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Sunday, June 15, 2014

Who believes in the world recovery myth? Not the World's Central Banks.

The “WHY” Of Negative Rates

The fear of sliding into a deflationary spiral currently outweighs concerns about future inflation. In moves similar to those taken by central banks in the UK, Japan, and the U.S., the ECB has pumped liquidity into the markets in an effort to stimulate their economy. But, much of this liquidity has never made it into the marketplace and, instead, has been locked away in the vaults of the major banks. According to the Financial Times (June 6, 2014 edition), European banks held €120 billion ($163 billion) of excess liquidity on deposit at the ECB. Unlocking these funds by putting them back into the system to be exchanged and “recycled” would certainly give a lift to European Gross Domestic Product (GDP).

That is what these central bankers are trying to do with the negative discount rate – to try and increase the “velocity” of the money they have placed into the system in order to get more bang for their bucks (or rather euros).

The St. Louis Fed defines Money Velocity as, “a ratio of nominal GDP to a measure of the money supply (M1 or M2). It can be thought of as the rate of turnover in the money supply – that is, the number of times one dollar is used to purchase final goods and services included in GDP.”1

By charging banks to park money at the central bank, the ECB hopes to convince them to lend these funds out, putting them back out into the economy and increasing the velocity of this money. But, the question remains: will there be enough loan demand from credit worthy borrowers? After all, banks are interested in making money and the easiest way to do this is to lend funds at a greater rate than they are paying depositors. I would think that if there was existing demand from credit worthy borrowers, these banks would be making loans instead of parking funds at the central bank at the previous rate of 0%.

Will They Migrate West?

Another question that comes to mind is just how long will it be until our own Fed joins in this experiment? The U.S. economy is not recovering as quickly as many of our leaders would like. True, the Federal Open Market Committee (FOMC) continues to taper their latest round of quantitative easing (QE), but I will remind readers of the Daily Pfennig® newsletter that, according to the minutes of the FOMC, this taper is not because the U.S. economic recovery is gaining steam, but, instead, because the bond buying was “not having the desired impact.” If the U.S. economy stalls out, Fed Chair Janet Yellen will be searching for a “new and improved” way to try and stimulate it. Investors could potentially be weary of another round of QE; so negative deposit rates may be something that the FOMC would consider.

Portrait of a stalled economy, dependent on Central Bank largesse:

Source:Federal Reserve Bank of St. Louis
(Click here to view a larger image.)
As illustrated by the above chart, the velocity of money in the U.S. has steadily dropped since peaking in January 1981. This graph from the St. Louis Federal Reserve measures MZM (money with zero maturity), which is the Fed’s broadest measure of the money supply. This measure best determines the frequency at which financial assets are switching hands within the economy.

As shown, the velocity of money here in the U.S. has steadily decreased over the past 30+ years from a reading over over 3.5 to the current reading below 1.5. This means that every dollar “created” by our Fed in an effort to stimulate our economy has much less of an impact when compared to prior years. Like the ECB, our Federal Reserve would love to figure out a way to turn this trend around and start to increase the velocity of money. Negative interest rates may just make their way across the Atlantic.

What would this mean? First, negative interest rates would typically lead to lower currency values as individuals search for countries and currencies which can offer better returns (and higher interest rates). I believe this was actually one of the unstated goals of the ECB’s recent move; they wanted to try and drive the value of the euro lower in order to make their exports more competitive.

However, the longer term consequences of these negative rates are still a mystery.   

But five years after near total collapse of the world financial system, world GDP is still anemic to non-existent.

Certain outcomes: 

Competitive devaluations of currencies continue.

Wages remain stagnant.

Cost of living continues to skyrocket.

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