand steering wheel!
In 1971, US President Richard Nixon
ended the gold standard which had been at the core of most of the world’s
monetary systems for centuries. The world truly went on fiat money. That would
have been a difficult task in the best of circumstances given the previous
history of fiat money. In the case of US, and most other countries, it
became an impossible one given that no attempt was made to upgrade the monetary
system to the new reality of fiat money.
Every country we have visited so far on our journey is unique on its own, but no country in the world is so truly unique as Myanmar when it comes to driving on the road. We spent almost a month in Myanmar and honestly it took me some time to realize that we were driving on the right side of the road but also the driver is sitting on the right side of the car! Can you imagine how hard and crazy this is? I actually can, having lived in London for two decades and frequently driven to Europe. But even that is not a good comparison as I would generally drive on well-kept highways in Europe, while in Myanmar there are no real highways, all roads are single lane and quite bad by European standards. Try overtaking under these conditions in Myanmar: when the steering wheels of cars didn’t change, people were left with relying on honks and passenger guidance when merging into a lane.
Something similar happened with our monetary system: in 1971 we finally, and for good, threw off the gold shackles but we did not change the gold standard accounting (CB reserves vs. government bonds) and continued to impose imaginary limits on government finances and money supply in general. This is as backward, inconvenient and dangerous as a right-hand drive on the right side of the road.
I started paying attention to this
monetary inconsistency only after GFC’08 when it became obvious that there is
something ‘not right’ with our money supply: the way the Fed was conducting QE,
the way inflation did not budge, and the way no one batted an eyelid when the
$700bn financial rescue plan was announced. Then I discovered Mosler, Wray and
the rest of the original MMT crew. Finally, I brushed up on financial history going
well beyond the Great Depression, when ‘MMT’ was last popular, to Knapp and
even beyond (“Debt: the first 5,000 years”). But what convinced me most that
our monetary transmission mechanism is far from optimal (just like in Myanmar,
I had to spend some time on its roads to even notice the peculiarity) was that
I was intimately involved in the plumbing of the financial system by trading and
having exposure in the short end of the money markets, especially in the years
What is extraordinary for me in
both cases is that people don’t seem to be bothered and despite the obvious
difficulties prefer to just get on with the existing status quo. Speaking to
locals in Myanmar, there is neither appetite to change back to the previous
driving system, nor to start importing left-hand driving wheel cars (even
though some people have mentioned a draft law that would have a cut-off point
after which only left-hand drive wheel cars would be allowed to be imported).
In the case of gold-standard-monetary-system-not-fitted-to-a-fiat-world, the
people in power (central bankers, prominent economists) have ridiculed any
attempts to think of possible improvements.
Unfortunately, the ideas that keep us plugging pointlessly at monetary policy are not that dissimilar to the ideas which will push us into trying fiscal policy: both of them are based on using the old industrial model of labor and capital income distribution which is much less suitable in the digital age where technology takes center stage.
What particularly caught my attention was the 3rd paragraph and this very relevant question: “If these countries really did have a zero output gap, then why is inflation below target?” Which gets to the core of the issue about how technology has possibly substantially increased potential output.
Yet, our models do not fully capture that. Perhaps that is because we continue to put too much weight on capital and labor in the production function when clearly technology has marginalized them both, the evidence being in zero rates and flat wages.
Let’s take capital.
1) there is a large corporate capital surplus;
2) digital technology does not require so much capital;
3) consumer debt is maxed out.
All three of the above lead to low demand for credit meaning low interest rates regardless/independent of monetary policy.
So, after years of zero/negative/low rates (decades in Japan) it is finally obvious that the monetary transmission mechanism is now clogged (see above). Naturally, despite all the opposition, we are probably just a recession away to switching to fiscal policy.
But as labor’s turn comes, there is no guarantee and zero evidence (see, again, Japan) that fiscal policy would work as its transmission mechanism is probably also clogged. And the reason can be found in the fact that it is easier for corporates to switch from labor to technology in automating production.
That’s where the debate about technological unemployment comes in. And here I am in the camp believing that this time things are different because technology is more advanced and is taking away ‘IQ’ jobs in addition to just ‘brawn’. ‘EQ” jobs are humans’ last call of resistance but maybe not for too long.
Sure, no evidence of this for now but that’s because in the initial stages, with aggregate demand low, companies will choose to focus on cost reduction by using cheaper labor (taking advantage of the threat of automation keeping a lid on wages), than higher output/higher productivity using technology.
We’ve had jobless recoveries before but post GFC’08, we’ve had a ‘wageless’ recovery – plenty of jobs but anaemic wages. Neither is particularly good for aggregate demand as individual purchasing power barely increases.
The situation is even worse now as consumer debt to disposable income keeps rising (people now need two jobs to survive).
In the short run, we could potentially see a rise in wages as the labor pool gets gradually depleted, but the switch to automation would also be faster which would push unemployment up/wages back down. In the long run, technology substitution becomes inevitable as both its cost continues to decline and its capabilities to rise.
And, by the way, we are not helping, as apparently we are also getting dumber (see “Were the Victorians cleverer than us?” by M. Woodley et all).
So, the most obvious fiscal policy stimulus is infrastructure spending. That’s much easier to get voted in given the state of our roads and bridges, etc., and the fact that there are probably already too many people shuffling papers on desk jobs working for the government.
Infrastructure spending could be the most economically beneficial option but could also contribute the least to aggregate demand if it bypasses labor due to automation: awarding a billion $ contract to a company to renovate a bridge using mostly automated machinery is hardly going to increase labor’s purchasing power.
My feeling is fiscal policy will indeed soon become the default option. Sadly, not necessarily because it would work better overall for increasing aggregate demand but simply because it has become plain obvious that monetary policy is powerless.
Instead, we need to think ‘beyond the Overton Window’. The income transmission mechanism which we have adopted since the first industrial revolution, Work->Job->Income is broken. Monetary and fiscal policy thus become redundant. We need a new model more suitable for the digital age.