It is remarkable, despite almost $9 Trillion worth of deposits earning virtually negative yield since September 2008, has not translated into substantial increase in consumption. If deflationary hypothesis was correct, negative real yield would have discouraged savings and people would have increased their spending but that did not happen. Surprisingly in countries like Canada & Australia, where interest rates are higher, relative consumption since 2008 has been higher. If we look at the consumption pattern in the recovery from the recession of 1980, when interest rates were much higher, relative consumption was high and so was GDP growth despite US running significant trade deficits. If we look at the incremental credit data, it was also much higher in 1980s. When the Federal Reserve kept interest rates at ultra low level during 2000-03, it triggered a credit boom but since 2008, it did not make much difference. May be it tells us something about the behavioral aspects of consumers. In post credit crisis phases, issues are always availability of credit than the price of credit and direct credit interventions are more effective than indirect tools like low rates to trigger credit creation. It is very difficult to empirically establish but my intuition based on adaptive expectation hypothesis is that had interest rates been slightly higher, it would not have made much difference, in fact it would have encouraged consumption. Lost income on these deposits, assuming an average interest rate of 2.5% is almost $ 1.3 Trillion since 2008 and bulk of these income would have accrued to the most risk averse consumers, which would have given them a sense of comfort and encouraged them to spend than what the deflationary hypothesis conjectured, which would have increased transaction velocity in the economy and resulted in the desirable outcome of positive inflationary expectations. Asset allocation theme also did not materialize. Dividend yield was much higher in 2009-11 period but retail investors continued to increase their allocation to Fixed Income than to Equity oriented funds and it was only in 2012 & 13 we have seen increased retail participation in equity markets. Equity markets goes up when there are more buyers than sellers. This analysis is applicable to Britain & Europe also. My feeling is our understanding of dealing with deflations is still evolving and ultra low interest rates are not necessarily the right tool to deal with it. In the emerging markets, rates have been very high since 2010, when Central banks started their tightening cycle resulting in lower consumption and investment and that threshold of higher interest rates triggering a slow down in economic activity is slightly higher depending on domestic inflation.
Posted on: Thu, 01 May 2014 08:30:15 +0000