“Cash is King” Mentality Hurting Inflationary Cause

This past week, I had a client refinance a mortgage at 3.5% fixed for thirty years.   Interestingly, this same client locked in a rate at 4.00% three years ago when she bought the home.   I remember our conversation at the time around the purchase and thinking to myself, “there is no way rates get any lower than this!”  The Fed had just announced that it was ending its bond-buying activity (the behavior assumed to be keeping rates low) and we all assumed rates would naturally drift higher over the coming years.  At least so far, that has proven to be incorrect.  So, how in the face of the Fed actually raising rates in 2015 and the unemployment picture showing improvements, are rates still at historically low levels?  From our perspective, you have to look no further than the inexistence of any inflation or inflationary fears.

Traditional economic theory tells us that increasing the money supply eventually leads to inflation.  Remember the term “Helicopter Ben” which referenced Ben Bernanke essentially dropping billions of dollars each month into the American financial system…. This activity was assumed by many to be the “kindling” to the eventual inflationary fire.  As we stand today, inflation is well below the 2% target the Fed had originally targeted (CPI was reported for July at an annualized rate of .8%).  This begs the question: how has inflation stayed so low when the Federal Reserve infused $3.5 Trillion into the financial system?  Simply put, money is moving through the financial system at a glacial pace.

There is a very basic economic theory that says any one dollar placed in a bank actually results in multiple dollars being placed in the financial system.  In fact based on a current reserve rate of 10% (what banks have to keep on hand), the described theory would result in up to 10 dollars in the economy.  This phenomenon is based on the idea that dollars not reserved by the bank are used as loans.  Once lent out, those funds are redeposited into banks and, once again, 90% of those funds are used for loans, and so on.  The theory and formula can and should be tailored and made more complicated to account for other variables but there is no denying that the current environment is setup for any one dollar to have an impact worth multiple dollars.  Today, the problem is that money is being reserved in banks and is not being lent out at a desirable pace.

In the above chart, it is easy to notice the marked fall off in the money multiplier in 2008 and the absence of any decent rebound since that time.  The reasons for this issue are varied: economists point to the lack of risk taking in bank lending, the increased regulatory environment making lending more difficult, and the fact that banks get paid interest on reserves they park at the Federal Reserve, deemed risk-free.  It is also very possible that banks are still acting conservatively with the financial crisis feeling all-too-recent.   If money placed in the system doesn’t “multiply” at a rate even close to historic norms, we believe inflation is very likely to remain subdued.

In three paragraphs, it is impossible to detail the complexity of this issue so my hope would be just to shed some light on why rates continue to stay low even as the Fed has started raising rates and unemployment numbers improve.  From our perspective, a “Money Multiplier” shift higher should prove to be telling of future inflationary trends.  Until then, we expect to work with more clients who will see very little interest paid on their bank deposits but are simultaneously able to borrow at historically cheap levels… if the bank is willing to lend it.