American (or European) Py

This morning the European Central Bank made some very accommodative moves.  While the details are a little wonky, here is a rough summary (emphasis on “rough”):

  • Targeted Long-Term Refinancing Operations (TLRTO):  These operations are designed to “grease” the monetary policy transmission mechanism so accommodation becomes reflected in the “real” economy.  To make the operation more attractive to banks they may eliminate the premiums charged to banks and lower the benchmark rate.  Today’s announcement lowered the cost of funding to 0.10% above benchmark.
  • ECB to purchase ABS:  The idea here is for the banks to bundle various securitized loans and sell them to the ECB.  Today’s plan includes both new and existing Asset Based Securities and Residential Mortgage Backed Securities.
  • Lowered Rates:
    • Rates on main refinance operations were lowered to 0.05%
    • Rates on marginal lending were lowered to 0.30%
    • Rates on deposit facility were cut by 0.10% to -0.20%.  Yes.  Those little dashes in front of the percentages indicate that banks will be paying interest on the money they deposit at the ECB.

In the wake of this, rates on 2-year paper in eight European countries went negative; with the lowest negative rate being paid to Switzerland (-0.119%) and the highest negative going to Austria (-0.049%).  I think I’d balk at the privilege of paying the Swiss 0.119% to give them the use of my money.  But hey, that’s just me because apparently someone is willing or the rate wouldn’t be where it is!

As I write this, the EUR/USD has fallen 1.60% to 1.2939 – the ECB having (at least for now) the desired impact of hammering down the Euro.

In Europe, reactions in the equity markets were generally positive.  The DAX gained 1.02%, the FTSE gained 0.06%, and the CAC 40 gained 1.65%.

That’s a pretty healthy reaction.  It seems that draconian fixes are considered bullish while the underlying problems necessitating these fixes are ignored.  A money manager has to make his numbers each quarter, so I suppose that’s understandable on some level.

The US markets were generally positive early in the day, but the gains faded after the 159, 648th rumor came out of Ukraine.  This was the most recent of the 79, 824 bad news rumors, and it took the markets fractionally lower.

Early this week I linked an article about “liquidity traps.”  Roughly (again) defined, a liquidity trap is where injections of cash by a central bank into the private banking system fails to decrease interest rates because there is a prevailing belief that interest rates will soon rise.  Similarly, if the cash is not being deployed due to “hoarding” there is little impact on creating inflation (which a few countries could use right now…  Italy, I’m talking to you).  This is described as M * V = Py, where M is the money supply, V is the velocity of money, and Py is the product of price and units.  An increase in Py would be evidence of inflation.

Since there is no question that the Fed and the ECB are ramping up the “M”, and there is little evidence of an increase in “Py”, one could deduce that “V” is the lollygagger.  To wit, here is a quote from the St. Louis Fed’s website:

“During the first and second quarters of 2014, the velocity of the monetary base was at 4.4, its slowest pace on record. This means that every dollar in the monetary base was spent only 4.4 times in the economy during the past year, down from 17.2 just prior to the recession. This implies that the unprecedented monetary base increase driven by the Fed’s large money injections through its large-scale asset purchase programs has failed to cause at least a one-for-one proportional increase in nominal GDP. Thus, it is precisely the sharp decline in velocity that has offset the sharp increase in money supply, leading to the almost no change in nominal GDP.”  – Economist Yi Wen and Research Associate Maria Arias in a St. Louis Fed article:  http://www.stlouisfed.org/on-the-economy/what-does-money-velocity-tell-us-about-low-inflation-in-the-u-s/

Now, in full disclosure, the concept of the liquidity trap is a construct of Keynesian economics.  The Austrian School would argue that the lack of velocity during these periods of low interest rates is a result of previous mal-investment and the discounting of an assets value at an extremely low rate (time preference).

I wish I definitively knew the cause of the flaccid “V”, but after witnessing 5 years’ of ramping up “M”, I’m beginning to side with the Keynesians on this one.  It would seem that much mal-investment would have worked through the system at this point, resulting in some juicy Py.

Mmmmm.  Juicy Py.

pie