Avoiding the liquidity trap

By Mr Bearbull, 15 February 2012

The new year has started brightly. So far in 2012, the FTSE All-Share index has risen 6.6 per cent – not bad for about 30 days of trading. That was due in part to encouraging news about economic revival, especially from the US; and to relief that the eurozone isn't quite ready to implode.

Will equity prices kick on from here? It's by no means certain. After all, there are plenty of issues outstanding in the eurozone, not least the concern that the troubled southern European economies have yet to attempt to renew substantial amounts of government debt. Even so, two plausible reasons indicate that equities could have a decent year; though don't imagine progress will be nice and smooth.

The first, the more important and the more complex reason is about the steps that central banks must take in order to avoid what's labelled a 'liquidity trap'. Second, using simple but useful quantitative tools to judge it, London's equity market looks quite cheap anyway.

Let's major on the liquidity trap because it is topical. In particular, Bill Gross – probably the world's best-known bond investor because he's the founder and co-investment chief of Pimco, the world's biggest bond manager – reckons that the developed world is falling into a liquidity trap that will be much like the metaphorical black hole into which Japan's economy dropped in the 1990s.

That sounds nasty, but it does not have to be. The crucial issue is how central banks respond to the possibility of a liquidity trap. To explain, let's go back to the dawn of macroeconomics in the 1930s when economists, using the work of JM Keynes as a catalyst, tried to understand the relationship between the cost of money, the quantity of money and output. In particular, they found there is a point where a central bank's monetary policy becomes impotent. That can happen when interest rates get close to zero, as they are currently in the UK and the US. If interest rates are driven down sufficiently so that returns are similar across all maturities – long-term bonds as well as short-term deposits – then in effect there is no difference between holding deposits or long-term bonds. That has a profound effect on banks, or any long-term lenders from the private sector – they are deprived of their usual incentive to borrow short and lend long. As a result, the so-called 'maturity transformation' on which economic growth depends dries up; banks don't lend; the wheels of the economy don't get greased by finance; the machine seizes up.

As to why lenders will not lend in those circumstances, it is not just because they reckon the interest-rate gap between short-term and long-term loans is inadequate. It's also because they fear losses if they lend long, and that's where the central bank's role is vital.

Normally, the major function of a central bank is to target price stability – just enough inflation; not too much, not too little. That means that when price levels show signs of rising too fast, a central bank responds with higher interest rates. It is on that response – and the private sector's expectation of it – that the bank's credibility rests. But that very credibility also produces a perverse outcome when interest rates are near zero. It deters the private sector from lending long because they fear the losses – especially in the value of government bonds – that higher interest rates would bring. In short, lending long isn't worth the candle.

This can put a central bank in a real bind. Its credibility depends on fighting inflation, yet that very credibility deters the private sector from doing what it needs to do to drive recovery. So, somehow the central bank has to persuade the private sector to suspend its belief in the bank's inflation-fighting credentials. To adapt Mae West's famous line, it's saying: "I'm still Snow White. I'm just drifting temporarily".

In the US, the chairman of the Federal Reserve has done this by assuring markets that interest rates will stay at their current levels for some years. In the UK, the Bank of England has kept bank rate at 0.5 per cent for the past three years and, by extending its programme of 'quantitative easing' this month, implied that there is no more than a minimal chance of rates rising in the next couple of years.

Quantitative easing, which entails creating money to buy long-dated bonds, is essentially a price support operation for gilt-edged stock. But its effects are likely to wash over into other assets, particularly equities. That's especially likely considering the yield on ordinary shares – about 3.5 per cent – is so much more enticing than on, say, 10-year gilts – about 2 per cent. Not just that, but the tool for assessing share values that I referred to earlier – the cyclically-adjusted price-earnings ratio – rates shares as cheap on a 25-year view. The cyclical adjustment is to average earnings over the previous five years and divide that into prices. On that basis, London's average PE ratio since 1977 is almost 17 times, but currently it's little more than 12 times, which is more than one standard deviation below the average.

That's the sort of reassuring statistic which says that, if the developed world's central bankers continue to fight the liquidity trap by throwing money at the problem, then, one way or another, equities will do all right.

visible-status-Public story-url-Features_Bearbull_140212.xml