Wall Street Yield Trade: Another Explanation For Low Inflation

EconMatters's picture

By EconMatters


In an unprecedented move to fight off the threat of deflation, ECB cut its main interest rate to near zero at 0.15%, and its interest rate on deposits to a negative 0.1% for the first time. This means ECB will now be charging banks 0.1% to hold their reserves.  ECB hopes these aggressive measures would spur banks to ramp up lending, and also weaken the euro. France has long been arguing that high euro exchange rate is holding back the economic recovery in the Euro Zone. 


Testing Keynesian Theory


ECB and the U.S. Fed essentially have the similar Keynesian idea: Central Bank's act of reducing interest rates and increasing money supply would discourage savings, stimulate spending and demand for goods and services and improve bank balance sheets and banks’ capacity to lend.  This sounds nice in the context of Keynesian Economics; however, it has not worked quite that way in the U.S. despite Fed's massive money printing operation since 2008, an observation I'm sure Draghi 'overlooked' trying to repeat the proven ineffective steps of the Fed.


Deflation Anxiety

Conventional wisdom had many concerned about run-away inflation because of the $3.5-trillion injected by the Fed into the economy, but that did not really materialize.  In fact, up till the two most recent hot CPI and PPI reports, one major anxiety of the Fed was that the U.S. would fall into a prolonged Japanese-style deflation.



The Liquidity Trap?

Some economists believe the disinflation seen in the U.S. is mostly due to weak demand commonly seen during an economic recovery.  A blog published in April by the St. Louis Fed noted that as money supply (M0) increased 40.29% between December 2008 and December 2013, or about 8% per year on average, inflation should run at a pace of 4.3% per year.  But this did not happen.  St. Louis Fed posits that the liquidity trap could be an "alternative explanation for the generally unanticipated disinflation or low inflation levels".


Liquidity trap is a situation characterized by interest rates that are close to zero and fluctuations in the money supply that fail to translate into fluctuations in price levels.  One cause of the liquidity trap is cash hoarding because people expect a crisis event such as war or market crash.  As St. Louis Fed describes it:

During a liquidity trap...., increases in money supply are fully absorbed by excess demand for money (liquidity)....if money demand increases more than proportionally to the change in money supply due to the downward pressure LSAPs [Large Scale Asset Purchases] exert on the interest rate, the price level must fall to absorb the difference between the supply and demand of money.

Flight to Cash

As we can see in the chart below, Personal Saving Rate jumped up during the post-crisis recession period, and has remained higher than pre-crisis levels ever since.  In addition to consumers, American companies are also building up liquidity and holding onto record $5 trillion in cash.  This seems to support St. Louis Fed's position that low interest rate may have induced the flight to cash thus increasing the demand for money.



Wall Street Yield Trade


In our view, another major factor to the slow growth/low inflation in the U.S. is that Fed's ultra low near-zero interest rate actually incentivizes the Wall Street Yield Trade -- using the free money from the Fed to buy up Treasury for a risk-free profit delta bidding up Treasury prices while pushing down Yield.  As the bond market gets more crowded, some banks would use that money to buy up stocks or commodities such as crude oil or agricultures for a much better risk/reward return than mere lending to business and consumers.



Low Interest Rate Is Deflationary


In other words, by incentivizing unproductive use of capital, low interest rate is deflationary.  The majority of Fed's QE liquidity ended up in personal or corporation cash holding, or in the market (Treasury, Bond, Stocks, Commodities) without trickling down to the real economy leading to slow growth and disinflation (U.S. consumer inflation averaged around 1.6% per year from 2009 to 2013 in terms of CPI-All Urban Consumers).


European Bond Holders Could Take A Nasty Fall


In the case of the Euro Zone, low interest rate by ECB may have helped those semi-insolvent PIIGS governments to refinance their insane levels of debt.  Nevertheless, bond yield is supposed to be a risk measure.  After ECB announced its new low interest rate, the Wall Street Yield Trade has rendered the yield of some Euro Zone government bond a total mis-representation of the related sovereign risk.  For example, while U.S. 10-year Treasury yield is hovering around 2.6%, Spanish government can now borrow at 2.57%, a rate lower than Uncle Sam.  Equally ridiculous is that Italy now only pays 2.70% (or 0.1% above the U.S.) interest for its debt.



Everybody loves a risk free trade, but this is not a normal situation.  Once interest rate starts to normalize. the bondholders of the more risky Euro Zone government debt could see a rapid and nasty devaluation of their holdings.

Inflation Heating Up

The most recent reports on jobs, CPI, and PPI all suggest U.S. economy is picking up solid pace. And the chart above also shows a downward shift of Personal Saving Rate.  Saving Rate is trending down most likely due to better jobs market and inflationary pressure on everyday stuff (e.g., food and energy).  Inflation is indeed heating up -- the average annualized inflation rate for 2014 (Jan. through Apr.) is around 5%, while the same inflation trend from the Producer Price Index (PPI) is well above 5%.


The Right Move: Raise Interest Rate


Most central bankers are academics in the ivory tower making decisions based on economic theory that defies reality or common sense.  But in its blog post, the St. Louis Fed actually made a logical argument:

....more monetary injections during a liquidity trap can only reinforce the liquidity trap by keeping the inflation rate low (or the real return to money high). ....the correct monetary policy during a liquidity trap is not to further increase money supply or reduce the interest rate but to raise inflation expectations by raising the nominal interest rate.

With both inflation and economic activity ramping up, we also believe that the Federal Reserve should raise interest rate to get ahead of the inflation curve and also to push the liquidity out of the 'risk free' Yield Trade, into more productive economic and business activity.    


© EconMatters All Rights Reserved | Facebook | Twitter | Post Alert | Kindle

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
ebworthen's picture

The first chart illustrates things well.

When there is no incentive to save people don't.

When you flood corporations with liquidity you give them capital to do buy backs, fire employees (who do the actual work), and raise prices on consumers.

Prime rate to 5% and no bailouts or QE - but that would be rewarding savers and making corporations work for their profits - so the FED won't do it.

RMolineaux's picture

Large corporations cash hoards could be used to make capital investments and thereby expand jobs.  But they have chosen instead to buy back stock and increase executive remuneration.  The remedy is to reward new capital investment and punish hoarding, stock buybacks and excess executive remuneration through the tax system.  The problem is that the congress does not represent the citizenry but rather the same corporations that are strangling the economy with their greed.

OC Sure's picture

Gotta disagree with you here, RM. Instead of getting the govt involved more by coralling incentives and disincentives, why not get the govt out of the banking business? Audit the Federal Reserve and put an end to the USA's 3rd venture into centralized banking.

What is the source of all those cash hoards and why are citizens generally poorer than they used to be? What is it that lowers the purchasing power of the currency?

What if no more currency or digital blips were created anywhere on earth. What would people have to do to earn a share of the existing pool of currency? Actually work for it?

teslaberry's picture

there is no low inflation. inflation is at this point HIGH. and being MASKED OVER BY MANY METHODS.

just because we don't have hyperinflation yet doesn't mean inflation isn't very high already.


OC Sure's picture
It seems like the inflation of counterfeit has stolen as much as it can from the present economy that it must now steal from the production of future work via finding its home in debt and financial markets and that's what the "liquidity trap" is all about. It is still the ongoing theft as facilitated by an exchange of nothing for something. Prices are not only rising from the inflation of counterfeit but also from the simultaneous deflation of productive work. Those 90 million humans who have dropped out of the labor force, are they producing new products to account for the new currency? This deflation of productive work will increase as rates rise because marginal producers who borrowed at lower rates will get squeezed out in a rising rate environment. So, the devaluation of the currency, its decreased purchasing power, will feed on itself as rates rise and everyone will be scratching their heads, once again, as they can't understand why. Knowing the reason why is knowing the difference between money and counterfeit.  - http://ocsure.blogspot.com
TrumpXVI's picture

 "And the chart above also shows a downward shift of Personal Saving Rate.  Saving Rate is trending down most likely due to better jobs market"


Yeah, right, that's the correct analysis.

Stuck on Zero's picture

There is no Keynesian stimulus.  That is just a term to cover theft of the national treasuries.


The Most Interesting Frog in the World's picture

Great analysis.  Thanks!  Not sure I agree that the ECB and Euro governments will, in the end, permit rates to go higher (they will do whatever it takes)...  but time will tell.