NIRP, its likelihood and effect on commoditiesOct 1, 2015·Alasdair Macleod
In last week's article I pointed out that negative interest rates should lead to a general shift in consumer preferences from money towards essential goods. Central bankers may wish for this outcome on a controlled basis to allow them to hit their price inflation targets, and this could happen quite quickly. If people face a tax on their cash and bank deposits, which is what a negative interest rate amounts to, they will simply reduce these balances, artificially boosting demand.
There can be little doubt that negative interest rate policies (NIRP) are now a distinct possibility after the Fed backed down from raising the Fed Funds Rate at their September meeting, having prepared markets well in advance for the event. In fact, many mainstream analysts still expect the Fed will raise rates in the coming months. However, external factors are rapidly changing everything, with China's economy succumbing to a credit crunch, and all the countries supplying China with raw materials suddenly facing a fall in demand. The bad debts in commodity financing (including energy) are a growing concern, as the collapsing share price of Glencore attests. International trade is now contracting for the first time since the wake of the Lehman crisis.
The welfare states have spent the last seven years in the economic equivalent of suspended animation, with the reallocation of capital from unproductive, unwanted and over-indebted businesses impaired by zero interest rate policies. Even though ZIRP didn't work, central banks undeterred will probably opt for NIRP. We now know the Bank of England is examining the possibility of NIRP at the most senior levels, in which case it is almost certainly being considered by all the major central banks.
It would be a bold step. This is not Switzerland, or Denmark, whose experiments in this direction are frankly irrelevant to the big picture. So how likely is the Fed to introduce NIRP for the world's reserve currency?
There are two events likely to make NIRP a possibility: firstly, if the global economic outlook deteriorates to the point that the balance of expectations at the Fed tips towards deflation, and secondly if the mounting losses in commodity financing and associated derivatives threaten financial stability. Because the first usually begets the second, we shall focus on the possibility of deflation, and here we are juggling with two further issues. As well as the Fed's phobia of deflation, the statistics the Fed relies on are badly flawed, under-reporting inflation while exaggerating employment.
Whatever the private misgivings of the Fed's rate-setters may be, they are mandated to be guided by the statistics. We can be reasonably certain the Fed knows the quality of jobs gained over the last two years is relatively poor, and that the percentage of the workforce actually in employment is at historic lows. That being the case, we are left focusing on inflation (CPI), which is being undermined by both lacklustre demand and falling commodity prices, including energy.
Falling commodity prices will force the Fed to take the global position into consideration. Emerging market economies now account for the majority of world output on a purchasing power parity basis, and they account for about 40% of world trade. Gone are the days when America sneezes, we all catch a cold; now if China sneezes, America catches a cold, along with the rest of us. However it would be a mistake to think China cares overly much.
China's deflating credit bubble is not her overriding concern, because she has another agenda. She will embrace her economic downturn in order to pursue her thirteenth five-year plan, which comes into effect next year. Put another way, China is a mercantile state, which regards itself as a business to which her citizens have a duty to cooperate. This contrasts with the welfare nations whose priority is the maintenance of welfare. It is a common mistake to confuse the economic policies and outcomes we take for granted in the welfare states with the very different ones in China.
President Xi Jinping is mandated to refocus China's economy from being the world's source of low-cost goods into services, technology, and the development of infrastructure throughout Asia. She needs her labour force, of which only about 5% are actually unemployed, to be continually re-educated and redeployed to these ends. Contrast this with the welfare states, which cannot afford to see tax revenues decline under any circumstances.
Because of this difference, it is the US economy that faces the greater problem, and in the planners' minds the ever-present danger is deflation. Therefore, the likelihood of NIRP being introduced will probably increase in the coming months, as recent falls in commodity prices and the contraction in world trade have their effect on the CPI. Capital markets and commodity prices will have to accept the possibility of negative interest rates.
The effect on commodities
If NIRP looks like becoming a reality, commodity markets should begin to adjust to a general state of backwardation, reflecting the anticipated cost of holding cash deposits compared with owning physical commodities. Speculators holding short positions and therefor long of dollars will expect a cost arising from negative interest rates to replace the positive interest rate return normally reflected in futures pricing. In other words, all market participants would be better off being long instead of short. The effect could be dramatic, as recent experience of the oil price attests, which last year more than halved over a brief period of a few months, driven mainly by shifts in speculative positions. The reversal of commodity price weakness could be equally unexpected and sharp.
This is not something industry will necessarily be happy about, if rising commodity prices end up squeezing operating margins. Businesses are bound to more rigorously control manufacturing costs by limiting wages and stock levels. So talk of NIRP ahead of its implementation could end up increasing prices and unemployment at the same time. Its actual introduction would be a different matter, because at that point the public will be directly affected through their bank accounts. The hoarding of necessities, reflecting a decrease in the general public's level of preference for money relative to goods, would then become the dominant effect on prices. It would be similar to the development of the stagflation of the 1970s, with the additional risk of prices spiralling out of control.
A very serious problem would almost certainly arise in the gold market. Futures prices are already often in backwardation, and NIRP would make this situation worse. But the real trouble would become apparent in the balance sheets of the bullion banks, which traditionally have positioned their dealings to benefit from the higher interest rate in the interbank market, compared with the gold lease rate. Admittedly, ZIRP has reduced the interest rate spread between the two to virtually nothing, but there is a legacy of unallocated gold accounts which gave the banks this benefit on a geared basis, exceeding the bullion banks' capital by as much as ten times. Nobody yet has woken up to this crisis-in-the-making, but if they do, NIRP, or even the threat of it, could plunge the international monetary system into crisis by exposing the lack of physical gold in western vaults.
The effect NIRP would have on the gold price and the crisis it would generate at the heart of the financial system is an obvious reason why it should not even be considered, the other being the danger that it could trigger a series of events leading to the early destruction of the dollar itself. It would be the final experiment by central bankers on an unsuspecting public.
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