thoughts toward a deflation reversal mechanism
by Dr. Tom Drake
18 August 2002 04:15 UTC
From the Longwaves discussion board at: csf.colorado.edu
I have discussed here several times over the past few years the
mechanism whereby falling crude goods prices eventually reduce
investment in production, storage, processing, transportation, and
inventory levels to the point that small upticks in demand cause
rapid price reversals.
We saw this over the past few years in petroleum, gas, hogs,
cocoa, gold, and possibly now in grains.
Besides crude goods prices, the other large factor in Long Wave
economic cycle trends is interest rates. I've been looking at
mechanisms here too for a supply/demand reversal.
It is becoming clearer that a falling interest rate is deflationary.
It is common knowledge, but incorrect, that lower interest rates
are necessarily good for whatever ails us economically.
Even if one comprehends that fallacy, one tends to think that falling
prices and falling rates are symptoms of disinflation/deflation, but
that isn't necessarily true either. They may be causes of deflation
under certain circumstances.
Falling rates are good for the banks, up to a point, as they can
borrow short for less and go out further to notes and bonds and
make money on those treasuries.
That's how the banks were bailed out in the early 90's and how
they are remaining strong now.
For a long while as rates are low and falling banks have no
incentive to lend to businesses as they can make more with less
risk by buying treasuries. The FED can talk and encourage the
banks to lend, but they don't do it. The FED loan officer surveys
show that officers have been tightening loan terms for two years as
rates fell.
However, as the actual spread between short and long term
narrows, there is less net income and some greater market risk in
holding the treasuries since they have been bid up by this very
"FED carry" by banks and funds.
So the tradeoff for banks is where is the greatest income spread on
their borrowed funds, and where is the least risk at that time?
Once that spread gets narrow enough and the market risk on bid-
up treasuries gets high enough, a cessation in lowering rates or
even early and modest rate increases can induce banks to lend
once more. (In all this I am assuming that some old and some new
people still have good business ideas and plans at all times, but
they don't get funded when the banks can make money so easily
on treauries.)What the economy "needs" is some business finance
for new businesses with new ideas or products and leadership.
With short term rates getting down near 1% and the rates on 2-10
year notes plummeting, it could be that even a cessation of rate
lowering and the fear of a rate rise could stimulate lending to
businesses. And the banks are flush with cash and notes and
bonds.
In this project I have going, I am looking at actual market
mechanisms which can self reverse a market. Interest rates can be
too low for anyone to make any money just as they can be too
high for anyone to make any money.
So if the spread between treasury notes and deposits or funds gets
too narrow, banks have to find another way to make some money.
They will have to begin to take on a little more risk in order to make
more money, so they will begin to look at loans.
This could happen just on its own as an equilibrium phenomenon,
or a clever FED could raise rates which would squeeze the
note/funds spread.
Maybe even a "buyers strike" by CD investors and other "dead
funds" could begin to accomplish the same thing, drying up cheap
fund supply.
I'm not saying when or if this will happen, but rates are getting low
enough to squeeze the spread.
Reducing rates does nothing but reliquify the banks and stimulate
a bond and note market rally by bank buying.
This sounds absurd at first glance, but let's get rid of this ugly
hyperinflation in bonds which is destroying the economy. Antal
Fekete got me onto this idea about ten years ago when he said
that the treasury bond market rally in the 1930's prolonged the
depression. I didn't fully understand the implications of the idea
until recently. Now it makes a lot more sense.
Dr. Tom Drake
Tenorio Research/NBU
csf.colorado.edu |
