Bespoke Investment Group observed on its blog that the 3-month U.S. Treasury Bill Yield recently dropped below zero as investors seeking a safe haven for their cash pile into short-term treasuries. A yield below zero is the equivalent of lending money to the government, and paying it for the privilege, rather than the government paying you for borrowing your money. Crazy? It certainly seems that way. But maybe the economy will get so bad that paying the government to hold your money will seem like a good idea. Apparently, to some investors, it already is.
We should not make too light of this situation, however, because it raises the spectre of a something akin to economic quicksand – a liquidity trap. When nominal interest rates fall to zero (or below), the opportunity cost of holding cash dissipates. In other words, one might as well literally stuff money in the mattress if one cannot loan money and receive a return on the investment. Liquidity traps can occur when prices are falling (a deflationary cycle) and the Fed lowers rates to spur borrowing and lending. No investor wants to buy assets because the prices keep falling, and then, when interest rates fall toward zero, investors and lenders begin hoarding cash, as there is no longer any disincentive (inflation or better opportunity for returns) to holding cash.
One reason we are approaching a liquidity trap now is that our banking industry faces a balance sheet crisis. Thus, even though the government shifted its goals for the Troubled Asset Relief Program and began investing directly in banks, the financial industry is not using that money to lend. Part of the reason is that rates are so low and balance sheets so fragile, that banks are hoarding cash to protect themselves. That is why borrowing rates are not improving (although mortgage rates have come down thanks to a different government program) despite the Fed lowering its federal funds rate to 1 percent and massively increasing the money supply.
Another issue during a period of deflation that adds to the liquidity trap concern is the fact that the real value of nominal liabilities increases and thus, real interest rates increase as the nominal rate trends toward zero. To put this in clearer terms, imagine you bought a house for $100,000 and have an $80,000 principal balance on a mortgage. That leaves $20,000 of equity in the asset, the house. But then housing prices drop, and now your house is only worth $80,000. The mortgage has not changed and the mortgage interest rate has not changed either. However, the real value of the mortgage and the interest on the mortgage has gone up, because now you are paying the same amount for an asset that has dropped 20 percent. In order to regain the nominal equity in the house, it will be necessary to reduce the mortgage principal by $20,000, which is 25 percent of the mortgage and, now, also 25 percent of the value of the house. Now, let’s say $20,000 falls into your lap from the sky. You can invest it and earn zero percent, you can pay down your mortgage, or you can hold onto it and wait. Most consumers in this environment will hoard cash, just like the banks are doing now, until a clear choice can be made, because the other alternatives are too unattractive. And here is the problem from the macro economic point of view, $20,000 was added to the economy, but it went into the mattress and so, it had no stimulating effect on the economy.
The liquidity trap is why the government needs to refocus away from simply easing access to money and concentrate on fiscal stimulus and, more importantly, restructuring banks’ balance sheets. I believe the government will take all three of those paths in the coming year, will which spur a temporary improvement in the economy and the stock markets. But the resulting inflation, continued lack of consumer spending, and lack of a jobs recovery will likely tip the economy into stag-deflation sometime in 2010. This is when we could see the stock market hit some truly ugly lows (no, we have not seen the worst, but it will look like it is getting much better over the course of the next year—use it to your advantage, but do not be fooled).
By the way, if any of you cash hoarders out there are thinking a money market fund is the best place to be right now, please read this article at Bloomberg.com: Money-Market Fund Yields May Fall to Less Than Zero.
![[comback kid]](http://s.wsj.net/public/resources/images/SJ-AD409_07LEDE_NS_20081205203220.gif)
Gregg D. Killoren
victoria1014
Disinflation/Inflation/Deflation and Fiscal Stimulus: A Look at 2009
On December 12, 2008, the Bureau of Labor Statistics of the U.S. Department of Labor announced that the Producer Price Index (PPI) for Finished Goods dropped 2.2 percent in November. This decline follows recent decreases in PPI of 2.8 percent in October and 0.4 percent in September. Food prices were flat and energy prices declined by 11.2 percent. If one removes the prices for food and energy goods from the equation, as the government likes to do because those prices are considered to be too volatile to rely on them for long-term policy decisions, the PPI increased 0.1 percent. The other economic news of the day was a report that retail sales fell 1.8 percent in November, a record fifth consecutive monthly decline.
What these numbers are reflecting is that the U.S. economy is experiencing disinflation, and not yet deflation. There is still inflation (the “core” PPI increased), but its impact is lessening over time, particularly as commodity and energy prices have dropped. Deflation is a condition where the prices of all assets classes decline, usually because the money supply has been restricted. Part of what makes deflation so devastating to an economy is that it discourages investment. Imagine a world where every asset one buys almost immediately decreases in value. In other words, imagine if the only investment option, other than holding cash, was to buy a car. Wouldn’t one rather hold cash than invest in an asset that immediately loses upwards of 10 percent of its value, and continues to drop over time? That is what deflation does to investing. It makes every asset look like a car.
The U.S. economy may be heading toward deflation if the money the U.S. government and other countries have pumped into the financial system does not find its way into the hands of businesses and consumers, or does so at such high cost as to make borrowing unattractive. The sheer volume of efforts made by governments, and, in particular, those yet to be made by the next U.S. administration, will likely postpone deflation in 2009. However, central banks will have to shoot their way out of the liquidity trap that has been forming (see my previous post).
Let’s put some quick numbers on this to demonstrate what next year may look like. Analysts at RGE Monitor calculate that the combination of the negative wealth effect of the drop in housing and a return to the 1990s’ savings rate of approximately 6 percent would result in a decline in consumption over time of more than $1 trillion. Specifically, if housing prices return to their long-term trend line, that would be roughly a 30 percent drop from peak to trough. The negative wealth effect from such a drop would subtract approximately $400-500 billion from private consumption over time. The rebalancing from a debt-oriented consumer to a savings-oriented consumer would reduce consumption by $1 trillion. A fiscal stimulus plan, like the one outlined by President-elect Obama, that would invest in infrastructure, public services and green technology would greatly help toward offsetting the lost consumption, and since it is not simply pumping money into the financial system, it avoids, and hopefully resolves, the liquidity trap. However, just to keep the economy limping along, such a program would have to be at least $700 billion.
Even if such a fiscal stimulus package were to be enacted, and it almost certainly will be, we cannot expect that it will end the recession. But, it will forestall deflation for now. The hidden danger in such a plan is that it will reinflate the commodity bubble, especially in oil and metals. In fact, in the recent run-up to what was expected to be an auto industry bailout, oil and iron ore sprang up off their lows. A spike in commodities next year, along with the large increase in the money supply and low interest rates (probably at zero) would instantly spark inflation, which, in turn, would likely snuff out any economic recovery within a few months. It would be too soon for the Fed to raise rates to temper inflation because private investment in the economy would not have returned. Then, in 2010, after the commodity bubble bursts once again, the U.S. economy would turn deflationary, and there would be no stopping it. This is but one possible outcome, and there are many variables involved, and a change in any one of those variables would have a meaningful effect on the outcome.
What we should be watching next year, then, are the prices of oil and copper. Both are key elements in any recovery, and with a stimulus plan focused on infrastructure, both will be in demand. If those prices rise too far and too fast, we will wind up in a “Groundhog Day”-type scenario, where the stock market and commodities prices peak in May/June and then spend the rest of the year falling, just like this year. The only difference is that the fall will be from a lower high (10,000 to 11,000 on the Dow ones Industrial Average, and $80-100 per barrel of oil) and will result in a much lower low (5,000-6,000 on the Dow, $25-35 per barrel of oil). Now, on the bright side, if commodities prices manage to move within a reasonable range, the recession may ease, and while the bear market will persist, volatility would come down and thus, the lows of November 2008 would likely represent the bottom.
→ 2 Comments
Posted in Credit Crisis, Economy, Finance, Market Commentary
Tagged Economy, Finance, Market Commentary