was only declaring a small price increase and minimal
number with his With coconuts representing only about 10 percent of the original $1,000 the $2 increase in demand had only raised prices about 2 percent, which is what the econo- mist declared as the official rate. There was a significant difference between real inflation = 3.57%) and CPI in- flation it was only when CPI began to spiral that CB had to rein in his new money spending.
THE LIQUIDITY CYCLE IN MODERN ECONOMIES
How the Central Bank Stimulates the Economy
Like this island economy, most fractional reserve central bank economies have indexes of that price increases on a small representative basket of goods. Just as on the island, how- ever, price of this small sampling of goods dictates much of the reactions of the marketplace. And like CB himself, if you can begin to see when and how a central bank is spending money, you can often anticipate when the CPI will increase and be one step ahead of other investors.
Moreover in most economies around the world, the central bank doesn't an old hoard of just prints it. Exam- ining how this process works and observing how this money
through the economy are preliminary steps in learning how to profit from the system.
One of the main implications of the distortion of a central bank is the creation of a boom-bust cycle, known as the Liquidity but referred to as the business cycle (although it has nothing to do with business or an economy in the absence of the distortion of a central bank). Figure 2.1 illustrates the main cycli- cal phenomenon created by central bank activity (although long- term devaluation of the value of the currency is usually another prominent feature of central bank unbacked currencies).
Most central banks are either created or increase their power during wartime to allow the government to spend beyond its means, or during a recession or depression to kick-start an al- ready distorted economy. Thus, it is easiest to follow the Liquid-
ity Cycle chart by starting at its bottom during a state of recession
52 PUMP THAT PRIMES INVESTMENT FLOWS
Figure 2.1 THE LIQUIDITY CYCLE
Note: This cycle depicts the rise and of liquidity. An expansion in liquidity during dis- inflation influences the most liquid assets first then into the general economy.
In a recession trough (near the trough of the Liquidity Cycle shown in Figure 2.1) GDP growth is slowing and then is negative, bond prices, property equity prices, and inflation are falling, and intermediaries (like banks) are cautious and cutting back on the pace of loaning activities. Banks cut lending because company earnings are falling, balance sheets are deterio- rating, property values are declining, and they're worried about getting back their principal on loans. Negative general sentiment is pervasive. As the recession deepens, the central bank begins to notice that capacity utilization and pricing pressures are so low that the central bank (Federal Reserve Board, or Fed) will be able to pump up money supply without affecting negatively (more money is unlikely to into coconuts until the rest of the economy is producing near capacity). So the Fed cuts the discount
THE LIQUIDITY CYCLE IN MODERN ECONOMIES 53
rate (which is a short-term interest rate it charges member banks to borrow from and very short-term interest rates in the mar- kets move lower in response.
As the Fed essentially cuts short-term rates by reducing its discount the effect is felt to a diminishing degree all along the yield meaning that long-term rates also fall, but to a much lesser extent than the very short-term interest rates that the Fed is manipulating directly. The yield curve is the difference be- tween short-term rates and long-term interest rates, plotted by du- ration, as shown in Figure 2.2.
This yield curve is relatively normal: long-term rates are slightly higher than short-term rates. People lending over a longer period of time generally demand a higher rate of interest to com- pensate them for the increased opportunity cost of tying up their capital for a longer period. In addition, there is a great deal more risk of rates rising the longer the duration of a loan.
Figure 2.2 YIELD CURVE EXAMPLE
54 PUMP THAT PRIMES INVESTMENT FLOWS LIQUIDITY CYCLE IN MODERN ECONOMIES 55
As the Fed continues to cut the discount the yield curve begins to steepen and short-term rates fall far below long-term rates. The steeper the yield curve, or the more short- term rates fall below long-term rates, the greater the incentive banks have to borrow from the Fed at the discount rate (up to their full fractional reserve requirement limit) and loan to the long-bond market at a higher profiting from the difference. Banks with excess reserves begin to borrow up to the full extent of their reserve capacity to maximize by borrowing at the lower short-term rate and loaning to the government at a higher long-term rate. So the recipients of Fed money printing are the banks, who in turn loan the money to the bond market forcing interest rates down all along the yield curve. As banks loan to the longer-term bond the yield curve behaves like a rubber band, eventually forcing long-term rates lower as well.
The lower short- and long-term interest rates become, the more enticing it becomes for companies to borrow in order to ex- pand. Less ventures become more viable when interest costs are low. Eventually, companies begin to try borrowing more aggressively since one of the biggest costs of doing business, the interest expense of borrowing, is declining to a relatively low level.
As interest rates drop, the movement has implications for eq- uity prices. In theory, the price of a firm is equal to the present discounted value of the future stream of earnings that an investor hopes to gain from owning a share. The present discounted value is discounted by the bond rate: as the bond rate the value of that future stream of earnings rises. as one of the largest costs of doing business (borrowing costs) goes down, in- vestors begin to increase their earnings expectations for com- panies they own shares in. So investors, discounting an increase in earnings from dropping interest rates and also attempting to exploit the increase in the value of those discounted earnings, begin to out of bonds and other assets and into equities.
The of new money goes to banks to bonds to stocks as a portfolio shift into stocks develops from lower interest rates. When rates are low enough for companies to profitably borrow more, and when the equity market heats up enough to allow rela- tively easy issuance of secondary offerings and companies are also able to get money readily from the equity markets. The
result is that the new money liquidity eventually from equi- ties and bonds to companies that in turn finally invest money in new businesses and business expansion feeding into the real economy. The new liquidity has from banks to bonds to stocks to corporations to the real economy, and economic activity begins to pick up. This entire process has a long time lag; any- where from 6 to 18 months may pass after initial Fed action be- fore results begin to be felt in the real economy. This means that the Fed has a very difficult job. As an analogy, imagine you are controlling the rudder for a huge ship, but your steering does not affect the ship's movement until 6 to 18 minutes after you have made the adjustment.
Figure 2.3 shows clearly the relationship between bond prices and stock prices (S&P 500) since 1954 in the United States. Virtu- ally every major stock market advance since 1954 was preceded in time by a bond market rally meaning a decline in bond rates, as the dotted lines indicate. Astute investors will also see that most major tops in the S&P were also preceded by a sharp drop in bond prices, or higher bond rates. This is not just an arcane academic theory, it is cause and effect and is an extremely valuable tool in determining the right time to aggressively buy or move out of eq- uities in any one country.
Investors should also note that Figure 2.4 shows the incredible relationship between the yield curve and economic growth rates. The middle section is the yield curve as represented by the 10-year T-note divided by the 3-month The top panel is the annual real GDP growth rate. As highlighted by the arrows, virtually every major advance in GDP growth rates has been preceded by a steepening of the yield curve (a move by the ratio above 1.5), and virtually every major drop in GDP growth rates has been preceded by or inversion of the yield curve (a move by the ratio to 1 or less). Once again, this is not coincidence; it is cause and effect as the liquidity created by the Fed its way into the economy or as banks pull back lending and cease borrowing from the Fed under an inverted yield curve. An inverted yield curve occurs when short-term rates rise above long-term rates creating a loss for any bank borrowing from the Fed and therefore drying up new borrowing incentives. Many observers call the yield curve the gas pedal and brake pedal of the steep yield curve indicates full throttle, while an inverted yield curve indicates full braking.
56 PUMP THAT PRIMES INVESTMENT FLOWS
Figure 2.3 BONDS LEAD STOCKS IN U.S. FRACTIONAL RESERVE SYSTEM
Source: Reprinted by permission of the Bank Credit Analyst.
THE LIQUIDITY CYCLE IN MODERN ECONOMIES 57
Figure 2.4 YIELD CURVE AND ITS IMPACT ON GDP GROWTH
Note: Notice the amazing correlation between the yield curve and real CDP growth. Down arrows show that whenever the yield curve becomes inverted (<1), real CDP quickly turns down. Conversely, whenever the yield curve moves from inversion to steep- ness the top on the CDP chart show that GDP growth picks up.
Source: Reprinted by permission of the Bank Credit Analyst.
To return to our original Liquidity as the economy be- gins to pick up, we move up the Curve. Bond prices rally first, then stocks, then the economy picks up. Up to this point, printing money looks like an almost magical elixir for whatever ails the economy. Print enough funny money and things will pick up, it would seem. The problem is that what likely ailed the economy in the first place was some sort of distortion to free-market and the new money printing distortion causes problems of its own. You can rarely get something for nothing in the world of economics.
58 PUMP THAT PRIMES INVESTMENT FLOWS
How the Central Bank Distorts the Economy
Some of the problems created by the distortion of money printing occur because the demand from new money is artificial and ex- cessive (beyond free-market) demand in the economy. Just as in our island real or the sum of the price of ab- solutely everything, goes up pretty much instantly by exactly the same amount of the new money created. It takes a long how- ever, before some of that new money creeps into the small sam- pling of the Consumer Price Index used to measure In the meantime, free market forces operate under the assumption that the demand is real because no one can tell the dif- ference between a new dollar and an old one.
Corporations begin to exhaust their capacity to meet the new demand, and believing that the demand comes from customers, they begin to increase capacity. But, as soon as the rate of money creation begins to slow, demand will dry up overnight; they are really building overcapacity that produces far beyond non-money- printing demand.
The new money into hot spots, or areas of the mar- ketplace where speculation begins to force prices to levels that would be unrealistic in the absence of the new money creation. In periods where the economy is particularly the central bank will have to prime the pump of money so hard that short- term rates actually fall below the inflation rate. This so-called negative real interest rate (the real interest rate is the interest rate minus inflation) usually leads to excessive real estate speculation because investors are paid to borrow money and put it into real as- sets that will appreciate at the rate of inflation while they can leverage the gain by paying off debt at the lower interest rate. It also leads to another chronic problem associated with fractional reserve central banking explosion and proliferation of debt assumption.
An increasing period can actually be secular, mean- ing it can last over several Liquidity Cycle booms and busts until finally the bond market stops the inflation spiral (or, in the ab- sence of a large freely traded bond market, can de- velop). Once speculation in real estate and real assets has boomed and busted, and inflation has become excessive and begun to a new hot spot emerges. During high
the bond market crashes until bond investors are so concerned