Using Interest Rates To Create a Goldilocks Economy

With the sheer volume of money that has been pumped into the world economy by central banks over the last seven years, finding a home for much of it has become a problem.

Of course, the idea behind the three quantitative easing (QE) programs in the US, and those in Europe, was about trying to stimulate the global economy. The idea is that central banks purchase bonds owned by banks and other financial institutions, enabling the banks to lend the money they receive into the economy.

The process is often described as ‘printing money’, but it’s all done electronically. The central banks in effect create and transfer funds to the banks, in exchange for the bonds.

Like any business, central banks run a balance sheet. The US Federal Reserve has expanded its balance sheet upwards of $3–4 trillion on account of these purchases, starting with QE1, which ran from 2009.

In a nutshell, it’s all about creating liquidity. To generate a return on these funds, the theory goes that the banks lend the money to companies, who invest it to grow their businesses. This in turn creates employment growth, which flows through to benefit the broader economy.

But it’s not just about lending all the new money to businesses. Banks need to invest excess funds on hand to generate a return, which they can do by buying shares and bonds.

With both central banks and financial institutions buying bonds, this pushes up the price of bonds. As the price of a bond works inversely to the yield, this bidding up of the price of bonds leads to a lowering of the yield.

That’s another reason behind implementing a QE program. Yields on bonds become so low that banks are forced to lend money into the economy — that is, to people who actually do something, like businesses. Lending to businesses should generate a better return for the banks than parking funds in ‘safe haven’ bonds.

Although unusual, QE isn’t a new phenomenon. The Bank of Japan used a form of it back in the 1990s (and are still using it) to try and kick start an economy that was already mired in deflation.

Typically, central banks use monetary policy (interest rates) to stimulate or stymie demand. It’s all about finding the right balance of growth and inflation — not too hot, and not too cold. Or as the phrase goes: the ‘Goldilocks economy’.

Excessive growth can lead to a jump in inflation, requiring the central bank to raise rates to moderate it. Conversely, too little growth can cause a recession or deflation, necessitating the central bank to lower rates to stimulate growth and demand.

The problem with monetary policy, though, arose from the maelstrom that swept through the global economy in 2007¬–08. Central banks began to dramatically lower their cash rates, but…nothing happened. Expecting a complete financial meltdown, financial institutions started hoarding their cash and severely limited their lending.

As the central banks repeated the process, cash rates headed towards zero. But still without stimulating demand — in effect, monetary policy had been rendered useless.

QE was born out of the fact that monetary policy had stopped working. You can see how each rate cut produced a diminishing return in its aim of stimulating growth. A small difference in lending rates isn’t likely to be the final determinant in whether a business investment goes ahead.

Just as monetary policy has lost its impact, so too has QE. The world is awash with money, but an ever dwindling supply of places to invest it.

If you want to get a feel for where the money has gone, take a look at two charts. First, the Dow Jones. Then, look at the yield on government bonds. Below is the chart of 10-year bond yields for the US, Germany and Japan.

Source: RBA and Thomson Reuters

[Click to enlarge]

Trying to figure out how much of this QE money has found its way into the stock market is impossible to work out exactly. But it has clearly inflated it more than it would have without the QE money in the system.

Bond yields have been pushed down so far — and are now negative in more than a dozen countries — that financial institutions are paying interest to their central banks to deposit money with them. So much for investing it in the economy.

Under this scenario, it’s not surprising that some of these excess funds are finding their way into the Australian bond market. Yes, the yield on a 10-year government bond is at record lows — about 2%. But compared to Japanese 10-year bonds with a yield of minus 0.29%, it’s a pretty big difference.

This flow of money into Australian bonds is also having another effect — on our currency. The Aussie dollar — often described as a ‘risk currency’ — is once again pushing higher. It’s all about the flow of funds. To buy Australian bonds, offshore investors first need to buy Australian dollars.

Some of those funds will also continue to find their way into the Australian stock market. With our market currently trading on a yield of 4.3%, it’s a tempting return compared to what else is on offer. The worry, though, is if this yield trade starts to reverse. That could see both bond prices and the market fall at the same time.

It’s an unusual time in the markets, and has been for many years. Despite the unprecedented rivers of stimulus, the world economy remains sluggish at best. Poor old Goldilocks looks to be drowning in cold porridge.


Matt Hibbard,
Editor, Total Income

Editor’s note: The above article was originally published in Markets and Money.

From the Port Phillip Publishing Library

Special Report: The greatest mind of the modern era is about to embark on his greatest and most ambitious project yet… A revolutionary, digital network designed to beam superfast internet to every inch of the planet…from space! And for you — as an investor — it could mark the start of an epic 14-fold profit run…if you’re willing to take a calculated risk with a small portion of your capital…(more)

Money Morning Australia