Investors do not always need to be economists.
In fact, one of my favourite investors – Peter Lynch of Fidelity – is fond of saying, “If you spend 13 minutes on economics a year, you’ve wasted 10 minutes”.
But despite a path for vaccine-rollout across the world, there remain many economic uncertainties that are at the forefront of investor’s and adviser’s planning for the next few years.
One concern that most investors have is that of central banks printing money; they expect that this level of constant central bank stimulus is unsustainable, and that we are due for an inflation shock as all this money swirls around the system.
Which leaves us with one very important question: where’s the inflation?
The answer may lay almost 100 years ago, with the work of renowned economist and investor John Maynard Keynes.
The liquidity trap
Let’s first define ‘liquidity’: If an asset is liquid, it can be bought and sold with little price movement, with cash being the ultimate liquid asset.
Holding cash can sometimes be appropriate, but unfortunately in itself, cash held outside of a bank cannot generate income – the ‘stashed underneath my pillow’ economy has very poor growth rates.
An individual credit bond is quite illiquid relative to cash and are considered safe relative to bonds – these investments can generate income and returns, so are hypothetically enticing when the interest rate is too low to justify saving cash in a bank deposit.
A liquidity trap is the situation where the decisions of central banks become ineffective, because despite low interest rates, people look to save cash than consume, and the opportunity cost isn’t too large compared to cash-like assets (for example, government bonds do not have a sufficiently high yield at the moment to entice consumers away from hoarding cash). First proposed in Keynesian economic theory, the idea has become relevant again in the strange economic environment we find ourselves in.
A liquidity trap is characterised by;
- Historically low-interest rates
- Low inflation
- Slow/negative economic growth
- Preference for saving rather than spending and investment
- Monetary policy becomes ineffective in boosting demand because credit growth is inelastic
Doesn’t this all sound quite familiar?
Yes, if you subscribe to Keynesian theory, it wouldn’t be a stretch to say that most global economies are stuck in a liquidity trap at the moment – and unlike other traps in the past (see Japan’s 1990s deflation or the 2008 recession in Europe), COVID-19’s forced lockdown of consumers and small businesses is a structural handbrake on economic growth that we have not seen before.
Taking a look at the diagram below, you can see that at a certain interest rate (which is different for every economy), the demand for money will become completely horizontal – the market believes interest rates have fallen enough.
Beyond the point of MS 3 in the diagram above, any increases in money supply (i.e. printing more money to inject into the economy) fails to stimulate economic activity, because people just add it to their saved cash reserves.
How does this affect inflation?
One of the consequences of a liquidity trap is a high savings rate despite unattractive interest rates. This means that, regardless of how much money central banks pump into the ‘economy’, most of that cash will not make its way into the real economy through consumption or credit expansion (where banks buy bonds to leverage).
Global savings ratios are reaching decade highs, at the same time that we are seeing record collapses on services. In Australia alone, our June 2020 household saving ratio has reached levels not seen since the 1970s.
This is also reflected in the record levels of cash held in the Reserve Bank of Australia, which in turn indicates that our banks have too much cash on hand from deposits.
In November 2020, the combined stock of household and business deposits was $216 billion – a buffer worth approximately 11% of Australia’s GDP. There’s rampant speculation on if the circa $113bn worth of ‘extra savings’ accumulated by Australian households will be spent in 2021 – we won’t know if this has started until the next national account update on March 3rd.
How do we escape the liquidity trap?
The key to escaping the trap is to stimulate demand and get money to flow into the real economy (i.e. the purchase of goods and services) – with the knowledge that, in all likelihood, this will cause that long-awaited inflation we mentioned earlier.
The question of how we achieve that increase in demand often falls to your school of economic thinking.
Monetarists advocate for bypassing financial intermediaries (i.e. banks) to give money directly to consumers (“helicopter money”).
2020 was one of the first practical tests of this theory, with results being quite weak – hundreds of millions of people received direct stimulus checks, yet the recovery of household demand has been minimal.
Modern economic theory advocates Quantitative Easing (QE), through the use of financial asset purchase programs amongst other means. The theory is that banks should increase lending – in practice, banks often keep the funds as reserves to bolster their balance sheets, unless there’s a corresponding increase in demand for loans from creditworthy borrowers.
In December 2020, we saw the level of housing loans increase 31.2% YoY, but the level of business loans fell 28.9% YoY (Source: ABS), which indicates a two-stage economy situation where one aspect of demand grows whilst the other falls. But please keep in mind, dear reader, that housing only takes up 23% of our CPI basket, so if other goods still lag because businesses aren’t growing/borrowing, then we may not see much inflation as a result of this.
Another solution, and possibly the most unlikely to eventuate, is for central banks to raise interest rates.
The theory is that people will spend their money rather than hoard it, and banks will lend to people because of a higher return – because of the opportunity cost. Financial institutions may also respond by buying bonds to invest the cash.
In practice, governments with record levels of debt are unlikely to make it more difficult for themselves to service that debt – and since lowering the interest rate will have no material impact, we are at an impasse on where rates should eventually go.
So … when is the inflation coming?
The truth is we are in an economic scenario that is unlike any other we have experienced in history.
Liquidity Traps are notoriously difficult to escape in even the most accommodating of times, so there is no certain way to tell which central bank mechanisms might spur consumer demand back into the real economy. The only sure way out is growth, productivity growth in the economy has to create an increase in real wages, which then increases the power of the consumer to purchase goods and services – Jesse will discuss wages further in his note tomorrow.
What we can know is that once the world does escape this trap, it will be signalled by a pickup in demand and expenditure on goods and services.
So, keep an eye on your neighbour – if they’re suddenly buying a new ute to move all the IKEA furniture into their new investment property, inflation may be on the way.
The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.