Hello everybody. I am a regular reader of the Mish blog (two years now). This is the first post for me on the Silicon Investor. I felt the BC quote was thought provoking so I came to react.
The way I see it, we need to recognize that following a rate cut the movement of the demand curve precedes the movement of the supply curve. The movement of the supply curve will only come after the rate cut induced investment translates into product production. We can therefore abstract a two stage scenario where in the first stage only demand expands and in the second stage the supply curve moves to follow.
Demand, of course, is composed of consumer goods and capital goods. But while demand for consumer goods probably does not have much affect on the future, demand for capital goods will translate into future production. The prospect for the future movement of the supply curve is therefore determined by the composition of the aggregate demand in first stage.
If the consumer has debt free assets that he can present as collateral he may borrow to consume while the money is easy. But even if the consumer is not able to borrow his way into consumption, demand for capital goods will still make aggregate demand outstrips aggregate supply in the first stage. This means the first stage is bound to translate into growth and upward pressure on prices under both debt assumptions.
However, if the consumers debt is high enough so that in the aggregate they cannot take advantage of the low interest rate than demand will show mainly as capital goods demand. In this case most of the upward pressure on prices would show up in industrial raw materials. Otherwise, if the consumers, in the aggregate, still have some assets that they can place as collateral and they are willing to do so to consume, demand will be lead by consumer goods and it would show up as upward pressure on the CPI.
The second stage is a bit more complicated since we need to also consider what happens to interest rates.
If interest rates are normalized and there was consumer goods leadership in the first stage what is expected is a period of growth slowdown and disinflation. The demand curve moves back. Supply is only marginally higher then it was to begin with, which results in only minor bankruptcies.
If interest rates remain low and there was consumer goods leadership in the first stage what is expected is a period of back to trend growth and rising inflationary expectations. Real interest rates diverge from nominal interest rates and start hading into negative territory. An inflationary spiral commences as the public loses trust in the currency and starts using inflation adjusted contacts and foreign currency in transactions.
If interest rates are normalized and there was capital goods leadership in the first stage what is expected is a period of growth slowdown and deflation. The demand curve moves back as demand for capital goods dries up. Supply is much higher then it was to begin with, which results in major bankruptcies, credit contraction and price declines. Some deflationary expectations might develop. This will cause real interest rates to go even higher which could lead into a deflationary spiral. However, since nominal interest rates are high the central bank can pressure real interest rates back down by lowering nominal interest rates after the excess supply have been purged from the economy.
If interest rates stay low and there was capital goods leadership in the first stage what is expected is a period of artificiality extended growth that will only be stopped by a stock market crash followed by the development of a deflationary spiral. The demand curve will not moves back until the day it suddenly finds out that inventory is piling up and the CEO had left the building with whatever cash was left in the register. Supply simply can not just feed on its future prospects forever. Someone always knows what is going on and decides to jump ship. Eventually the investors get that they have been fooled and rush for exits. The demand curve moves back as demand for capital goods dries up. Unfortunately, Supply is by now much much higher then it was to begin with, which results in colossal bankruptcies, credit contraction and price declines. Deflationary expectations are sure to develop. This will cause real interest rates to rise in spite of the low nominal interest rates. However, since nominal interest rates are low the central bank can not pressure real interest rates back down by lowering nominal interest rates. The result is a deflationary spiral that can only be stooped by fiscal spending (i.e. war) in a fiat currency system or the confiscation of the people's gold (and then war) in a hard currency system.
I'm pretty proud of myself for this first post, hope it wasn't too heavy.
YanivBA. |
