Liquidity ramblings

Let me start by suggesting that you read what Morgan Stanley's economists have to say. It's a rare occassion when they get together to discuss the prospects of the economy, so I encourage you not to miss this opportunity to read (part I and part II of) their debate.

With a very broad brush, we may describe the discussion as focussing on the effects of shrinking global liquidity. Joachim Fells sets the tone by positing the following remarks:

With less liquidity available to chase asset prices higher, a correction in asset prices seemed like a logical response. Note that both the 1994 bond market crash and the popping of the equity bubble in 2000 were preceded by sharp contractions in excess liquidity.  The contraction in 1994 was of course due to the Fed’s tightening operation in that year and caused a major bond market crash.  And the contraction of 2000 reflected global monetary tightening and preceded the bursting of the equity bubble.

Richard Berner highlights the chilling similarities of the pre downturn markers of  '94  to our actual situation,

Call me old-fashioned but I think the common thread between 1994 and today is the Fed’s and other central banks’ efforts to pre-empt inflation in the context of upside surprises to growth.  At the start of 1994, no trader I spoke to thought that rates could go up by 100bp, much less 300bp.  Growth kept surprising to the upside through the end of the year.  The dollar sank, core intermediate PPI prices accelerated sharply, core CPI inflation rose by 50bp, and University of Michigan inflation expectations were rising.  Sound familiar? In my view it’s the shift in market expectations from a Fed that simply normalizes rates to one that could actually hurt you that triggered the mini global margin call.

Stephen Jen agrees with Stephen Roach on the questionable value of monetary aggregates (M1) to measure liquidity, he puts the emphasis on the yield curve as the driver of asset prices,

I couldn’t agree more. What fraction of the financial activities (hedge funds’ long positions in risky assets, carry trades, etc.) is financed through bank credit?  I suspect that many analysts have put too much emphasis on the outdated concept of monetary aggregates driving asset prices.  It is the yield curve — the opportunity cost of liquidity — that is key, in my view, in thinking about asset prices. Since central banks no longer have a great influence on the yield curves, it is perhaps not correct to blame the central banks for high asset prices.  So much of the financial activities are not a function of what banks do, but the non-bank financial institutions such as hedge funds.  The monetary aggregates say nothing about what these institutions are up to, what their perceived risk is, and what their risk taking appetite is.  Further, the Marshallian-k analysis actually says that the US base money to nominal GDP ratio has declined over the past decade, and the broad money to nominal GDP ratio being flat for the past few years. Those who believe there is a positive link between the Marshallian-k and asset prices have to explain away these facts.  Moreover, we need to be very careful about three concepts:  interest rates, asset prices and the real economy. Clearly, they are all related, but the Marshallian-k says very little about asset prices, though it might have some implications for inflation.

There is a further degradation of the value of money aggregates by David Miles, and Joachim Fell's counter remarks. In the end, I would say they agree that interest rates, or the price of money, tells the story best. In Joachim's words,

I’d be the first to admit that quantity measures of liquidity are not the holy grail — they are just one (though, I think informative) indicator to gauge the policy stance and thus the impact on financial markets and the economy.  That’s exactly why Manoj Pradhan and I have taken a very different approach — estimating the natural, or neutral, rate of interest using a neo-Keynesian framework that is very different from the monetarist-inspired quantity measure of liquidity. Comparing actual interest rates to the estimated natural rate probably comes closest to a ‘price’ measure for whether liquidity is abundant or scarce.  And guess what?  Our results for the US suggest that the Fed is already in restrictive territory, with the neutral rate in the 4.25-4.5% area, which would seem to fit in with the notion that global liquidity has become less plentiful.

So, a better measure of liquidity tightening, or lack of it, is obtained by determining the difference between the prevailing interest rate and the "neutral" rate.

In regards to other countries, Joachim states,

Regarding the same analysis for other countries, our estimate of what we call the Nat-EUR-al rate of interest for the euro area suggests that the ECB refi rate is still some 50bp below the natural rate — so the ECB is still expansionary, though not much so.  For Japan, we don’t have good estimates yet (this is work in progress), but it’s a fair guess that policy is expansionary at a policy rate of zero!  I would warn against putting too much weight on any particular estimate of the natural rate, however.  Like output gaps, this is a somewhat vague concept

In conclusion, albeit huge statistical errors, of up to 8%, liquidity in the US is restrictive, above the 4.25-4.5% neutral zone; whilst the liquidity in the ECB and Japan are still considered expansionary.