We have all known that the drastic reduction in interest rates engineered by the Fed was going to have unintended consequences. The first one has now appeared, and it is a whopper. The Fed has lost control of monetary policy. Here are the facts:
Real interest rates are negative in the US. Nominal interest rates in Europe are negative. That has never happened before. The result no one saw coming is that, in a negative interest rate environment, businesses who have customers who owe them money do not want to get paid (as long as the receivable is good). The account receivable created by a business transaction is now worth more than the money with which it will be paid. (the effect of this on the money multiplier is unknown but surely profound. That is a subject to complex for this email but worth having explained to you, suffice to say since AR is bought and sold all the time this an increase in the money supply not sanctioned by the Fed).
The implications of this are mindboggling. Setting aside what it means in vast bond market, consider the practical implications on a business’ balance sheet. In the asset account of Business A is an “account receivable” from Business B who purchased a widget from Business A for $100. If Business B pays that account receivable Business A must invest it. Given a negative interest rate he must now “invest” that $100 and receive less (-1% it would equal $99 on an annual basis) whereas if the account receivable were held for 1 year Business B would have to pay $100. Since Business A’s balance sheet is loaded with cash due to Fed policy it can’t reinvest in operations, the demand is just not there for its product. If he produces more the price will go down. That is a historically unprecedented deflationary pressure. Business B’s account receivable, even though subject to business risk including bankruptcy, is worth more than money backed by the US Government who can actually “print” the money if need be. That receivable is a misvalued asset if there ever was one.
Additionally, Business B does not want to be extended credit because the use of leverage is no longer as lucrative to him. In the past, businesses would, rightly, start to discount late accounts receivables due to it being less likely to be paid. Now, with the added element of that account receivable being more valuable (in terms of cash) the account receivable is not properly valued. There are no accounting procedures to contemplate this phenomenon. When there is ambiguity regarding the assets of a business its proper stock price is impossible to determine. While currently there is only a small influence of this phenomenon on the market, Jamie Dimon and others have warned they are seeing liquidity (amount of buyers) dry up in the bond market. If this will accelerate no one knows (personally I think it will, but I'm sticking to facts).
The conclusion is that under no circumstances can the Fed lower rates any more. The Fed knows this and that is why they are hell bent on raising rates (though they will not tell anyone, I’ll let you draw your own conclusions as to why). The clock, or the detonator, as it were, is ticking.
The only problem is that the Fed cannot raise rates because of the negative interest rates in Europe (even Warren Buffet said this last week several times). If the US were paying significantly more than the Europeans the demand/value of dollars would go up as foreigners purchased our debt. A stronger dollar would make imports so cheap US manufacturers would not be able to compete. This would create massive layoffs and a precipitous drop in domestic stock prices.
This is an over simplification, but undeniable explanation of why the Fed has lost all control over monetary policy. When coupled with the government’s acknowledged loss of control of fiscal policy, the status quo is obviously not an option. One can only conclude that the days of “kicking the can down the road” are over. As soon as the market figures this out it is “Katy bar the door”.
The day we have been warned about for years is here. The effect will be on every household in America as deflation greater than the 1930s, or inflation akin to 1920s Germany, develops, I’d guess, sometime during the next 6 months, probably sooner rather than later. In the days of electronic banking it will happen at lightning speed. America’s wealth will not be redistributed. It will evaporate, and soon.
I don’t know whether to warn of deflation or inflation. We are surely sitting on an inflationary bomb with the recent monetary and fiscal policy decisions. The only reason the inflation bomb has not exploded is because one component of inflation, velocity, has been absent. If there is an uptick in the economy the verdict will be inflation. If there is a decrease in economic activity (today a negative GDP number was confirmed) the verdict will be deflation. It might even be deflation if the Fed raises rates in response to an increase in economic activity as they promise. They are no more “data dependent” than a man in the moon as their reaction is an unknown.
If I'm wrong I will never post on TI again, promise.
Real interest rates are negative in the US. Nominal interest rates in Europe are negative. That has never happened before. The result no one saw coming is that, in a negative interest rate environment, businesses who have customers who owe them money do not want to get paid (as long as the receivable is good). The account receivable created by a business transaction is now worth more than the money with which it will be paid. (the effect of this on the money multiplier is unknown but surely profound. That is a subject to complex for this email but worth having explained to you, suffice to say since AR is bought and sold all the time this an increase in the money supply not sanctioned by the Fed).
The implications of this are mindboggling. Setting aside what it means in vast bond market, consider the practical implications on a business’ balance sheet. In the asset account of Business A is an “account receivable” from Business B who purchased a widget from Business A for $100. If Business B pays that account receivable Business A must invest it. Given a negative interest rate he must now “invest” that $100 and receive less (-1% it would equal $99 on an annual basis) whereas if the account receivable were held for 1 year Business B would have to pay $100. Since Business A’s balance sheet is loaded with cash due to Fed policy it can’t reinvest in operations, the demand is just not there for its product. If he produces more the price will go down. That is a historically unprecedented deflationary pressure. Business B’s account receivable, even though subject to business risk including bankruptcy, is worth more than money backed by the US Government who can actually “print” the money if need be. That receivable is a misvalued asset if there ever was one.
Additionally, Business B does not want to be extended credit because the use of leverage is no longer as lucrative to him. In the past, businesses would, rightly, start to discount late accounts receivables due to it being less likely to be paid. Now, with the added element of that account receivable being more valuable (in terms of cash) the account receivable is not properly valued. There are no accounting procedures to contemplate this phenomenon. When there is ambiguity regarding the assets of a business its proper stock price is impossible to determine. While currently there is only a small influence of this phenomenon on the market, Jamie Dimon and others have warned they are seeing liquidity (amount of buyers) dry up in the bond market. If this will accelerate no one knows (personally I think it will, but I'm sticking to facts).
The conclusion is that under no circumstances can the Fed lower rates any more. The Fed knows this and that is why they are hell bent on raising rates (though they will not tell anyone, I’ll let you draw your own conclusions as to why). The clock, or the detonator, as it were, is ticking.
The only problem is that the Fed cannot raise rates because of the negative interest rates in Europe (even Warren Buffet said this last week several times). If the US were paying significantly more than the Europeans the demand/value of dollars would go up as foreigners purchased our debt. A stronger dollar would make imports so cheap US manufacturers would not be able to compete. This would create massive layoffs and a precipitous drop in domestic stock prices.
This is an over simplification, but undeniable explanation of why the Fed has lost all control over monetary policy. When coupled with the government’s acknowledged loss of control of fiscal policy, the status quo is obviously not an option. One can only conclude that the days of “kicking the can down the road” are over. As soon as the market figures this out it is “Katy bar the door”.
The day we have been warned about for years is here. The effect will be on every household in America as deflation greater than the 1930s, or inflation akin to 1920s Germany, develops, I’d guess, sometime during the next 6 months, probably sooner rather than later. In the days of electronic banking it will happen at lightning speed. America’s wealth will not be redistributed. It will evaporate, and soon.
I don’t know whether to warn of deflation or inflation. We are surely sitting on an inflationary bomb with the recent monetary and fiscal policy decisions. The only reason the inflation bomb has not exploded is because one component of inflation, velocity, has been absent. If there is an uptick in the economy the verdict will be inflation. If there is a decrease in economic activity (today a negative GDP number was confirmed) the verdict will be deflation. It might even be deflation if the Fed raises rates in response to an increase in economic activity as they promise. They are no more “data dependent” than a man in the moon as their reaction is an unknown.
If I'm wrong I will never post on TI again, promise.
