Alasdair Macleod – 23 August 2013
There is increasing evidence that money is migrating from purely financial into economic activities. Business and retailer surveys all point in this direction. GDP forecasts are cautiously being revised upwards. While the stated objectives of the Fed and the other major central banks are to keep interest rates low for an extended period of time, bond yields are already pushing higher indicating underlying pressures for interest rates to rise.
The first thing we must do is put GDP into context. It is simply the money-total of all recorded transactions in the economy over a period of time. It must not be confused with economic progress which is impossible to quantify. As a money-total, GDP will reflect the migration of extra money and credit into the economy. We know that financial resources are shifting from interest-rate sensitive financial activities, such as investment in government bonds, into less interest-rate sensitive economic alternatives such as residential property. Furthermore, there is a growing feeling in the corporate sector that the outlook is improving now that money is flowing into the economy, and that interest rates will therefore rise: the message is borrow now to invest in your business while the cost of credit is still cheap.
This will almost certainly lead to some capital investment purely to exploit the opportunity, driven as it were by the widening difference between short and long-term interest rates. It is unlocking an accumulation of money and credit that has so far been withheld from economic activity. The result of this capital investment together with the money flowing into property is likely to be that GDP growth turns out to be considerably more robust than anyone thinks likely today, and within a month or two this should become very evident.
The second thing to consider is the effect on interest rates themselves. The central banks are telling us that rates will remain low for an extended period, but if nominal GDP picks up as seems likely without intervention they should increase quite sharply in the coming months. There already appears to be confusion over this issue, with the Fed regarding tapering, in other words reducing the means of supressing long-term rates, as a separate matter.
Of course, it’s not. If the Fed is to keep interest rates at current levels as nominal GDP begins to grow, it has to continue to buy short-term debt to keep the rates down. So the idea that the Fed can gradually withdraw its monetary stimulus is only true if it is prepared to allow rates to rise closer to a market-determined level.
It’s not just the Fed. The Banks of England and Japan as well as the European Central Bank are all keeping interest rates close to zero and expect them to stay there for a considerable time. For stated interest rate policies a better-than-expected recovery in GDP is the worst thing that can happen.
As money flows from Wall Street to Main Street, driven by falling bond markets, it is certain to bolster GDP. The timing is no longer at some time in the future, but upon us now. Experience tells us that central banks will persist with low interest rate policies, believing they can muscle the markets into their way of thinking. It looks like being a tough autumn for central banks.