Lower for Longer?

“The stock market is never obvious. It is designed to fool most of the people most of the time.”

-- Jesse Livermore

Remember when everyone called for higher rates? Recall when it was “only a matter of time” before the ten-year yield in the US approached its longer term “fair value” of near 4.5 percent (two percent inflation plus 2.5 percent real growth)? I can remember. I can also understand why we may be in this low interest environment far longer than we all may have believed possible. Europe is dangerously close to deflation and the European Central Bank’s recent negative charge on banks’ excess reserves and a record low policy rate attest to this. Rapid technological advancements have created a huge productivity boost that is benefiting capital and frustrating labour. Furthermore, the record reserves held at central banks are not inflationary. Let’s discuss how these two often sited concepts that suggest inflation and thus yields could rise may be misinformed.

Strong Employment

The labour market is strengthening and growing in the US but there is still a lot of slack. It is true we have gained back all the jobs lost since the great recession but the composition is not really the same. Non-farm payrolls are back to all-time highs but full-time jobs are still about 2.6 percent below their all-time high (nearly seven years later). Remember, over this period the population has actually grown so if total employment was really booming we would be well above all-time numbers. Technology and efficient outsourcing have reduced the overall demand for labour per unit of output. In fact, labour participation is at a 30-year low and there may even be a risk of discouraged workers returning to the workforce upon any semblance of new decent job opportunities (skills permitting). The U-6 unemployment rate which includes unemployed plus marginally attached workers and part-time employed for economic reasons, is 12.2 percent compared to eight percent in 2006 and 2007. I don’t foresee much in the way of demand pull pressure from an extremely tight labour market anytime soon. In fact I’ve quoted this before but according to Gallup chairman Jim Clifton in the book The Coming Jobs War:

“Of the seven billion people on Earth, there are five billion adults aged 15 and older. Of these five billion, three billion tell Gallup they work or want to work. Most of these people need a full-time formal job. The problem is that there are currently only 1.2 billion full-time, formal jobs in the world. This is a potentially devastating global shortfall of about 1.8 billion good jobs. It means that global unemployment for those seeking a formal good job with a paycheque and 30-plus hours of steady work approaches a staggering 50 percent, with another ten percent wanting part-time work.”

Although employment is turning in some economies, massive global slack remains.

Broken and Unlinked Transmission Mechanism in Central Banking

The other aspect that gets offered up as evidence that inflation is inevitable and likely to burst forth is ‘look at all the central banks inflating their balance sheets’. Unfortunately, this is a misconception that gets continually propagated because a lot of people do not understand fractional banking. Let me try to explain briefly (apologies for the technical nature of this).

Banks don’t lend reserves. It’s simply not possible on the macro level. The banks could issue new loans whether they had those excess reserves at the Fed or not — assuming they had qualified and willing borrowers and their own regulatory capital. In plain and simple terms, banks create money (bank deposits) when they lend. The other way the banking system gets deposits is from government deficits. When the government spends more than it takes in, it credits bank deposits. The offset for those deposits are reserves. Here is a summary on three ways reserves go down (none of them involve banks “lending” them out):

— The central bank sells assets (the reverse of quantitative easing “QE”).

— The government runs a surplus.

— The public increases its desire to hold cash, ie a bank run would do this (but of course this is highly deflationary).

The next time someone says that QE is inflationary or “all those reserves” sitting on central banks HAVE to lead to inflation tell them no. (Note: What is likely true that QE is great for asset prices and could be argued to lead to “asset price inflation” but not traditional definitions of goods and services inflation.)

For more information please read Paul Sheard, Chief Global Economist at S&P’s excellent piece here: http://www.standardandpoors.com/spf/upload/Ratings_US/Repeat_After_Me_8_14_13.pdf

Central banks get a lot of press these days but ultimately they are not the transmission mechanism for inflation. Private sector banks are. Furthermore, QE is a policy aimed at reducing interest rates but its linkage to lending is far from tight. Maybe, at the margin, lower rates induce a borrower to get a loan that it wouldn’t have otherwise wanted because terms are ’cheaper’. This, however, is debatable. The fact that banks don’t lend out excess reserves at the macro level is not debatable. In fact it may be true that QE is actually ’deflationary’ as income generated from securities bought by the Fed is not earned by the public and low rates lead to less interest income for savers to spend.

The spectre of deflation is still evident globally. Labour slack is still massive and very accommodative monetary policy has not created traditional inflation (but rather asset inflation). The situation is slowly becoming eerily familiar to one in which for decades, traders and investors have continually bet against — Japanese bonds. They continually put on trades that would benefit “once Japanese yields inevitably rose”. They have lost so much money on this bet that the trade on rising Japanese yields was dubbed “the widow-maker”. In markets there is never a “sure thing” even if you desperately want it to be. Rates could be low for a much longer time to come than anticipated by many.

Nathan Kowalski is the chief financial officer of Anchor Investment Management Ltd ( www.anchor.bm ). The views expressed are his own.

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