It's Not About Money, Nor Interest Rates.. Liquidity Matters Most

by Michael J. Howell3. January 2014 10:42
Like Mums and apple pie, more Liquidity is better than less. But surely interest rates and money matter more? Interest rates are important, but they are set by the market and not by Central Banks, despite all the pantomime and puff. What's more they derive from liquidity, viz the yield curve which as we show moves 3-6 months behind the liquidity cycle. Sure Central Banks can fix policy rates, like discount rate, but these seem to have little effect on market rates as 2008 proved. A more important price is the 'terms of a loan', but these reflect funding availability (ie liquidity) and typically move oppositely to policy interest rates, anyway. So what about money? For the non-economist, money is probably what we think of anyway as liquidity, ie. sources of funds, such as household savings, retained earnings and credit. For the economist, money supply is defined by bank deposits, or what has become a diminishing part of banks' funding sources, notwithstanding the fact that banks' themselves are also a smaller part of the lending universe. For example, our measures of US liquidity total some US$25 trillion, compared to roughly US$8 trillion for M2 money supply.' However, the damming evidence against money is 2013. US M2 money supply slowed to around a 5% annual growth rate. Admittedly, US credit growth was also tepid, but our measures of total sources of private sector funds leapt higher because US household rebuilt savings and US corporations enjoyed a big jump in their cash flows, viz the pick-up in M&A and persistent share buybacks. Adding these to the small rise in credit still allowed our index of US private sector liquidity to hit multi-year highs in 2013. Therefore, if we are correct this extra cash should underpin a stronger American economy in 2014. Flow of funds and liquidity should matter most.

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