Published in Business Day on 11 March 2015: http://www.bdlive.co.za/opinion/2015/03/11/monetary-policy-the-big-bad-wolf
PUBLIC enemy number one for central bankers in the developed world is deflation. When the consumer price index (CPI) declines we have deflation, when it rises we have the opposite, inflation. Prices in general fall when aggregate demand in the economy exercised by households, firms and governments fails to keep up with potential supply. Prices rise when demand exceeds supply.
The economic problem in the developed world, and in much of the less developed world including SA, is too little rather than too much demand and that has called for highly unconventional monetary policy.
Central bankers, with modern Japan very much in mind where prices have been falling and economic growth has been abysmally slow since the early 1990s, are convinced that deflation depresses spending and thus serves to prevent an economy from achieving its growth potential.
They are therefore doing all they can to stimulate more spending to arrest deflation or a possible decline in average prices. What they can do to encourage reluctant spenders is to create more money and reduce interest rates. Inflation, as they used to say, was too much money chasing too few goods. Deflation may be said to be caused by the opposite — too little money chasing too many goods. Inflation calls for less demand and so less money creation. Deflation calls urgently for the opposite — more money creation to increase aggregate demand and the supply of goods and services given widespread excess capacity, including the supply of labour.
While central bankers have the power to create as much extra cash as they judge appropriate, they have had to overcome a technical problem. The extra cash intended to encourage more spending may get stuck in the banking system and, when it does, there may be no additional demand for goods and services and the extra money created (at no cost) may not encourage spending or lending and provide no relief of the unwanted deflationary pressures. The banks may hold the extra cash as additional cash reserves or use the cash to pay off loans they may have incurred previously with the central bank.
The mechanics of money creation go simply as follows: The cash the central banks create (or more specifically the financial claims they create on themselves, called deposits with the central bank) when buying securities from willing sellers in the financial markets (typically pension funds or financial institutions of one kind or another) reflects immediately as extra privately owned deposits with private banks.
In the first instance, as the proceeds of a sale of securities by a private bank customer are banked, the private bank will have raised an additional deposit liability and will receive in return an asset in the form of an additional claim on the central bank. That is, the asset to match their additional deposit liabilities will take the form of an increase in their (cash) reserves at the central bank.
Normally the banks will make every effort to convert this extra cash into a loan that earns them more interest. Such loans would then lead to more spending. Normally banks keep minimal cash reserves in excess of the regulated requirement to hold cash reserves in fractional (say, 5%) proportion to their deposit liabilities.
But ever since the global financial crisis of 2008 this has not been the case at all. The central banks, led by the US Federal Reserve, have bought trillions of dollars worth of financial securities and the private banks have added trillions of dollars to their cash reserves.
The assets of the major central banks have expanded over the years. Their extra assets have consisted of securities issued by governments, for example, in the form of mortgage backed securities issued by the government backed mortgage lending agencies Fannie Mae and Freddie Mac in the US.
It should be noted that the European Central Bank’s (ECB’s) balance sheet has been shrinking in recent years, unlike those of the other central banks. This decline in ECB assets and liabilities (mostly cash reserves of the banks) has represented additional deflationary pressure on spending in Europe. The European banks have been repaying ECB loans previously made to them and the ECB has now responded by initiating a further programme of quantitative easing (QE), that is to say security purchases, intended to inject an extra €60bn a month into the banks of Europe over the next 21 months. That is to encourage bank lending and spending to counter deflation.
The important point to note is that creating money in the form of a deposit with the central bank by buying securities in the market costs society almost nothing. Creating money that is an asset of the banks, and so an addition to the wealth of the community, does not require any sacrifice of consumption or savings, as would any other form of wealth creation. It is literally money for jam. But in normal times too much money means too much spending and inflation. Hence the political resistance in normal times to creating more money — because it normally leads to unpopular inflation.
But the times have not been normal. The extra supply of money in the developed world has been accompanied by extra demands by the banks to hold money. So too little rather than too much spending has remained the economic problem. Hence the case for creating still more money, until deflation is finally conquered as the extra supply of cash is exchanged for goods and services.
The extra liabilities issued by the central bank matching the extra assets were mostly to private banks in the form of cash balances in excess of required cash reserves. In the US the banks have received 0.25% a year on these cash reserves.
It should be noted that the US banks have begun marginally to reduce their cash reserves with the Fed and that the assets of the Fed are rising more slowly with the end of quantitative easing in October 2014. Quantitative easing ended because the recovery of the US economy is well under way and presumably does not need further encouragement in the form of further increases in the supply of cash. The banks presumably have more than enough excess cash to meet the demands of borrowers. It could be argued that at least in the case of the US — the economy is recovering — the dangers of deflation have receded and the danger of inflation taking over is judged to be absent as a result of quantitative easing.
There is very little inflation priced into the yields offered on 30-year US Treasury bonds that offer yields below 3% and less than 2% more than inflation-protected US obligations with the same duration. Japan and Europe, it may be presumed, will be doing still more quantitative easing or as much as it takes to get the banks to lend out more of their cash.
The problem of deflation is complicated by very low or even negative interest rates. Cash has one advantage over other assets. The income return on cash can only fall to zero and no further. Other assets, for example, government securities or bank deposits, may come to offer less than zero income, that is only offer negative interest rates.
The German government, for example, can now borrow for up to five years, charging rather than paying interest to its creditors. In other words, it can borrow about €105 from you and promise to pay you €3 interest and only repay you €100 in a year’s time. In other words, the transaction will have cost you €2. But this, alas for widows and orphans and all those searching for a certain interest income, may be the best risk adjusted return on offer.
If prices decline by 2% over the year, your €100 will buy you as much as €102 did a year before, so adding to your real return. But you would have done still better holding cash as €100 in cash will still be worth no less than €100 after 12 months and will also buy you more if prices on average have declined.
Hence deflation forces down interest rates and encourages the demand for cash (and safe deposit boxes in which to store cash more safely than under the mattress, though they come with a fee).
Negative deposit rates therefore discourage the demand for bank deposits as an alternative to cash and more importantly for the goods and services that may be expected to become cheaper over time. Deflation also encourages banks and other lenders to hold cash reserves rather than lend them out. Loans may not be repaid in difficult times, especially when these enormous cash reserves earn the banks a positive rate of interest from the central bank.
Hence a further reason for central banks to fight deflation (and too little rather than too much spending) by flooding the system with additional cash to the point when the supply of cash can eventually, even with very low or negative interest rates, overwhelm the demand for cash. Just keep on pumping in the liquid stuff and the dam must overflow its banks. Once again the cost of doing so is zero.
Until Europe succeeds in overcoming deflation and stagnation we can expect interest rates in there to stay low and for the euro to stay weak. The US dollar, offering higher interest rates because its economic recovery is well under way thanks to three rounds of quantitative easing, can be expected to stay strong. We may also expect deflation and low interest rates in Europe to help hold down long-term rates in the US and elsewhere as European lenders seek higher yields abroad.
The weak euro and stronger dollar (and perhaps also stronger emerging-market currencies, including the rand) may also help restrain any increase in short- and long-term interest rates globally. It may take some time before the major central banks can say with any confidence: goodbye to deflation and welcome back the old enemy, inflation.