Hike rates when you hear the creak of inflation at the door, not when you see the whites of its eyes

 Hike rates when you hear the creak of inflation at the door, not when you see the whites of its eyes

Fed to raise interest rates next week, a common argument is that the asymmetry of the risk it faces. If it keep interest rates low for too long, it sets off inflation, no problem: it can quickly raise interest rates several times, so that prices fall the same. However, if an unexpected slowdown continued to raise interest rates too soon, the Fed will not have enough space to cut several times to determine its errors. This is because the zero lower bound, the Federal Reserve's advantage in world monetary policy. To avoid this problem, the Fed should be as long as possible to improve, at least until it before "to see the whites of inflation."

As Paul Krugman points out, the asymmetry is only a recent statement. Historically US interest rates have been hovering well above zero. If the Fed made a mistake, it does not have to worry about the following fixed, it can simply be ascribed rate has dropped a couple of times off the edge of the world. Rather than waiting until the last minute, before hiking to see the whites of inflation, the Federal Open Market Committee only hear the door creak inflation.

I do not buy the argument the current asymmetry. I'll probably buy it back in 2013, but the data has changed.

In the past year, Sweden, Switzerland, Denmark and the European Central Bank have proved to the world, central banks can not set off at a rate of a variety of adverse effects, economists have been worried about negative security is low, the main one is game to cash yield of 0%. Theory here is that if the central bank to lower interest rates, say, 0.1%, the paper its superior cash 0% return, begins to look very attractive. An arbitrage process begins, the central bank deposits, convertible into cash until all of the deposits are gone. Thus the rate can not be reduced to less than 0%.

In the past 12 months there is evidence to suggest otherwise. Since early February the Danish Nationalbank has maintained its deposit rate to -0.75%. Danes, however, do not scrambled notes, diagram as shown below. After seven months of negative rates, cash and coins is an excellent growth rate lies almost in its average level of two decades.

 Hike rates when you hear the creak of inflation at the door, not when you see the whites of its eyes

The Swiss National Bank has maintained a -0.75% overnight rate since January, yet there's been no spike in Swiss paper franc demand, as the next chart shows. In fact, cash outstanding seems to be growing at one of its slowest rates in years.

 Hike rates when you hear the creak of inflation at the door, not when you see the whites of its eyes

We expect cash to be particularly sensitive to Switzerland, when interest rates fall below zero, because the Swiss central bank issued the world's largest value banknote demand; at the high 1000 Swiss francs. More valuable store of wealth in cash under the cost of the bill. These transport costs are decided profitability flight into cash with negative interest rates is particularly important. The central bank could cut interest rates less than 0% sliver without setting off a fly out into a deposit money, as long as there is the inconvenience of storing cash. The larger of these inconveniences, the larger of the sliver.

In fact, the Swiss central bank has been able to keep interest rates at -0.75%, seven months do not set off a stampede to the 1000 notes indicate that the burden of holding the Swiss currency is higher than we previously thought. It seems that investors would rather lose 0.75%, with more than 1000 bear the cost of storage per year. In some negative interest rates, perhaps 1.5%, flight to Switzerland notes will begin. But not yet. As for the US, its highest value banknote lowly $ 100 so it is fair to assume that the cost of storage of US banknotes also significantly higher than the Swiss money. This means that if the Swiss can be safely cut to -0.75%, without setting off cash arbitrage, the Fed should be able to at least 1.0 percent decline followed a panic.

The second biggest fear surrounding minus US interest rates are always concerned about money market mutual funds. The worry here is that the Fed should cut interest rates too, is known as money market mutual funds (MMMF) financial intermediaries will be "below $ 1", causing ordinary investors panic and terror.

MMMFs the same, but their share prices remain unchanged for the US $ 1.00 package of ordinary mutual funds. Investors can cash in, as long as they want, enjoy significantly lower but stable dividend payout before this price. MMMFs maintain security through investment, strong liquidity and short-term debt face value conversion. However, if the Fed to push short-term interest rate is negative, MMMFs will be forced to invest in assets negative returns promised. $ 1000 invested in Treasury bills, for example, would be worth only $ 999 expires. This means that a MMMF will not have a sufficient number of assets so that everyone is US $ 1.00 package to redeem their shares. The fund will "break the buck," or like the 99 cents mark down the value of its shares, to allow all redeemed. Since MMMFs class should be cash - in fact, many people provide inspection writing skills, such a development would be disastrous, or let go of the story.

I do not think breaking the buck is a terrible outcome, but even so, the European money market mutual funds, in the face of negative interest rates, have found a clever way to avoid it; reverse distribution mechanism. Instead of reducing the redemption below par, the number of shares MMMFs just docked, each shareholder has his or her account. For example, as interest rates decline, rather than 100 units is only worth $ 0.99 each well below zero, the end of the shareholders' loss of one unit and 99 units worth $ 1.00. A deeper level of interest rates, fewer units each investor owns. The genius of this patch is that each share of purchasing power remains the same, but negative interest rates effectively transmitted to MMMF owner.

Therefore, a dash for cash is 0%, MMMFs collapse fears only wizard. If the Fed increased to 0.5 percent, this month, this proved to be a mistake, it still has enough space to make things right. Consider how well the European response in the past twelve months, the Federal Reserve cut interest rates could easily, in addition to 1.5% -1.0%; six quarter-percentage point reduction or thirty ten point reduction. Only when interest rates fell by more than Switzerland and Denmark level, say to 1.0%, the Federal Reserve found that the territory of their true asymmetry. (If desired, here are some simple ways to allow more negative rate).

To be clear, this does not mean that I think the Fed should raise interest rates next week. The FOMC continues to punch its 2% core inflation indicators facts seem to indicate that, on the sidelines may be the right thing. On the contrary, I do not think the Fed's policy makers need to wait to see the white of the eyes of inflation, before they are hiking, they just have to wait to hear the door creak inflation.

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