Jumat, 26 Juli 2013

Confidence slowly returns and that is huge

Consumer confidence is slowly returning. The University of Michigan measure of consumer confidence reached its highest post-recession level this month. Confidence remains relatively low from a long-term historical perspective, but there is little doubt now that confidence is increasing, and it's changes on the margin like this that are very important.

This has been the weakest recovery ever, and confidence has been extraordinarily low for most of the recovery. The world, in fact, has been very risk averse throughout this entire recovery. But things are changing. Gold was the beneficiary of investors' fears, rising to $1900, but now that confidence is making a comeback, gold has dropped to $1300. That's a big deal. Real yields on 5-yr TIPS fell to a low of -1.8%, as investors were willing to accept a decidedly negative real rate of return in exchange for protection from inflation and from potentially another collapse of the economy. Now, real yields have risen to -0.5%; that's a big deal too.

Risk aversion, a desire to rebuild and strengthen balance sheets, and the desire to deleverage led to a huge demand for money (e.g., the components of M2: currency, checking accounts, time deposits, and savings deposits). Never before has M2 been so high relative to national income. The bulk of the increase in M2 came in the form of bank savings deposits, which pay almost no interest at all: that is how intense the demand for money and safety has been.

But now that confidence is returning, it's reasonable to think that the world no longer wants to accumulate more and more cash and cash equivalents (i.e., money). The world may in fact soon attempt to reduce its money balances. Cash can't disappear, of course, but the desire to hold less cash can result in higher prices for other things and more economic activity (e.g., faster nominal GDP growth).

As confidence slowly returns, banks may become more willing to use their abundant supply of reserves to make more loans, and consumers and businesses may become more willing to seek out loans. Bank lending could accelerate, increasing the supply of money at the same time as the demand for money is declining. These are the ingredients for rising inflation, which up to now has been quiescent because the demand for money has been intense.

This has been the weakest recovery ever because the world has been exceedingly fearful of a lot of things. Those fears are slowly being replaced by confidence, and that means that we could be on the cusp of a sea change in the economic fundamentals, in favor of faster GDP growth and higher nominal prices (inflation). So far the only evidence of this is gold and TIPS prices and a modest rise in consumer confidence. But once this snowballs, the momentum and the magnitude of the change could become impressive. Will the Fed be able to react in a timely fashion and reverse QE in keeping with declining money demand? That could be the most important question of the next year or so.

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