The Paradox of the Zero Bound

For those who have heard calls that the Fed should raise short-term rates to avoid a deflationary trap, but cannot see how that could help promote growth, Bill Hester of Hussman Funds provides an explanation. He also illustrates investing tactics within such an environment, which feels more like a poker game than a functioning economy:

Promising low rates for long periods of time is particularly pernicious following periods of credit crises, points our Arun Motianey, now with Roubini Global Economics, in his book SuperCycles. In a discussion of Japan’s low policy rates over the last 15 years, Motianey points out that deflation became worse the longer Japan’s equivalent Fed Funds rate stayed at zero.

Motianey argues a slightly different transition mechanism that pushes the economy into deflation, mainly through lending markets. He argues that after a credit crisis, government-supported banks are borrowing at close to government rates and at the same time being coerced to lend at rates lower than they would otherwise demand for the risk of default. The result is that they demand higher credit standards (typically higher operating cash flow) of their borrowers. Borrowers, mostly companies, oblige by halting the growth in or cutting the nominal wages of workers. Generalized price deflation typically follows wage deflation.

Motianey sums up his argument up this way, “Very low nominal rates cannot be used to fight deflation, since they are, in these conditions – the condition of banking system distress – the cause of deflation.” He calls this the Paradox of the Zero Bound.

Read the full article by Hussman Funds