RATES TO REMAIN LOW IN A “HIGH-PRESSURE ECONOMY”

Policy makers have mostly been persistent in keeping benchmark rates lower for longer. The news recently particularly from the FED indicated they are contemplating not to increase rates as much or as quickly as previously thought, again.

This in itself is nothing new. For a while it has been widely known that FED’s inflation target is at 2% and that they haven’t been able to really reach it. Some well-known figures provided comments in the past that the central bank may at some point interpret the gap as a blessing for them to let inflation run higher, once it picks up. In this cumulative view on inflation Federal Reserve could tolerate inflation rates above 2% until the cumulative effect reaches their target.

Chair Janet Yellen recognized an economy of strong supply and weak demand and therefore temporarily running a »high-pressure economy« could make sense.

 

DOVISH TALK

Strong supply pressures in the economy nominally do not mean much. However it can mean the lot in a particular case. Let’s imagine we have a lot of new supply that is originating from innovations which are valuable and useful for everyday flow of consumers.

Every graduate can understand that when there is a new innovation produced, which introduces new value added and is not directly in competition with existing products and services, the emergence of such an innovation will produce a deflationary effect if the money supply did not take the new value added into account.

Yellen is focused on the notion that increased business sales would raise productive capacity and encourage additional spending. What if capital expenditures may largely have already been made and hence it is not wise to focus on the effect coming from increasing it. Nothing along the multiplication potential from goods being adopted has been discussed. This is extremely dovish talk as it shows the central bank’s mindset is deflationary by default and such that it would count on further increases of supply. Demand from her words seems to be demand for capital goods. Multiplier effect from such demand is lower and not focused on maximizing value added.

 

VELOCITY OF MONEY

If there is no additional money in the circulation, consumers will need to ditch some of the goods they were buying in order to acquire new goods.

Most probably monetary authorities know this, since the story has been told a number of times by history. The FED could pick a middle path by trying to focus on the velocity of money, rather than the nominal supply of it. While it makes sense to print new money for things we should economically adopt, it does not make sense to print money just to buy any supply.

Increased velocity of money would impose and ongoing competition for the unit of money to be allocated toward most potent new value added creator. Therefore policy focused on increased velocity may be the way to filter out the ineffective supply and at the same time honor the most useful part of it. The real question for chair Janet Yellen is therefore about the nature of this supply and what is this pending supply worth in real terms and what is the multiplier effect of it when observed from consumers’ perspective.

 

DEFLATION DANGER

In case we have a lot of very high quality supply of new innovative goods, which by default deleverage the monetary economy, then all the central banks may have been way too tight all along. When speculating if we are perhaps on the verge of a major breakthrough in how efficiently economic processes work in our world, then in such speculation central banks are behind the curve and unknowingly standing on a brake pedal, preventing smart goods from being adopted and start taking overall economic effect.

We cannot be certain about what part of the supply is junk. What we can be much more certain about is that if a major part of this supply is from the new era so to speak, then all that is left in the central banks’ set of real options is to print a lot of new money or risk destruction of new economy waiting in the wings.

Gregor Kozelj
Gregor

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