"The Money Famine"

The Indian economist and philosopher Amartya Kumar Sen, in his analysis of the rice famine in Bengal in 1943, concluded that the catastrophic food shortage was not because of a literal absence of rice, but was down to the human propensity to hoard in the face of a perceived future shortage. For instance, he noticed that the actual harvest in 1943 was higher than that of 1941, when there was no famine. Rapid price inflation followed and suddenly millions of people were too poor to buy it.

Without trivialising in the slightest the human losses in Bengal in 1943, there is a direct analogy between the human propensity to hoard rice then and the hoarding of money in economies right now; there is actually plenty of money around at this time. For instance, the Bank of Japan's estimate of excess reserves has increased ten-fold in the past month.

The problem has become that money is being hoarded by private banks to such an extent that central banks are having to step in and provide money to maintain the normal functioning of markets. Gone are the days when, as in 1907, Mr J.P. Morgan rang round his friends in the banking community and told them to start lending to stave off a similar credit crunch out of a sense of national duty. Such public spiritedness is absent in our world.

So it is being left to the US Federal Reserve and the European Central Bank (the Bank of England has declined calls for such assistance) to deal with this 'money famine' caused by private banks hoarding money as a response to a future perceived shortage of capital, brought about by the US sub-prime losses and its spread across the globe. You understand why 'private' money rates in the US (as symbolised by 3 month LIBOR) have flicked up to 5.5% whilst public money rates (as symbolised by 3 month US Treasury bill rates) have crashed down to 4%. Public lending standards are being loosened while private lending standards are being tightened, thus transferring credit risks from one sector to the other. This is one of the least glorious episodes seen in recent economic history; it is like the errant child running back to daddy to bail them out after getting into the trouble about which they had already been warned.

In effect what is happening here is a form of blackmail. The markets are forcing the hand of the US Federal Reserve (in particular) into cutting interest rates against their better sensibilities. For instance, it is now well recognised that in the next few months there will be a natural rise in inflation in the US. This is not because of anything in particular besides that energy was rather cheap a year ago and it has risen since then. We have written about this in the past, but in the light of the recent data, it is best that we update the situation. From here on in, what has been a natural drag on inflation increasingly becomes a push on inflation if you take the trend out (see first chart). This poses a problem for policy makers - they may be, if the markets have their way, forced to cut interest rates in the face of rising prices.

Notice though as we progress into 2008 that this effect reverses itself, and if the crisis persists, a convenient opportunity to cut rates actually presents itself at that time.

In the near-term the natural rise of inflation in the US means that it is more than likely that the yield curve will steepen. Bond markets don't like inflation no matter how it arises and the fact is that yield curves have become incredibly flat in recent years, because of an excess of money chasing too few assets. In addition, there is good evidence (not presented here) that governments like the US have increasingly shifted their funding from short-dated bonds to long-dated bonds. This means that, in addition to other problems, there is a collision course between supply and demand occurring; everybody wants short-dated debt because of sub-prime problems, but inflation scares them off from long-dated debt. If you look at recent history (see second chart) it's obvious that long-term interest rates have a long way to go before they get even close to recent historical norms. To put this into perspective, the last time there was a housing-related problem in the US, the yield curve had a difference between two year and 30 year rates of over 3%. Today this figure stands at just 0.6%. In other words there could be a long way to go in the steepening process. Of course, yield curves in all other markets will also be dragged in the same direction.

At least part of the problem for the yield curve here is that any money supplied to the markets at this time is ADDITIONAL to that already in the system. When the famine is over, it will have to be drained just as aggressively as it has been supplied. This means higher not lower interest rates going forwards.

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