A look back at 2005 (Kash)

Excessive Liquidity

The Economist is worried about the rapid growth in the world’s money supply over the past couple of years:

HOW loose is the world’s monetary policy? One gauge is that real interest rates in America and other countries are still negative. Another is that global liquidity has been expanding at its fastest pace for at least 30 years. This deluge largely reflects the combined effects of American and Asian monetary policies.

… Central banks are supposedly the guardians of money. Yet between them they may have created the biggest liquidity bubble in history.

With the exception of the stock market crash year of 1987, the world’s money supply has not grown this fast since the mid 1970s. But exactly where has all of this vast amount of liquidity gone? Since output and output prices have not been rising particularly fast, it seems that much of it has gone to fuel asset price inflation. Housing prices have probably been inflated thanks to all of this liquidity (as many people have noted), but so have bond prices. As a result, bond yields have remained unusually low for this stage in an economic expansion.

As the following chart shows, real long-term interest rates have continued to fall over the past year or two even as the economic recovery has gained strength. (I used the average inflation rate over the previous 24 months to proxy for 10-year inflation expectations, and the close correspondence with the 10 year TIPS rate suggests that this is a good first cut at gauging real long-term interest rates.)

The failure of long-term interest rates to rise recently as the Fed has pushed up short term rates has been puzzling to many observers recently, and troubling to some. But I think that the explanation is simply that long-term bonds are one of the only places left for all of this liquidity to go. As we know, much of this newly-created money has ended up in the hands of a few Asian central banks, and they are not in the habit of putting their liquidity into purchases of goods and services, or stocks, or real estate.

This creates what I think is a surprising paradox: the unusually low long-term interest rates that the US is currently enjoying may in fact be the direct result of the US’s financial imbalances, since that is exactly what has put so much of the world’s liquidity into the hands of those Asian central banks. And those financial imbalances are in turn the result of the US’s poor savings. So in a bizarre twist, we may be experiencing a situation where the US’s lack of saving is what is actually keeping interest rates low…