As the bond market gets more crowded, some banks would use that money to buy up stocks or commodities such as crude oil or agriculture for a much better risk/reward return than mere lending to business and consumers.
Low Interest Rate Is Deflationary
In other words, by incentivizing unproductive use of capital, low interest rate is deflationary. The majority of Fed’s QE liquidity ended up in personal or corporation cash holding, or in the market (Treasury, Bond, Stocks, Commodities) without trickling down to the real economy leading to slow growth and disinflation (U.S. consumer inflation averaged around 1.6% per year from 2009 to 2013 in terms of CPI-All Urban Consumers).
European Bond Holders Could Take A Nasty Fall
In the case of the Euro Zone, low interest rate by ECB may have helped those semi-insolvent PIIGS governments to refinance their insane levels of debt. Nevertheless, bond yield is supposed to be a risk measure. After ECB announced its new low interest rate, the Wall Street Yield Trade has rendered the yield of some Euro Zone government bond a total mis-representation of the related sovereign risk. For example, while U.S. 10-year Treasury yield is hovering around 2.6%, Spanish government can now borrow at 2.57%, a rate lower than Uncle Sam. Equally ridiculous is that Italy now only pays 2.70% interest (0.1% above what the U.S. is paying) for its debt.
Everybody loves a risk free trade, but this is not a normal situation. Once interest rate starts to normalize. the bondholders of the more risky Euro Zone government debt could see a rapid and nasty devaluation of their holdings.
Inflation Heating Up
The most recent reports on jobs, CPI, and PPI all suggest U.S. economy is picking up solid pace. And the chart above also shows a downward shift of Personal Saving Rate. Saving Rate is trending down most likely due to better job market and inflationary pressure on everyday stuff (e.g., food and energy). Inflation is indeed heating up — the average annualized inflation rate for 2014 (Jan. through Apr.) is around 5%, while the same inflation trend from the Producer Price Index (PPI) is well above 5%.
The Right Move: Raise Interest Rate
Most central bankers are academics in the ivory tower making decisions based on economic theory that defies reality or common sense. But in its blog post, the St. Louis Fed actually made a logical argument:
“….more monetary injections during a liquidity trap can only reinforce the liquidity trap by keeping the inflation rate low (or the real return to money high). ….the correct monetary policy during a liquidity trap is not to further increase money supply or reduce the interest rate but to raise inflation expectations by raising the nominal interest rate.”
With both inflation and economic activity ramping up, we also believe that the Federal Reserve should raise interest rate to get ahead of the inflation curve and also to push the liquidity out of the ‘risk free’ Yield Trade, into more productive economic and business activity.
This article is brought to you courtesy of Dian L. Chu from EconMatters.