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Is inflation about to return? If so, that would explain why benchmark bond yields are rising and why investors don't want to pay as much for 'assets'

Is inflation about to return? If so, that would explain why benchmark bond yields are rising and why investors don't want to pay as much for 'assets'

Long-term benchmark bond rates have been rising - until Wednesday and Thursday, when they dipped. But now Treasury has raised its four-year Kiwi Bond rates.

Wherever they go from here will be important. But why?

Interest rates are the 'price' or 'cost' of giving up cash (today's purchasing power) for a better result in the future.

Benchmark interest rates, those on bonds issued by sovereign entities, are important bases for how a huge range of other investments are based.

So watching what central banks do is important. And that is even more so these days as central banks try to screw the interest rate scrum with quantitative easing activity.

Fundamentally, assets are valued (or 'priced') based on a reference to a risk-free rate of return. But now central banks are screwing with these rates.

However, the key risk-free rate is the 10-year rate, and most of the central bank screwing is aimed at much shorter rates, usually three years or shorter. So the 10-year rates remain relevant even if there are risks monetary policy makers could turn their attention to longer terms.

Off the 10-year benchmark, the lower the bond yield, the higher the asset value, and vice versa. If a benchmark bond yield rises say +1% from today's levels, very roughly the capital value of a 10-year bond would fall about 9%. For some types of equities it could involve a decrease of as much as 15% in the asset price. This yield leverage is extremely powerful and can have broad economic impacts.

Investors must prepare for an investment situation that accounts for the new risk of rising long-term rates.

If economic growth accelerates in a broad recovery led by the US and Japan, and China benefits too, then it is very likely to include higher levels of inflation than we have become accustomed to. Central banks may look past early inflation heating - until they can't ignore it. It has happened before - in the mid 1990s central banks gave a mulligan to early inflationary signals, only to realise the situation could get away on them unless they acted. They acted because they didn't want to repeat the pain of inflation running high, like in the 1970s and the gruesome consequences at that time of controlling it.

Professional investors think one of the most likely central banks to have to change course and raise their policy rate sooner than indicated, is the Reserve Bank of New Zealand. Internal cost pressures, a lower exchange rate, and high export shipping costs are all likely to be inflationary sooner than the RBNZ wants. And these will all come at the same time the world's large economies are inflating as well. Markets are now pricing in an expectation the RBNZ will raise rates 'soon', and that pricing is reflected in higher yields on NZ Government Bond benchmark rates (as well as most downstream bond rates).

KiwiSaver investors in 'conservative' and 'balanced' funds have a lot at risk in the potential for bond price losses.

But equity investors do too. In New Zealand that is because many shares come with relatively generous dividend streams that have been around for a long time, long enough that this aspect is priced off bond yields. If yields rise, the future value of these dividend streams fall, and the value of the share price itself comes under downward pressure - even if earnings themselves remain unchanged.

Most listed property equities fall into this category. And that includes the retirement village sector.

And a re-rating lower will be emblematic of all property based assets being discounted as a result of rising benchmark interest rates. The residential investment sector won't be immune - but now the recent changes in interest deductibility, the change in investor leverage rules for borrowing, could compound the shift lower.

And companies with high levels of debt will get it in the neck two ways, from their rising interest costs and their lower share prices.

In the end it is the expectation of inflation and real economic growth that drive these changes.

If economic growth eventuates, there will also be winners, and they can offset the overall impact of rising bond yields.

One of the aspects of today's situation that's different to policy shifts at earlier times is that central banks tend to be much more transparent about what they are doing, so their policy changes are quickly priced in. But that can have the effect that markets can get things wrong more quickly resulting in unsettling volatility in the very short-term. That might be what we have seen over the past two weeks.

Investors need to watch long term benchmark rates. The US Treasury 10-year has risen from just under 1.00% at the start of 2021 to over 1.60% now. That is quite some move, even more so when you realise it was under 0.60% in August 2020. The NZGB 10-year has risen from under 1.00% to 1.70% over the same period from the start of 2021.

But things will get very 'interesting' when they rise to over 3% - something that hasn't happened in New Zealand for the past three years, or for the UST 10yr since late 2018.

Quantitative easing by central banks is their favoured way to screw the interest rate scrum. That results in more funds chasing the existing assets and tends to drive up prices (and send yields lower). But when investors either tire of low yields, or suspect central banks have overplayed their hand, then things could change quite quickly.

And with a very real prospect of rising inflation, the reckoning of a change of course may be upon us. Buckle in for a bumpy ride.

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46 Comments

I think RBNZ will keep the status quo until the actual inflation and unemployment targets are within reach. Coupled with the new house prices consideration, increasing interest rates will dampen construction activities which is counter productive to price stability. We may be still quite a way there.

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They can try... but they don't hold all the levers in the free and global market.

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Would David Chaston buy the US 10 Year Treasury Note??.. I doubt it because he's not an idiot.

As for NZ, if Orr starts rubbing up against the 60% limit, he better hope Kiwi bond vigilantes don't start selling. I think the RBNZ is naïve to the impact of a sustained bond sell off, especially if the NZD trends downwards.. in the face of new bond auctions.

The only things the NZ bond market has going for it are; RBNZ QE and the fact there are only limited asset classes in the world. I've defended the RBNZ's bond buying to an extent, as they are 'market markers' - yet, it's a fine line between that and 'market [money price] manipulator'. A thin argument indeed.

Good Luck.

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Exactly right. Very good analysis. Investors who pretend that interest rates will not increase, and sooner than expected, are in for a very rude awakening.

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Hundreds of comments on the housing articles, with 2 comments at writing on this one.

I think people are missing the significance of what rising rates will mean for all asset classes - especially while they are all potentially in bubbles.

Central banks will be stuck between a rock and a hard place.

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Yes, very interesting times ahead. I think that holding long-term bonds is a very dangerous position now. Same for highly rate-sensitive assets (including but not limited to residential housing). Having a higher than normal position in cash might be prudent for the time being.
I am also increasing my exposure to the resources sector.

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Yip Warren Buffett, Ray Dalio, Jamie Dimon...all think bonds are ruined. The Fed have destroyed the bond market. Why would you ever go near a bond now...cash is trash and bonds might be even worse!

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Short trade.

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Hundreds of comments on the housing articles, with 2 comments at writing on this one.

An old associate in the financial services sector used to decry how poor the level of financial literacy was amongst NZers. He'd been in the insurance game for over 30 years and interviewed thousands. People don't want to believe that this sort of thing is possible. Uncle Adrian will keep us all fat and happy, no work required. The same way beneficiaries think about auntie jacinda.

For the institutions, it'll be hot potato once this kicks off. Maybe they'll just wrap all the bonds up and repackage them as "semi-premier debentures" and hock them off to the retail market? They could offer them at a markup as a safe haven from the OBR, create a bunch of crypto/gold hedge funds with the proceeds, then let the debentures fade into the ether as fiat collapses and payouts turn to pesos. The lemmings will snap them up. By the time the smoke clears, Acme Finance will have been sold to Beta Investment Capital and the criminal liability will be in the wind. Although they may just as well get another bail out!

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Long term bonds are ‘long term’ market expectation re inflation and need to have % holding in asset class drives the market... as time elapses they roll them or end up trading on short curve rates

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The biggest danger to NZ Govt / RBNZ is under-estimating their power. Ultimately, Govt could simply decide not to issue long-term securities at all - and just pay 0.25% (or whatever) on bank reserves instead. What people forget is that Govt issue bonds as a favour - providing a risk-free financial asset for investors (e.g. pension funds). If the 'market' starts to demand higher yields, just withdraw the favour.

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It’s a crucial part of setting value of nations open traded currency...

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I think they lost control already. They just copie US, because they clueless and don't want to be seen that way, shame US fed doesn't know how to fix it and only put more fuel on fire. Good luck all.

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Investors must prepare for an investment situation that accounts for the new risk of rising long-term rates.

The option value of cash

With our value-focused asset allocation encouraging the highest allocation to cash since 1929, aside from the peak of a post-crash correction in early-1930 that preceded the bulk of the 1929-1932 collapse, now seems to be an ideal time to explain why the interest rate on cash can be a poor measure of the value of cash (or hedged equity) as an investment alternative.

Let’s begin with two simple examples, and then we’ll formalize the idea.

The first case is extreme because it will provide some useful intuition. Suppose I offer you a security that will pay $100 two days from today. You can buy as much of it as you like today at $50, or you can wait until tomorrow. Tomorrow, I’ll flip a coin. If it’s heads, I’ll sell you the security at $99. If it’s tails, I’ll sell you the security at $25. What should you do?

Clearly, if you buy the security today, you’ll double your money two days from now. That’s a 100% expected return for each dollar you invest, over that 2-day period. If you wait, you’ll earn nothing on the first day, but you’ll then have two possibilities. If heads, you’ll get just 1% on your invested money. If tails, you’ll get a 300% return, quadrupling your money. With a 50/50 chance at each, your expected return for every dollar you invest is 0.5*1% + 0.5*300% = 150.5%. So waiting adds 50.5% to your expected return over that 2-day period. With an extreme example like this, risk aversion would undoubtedly be a consideration, but from an expected return perspective, and particularly if we repeat the game over and over, you’re clearly better off staying in cash on day one, despite the very high expected return from investing right away.

It’s tempting to say, “Now, hold on. The expected price tomorrow is 0.5*99 + 0.5*25 = $62, which is higher than $50, so I should obviously invest today.” But this argument overlooks that there are actually two distinct investment opportunities that you obtain by waiting. In one, you will quadruple the entire amount invested. In the other, you will gain just over 1% on the entire amount invested. Each of these has a probability of 50%. While the “expected” price in the second period is obviously $62, that price is emphatically not the actual opportunity you will face in the second period. Option value emerges because the act of waiting splits the second-period opportunity set in a valuable way. The potential benefit of obtaining a lower future price outweighs the potential cost of missing an immediate gain. In other words, waiting provides an option that would be lost by investing immediately, and that option has value.

Now let’s extend this to a less extreme example. Suppose that a security will deliver a single $100 payment a decade from today. Suppose the price of the security is $74.40. With that, you can quickly calculate that the 10-year expected return on the security is 3% annually. We’ll also assume that cash earns nothing.

Given these assumptions, it seems obvious that the security is a better investment than zero-interest cash. But hold on. Suppose that the security price is volatile enough that it might be 25% higher one year from now with a probability of 0.51, or 20% lower with a probability of 0.49. I’ve chosen those numbers so their expected value is still 3%. With that extra piece of information, it turns out that you’re actually better off holding cash and waiting to see what happens, even though cash provides a zero return.

Why is cash a more valuable option? Well, if you buy the security today, your cumulative return over the coming decade will be $100/$74.40 -1 = 34.41%, regardless of what happens next year.

But suppose you wait. The action of waiting gives you access to two possibilities. In the event of an upmove, which has a probability of 0.51, you’ll miss that gain, the new price will be $93.00 and your cumulative return at the end of the decade will be $100/93.00-1 = 7.53% if you invest at that point. But waiting also gives you the possibility of a 20% price decline, to $59.52, in which case your cumulative return at the end of the decade will be 68.01%. Weighting those two distinct outcomes by their probabilities, your expected cumulative return if you wait is 0.51*7.53% + 0.49*68.01% = 37.17%.

Given the low expected return on the passive investment, coupled with a reasonable level of volatility, it turns out that holding cash has an “option value.” You might miss out on the upmove, but you also gain the potential to invest at a lower price than is currently available. In this example, holding cash for a year, even at zero interest, actually raises your expected wealth at the end of the decade by 37.17% – 34.41% = 2.76% over a passive buy-and-hold approach.

By holding the security today, a passive investor can expect an average price next year of $76.59, a gain of 3% from the current price, and a level that would be expected to provide further gains averaging 3% annually over the following 9 years. But the passive investor loses the opportunity to take advantage of potentially better returns that a decline might produce. The risk is missing out on a potential gain. That risk is highest when the security is reasonably valued and likely to produce acceptable returns, and lowest when the security is richly valued already and has a small expected return. So the option value of cash is highest when the investment security is at high valuations that imply relatively small returns, and when the security is also subject to volatility.

It’s worth noting that sufficiently high volatility can increase the option value of cash, even if a security is undervalued. However, cash stops having compelling option value when the expected return on the security is high, and volatility and risk-aversion begin to recede. That’s as good an explanation as any for why the strongest market return/risk profiles we identify are associated with a significant retreat in valuations that is then joined by an improvement in our measures of market internals.

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500 comments on a property investor thread and 9 on this one, which is odd because this is the thing that will bankrupt more speculators than anything the govt will try and do.

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Nearly every property investor I've talked to doesn't know what a bond is (say 90% of them) nor how they are valued, nor how rising rates and a larger number used to discount future cash flows might impact asset prices. But yeah...who cares.

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They just take advice from Ashley Church he sound like he knows heaps

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Exactly:

Here’s what, oh, the Reserve Bank of New Zealand (RBNZ) has to say about LSAP effectiveness:

When we buy assets, this increases their price and so reduces their yield. That means the interest rate, in this case on government bonds, fall. This has the effect of ‘lowering the tide’ on other interest rates in the economy, particularly longer-term interest rates of two years or more. It also reduces the cost of borrowing for households and businesses…

LSAP programmes have been conducted in the euro area, Japan, Sweden, the United Kingdom and United States.

The evidence shows LSAP proved effective in providing much needed support, lowering long-term interest rates and exchange rates, and underpinning economic growth and inflation.

Studies found the government bond purchases worth 10 percent of GDP have, on average, lowered 10-year government bond yields by around 50 basis points. [emphasis added]

It’s true; many academic studies from around the world focusing on different program types in different places have come to similar conclusions using all kinds of regression analysis. They find that QE programs do correlate with falling interest rates; maybe even “around 50 bps” (the “around” part means rounding up).

Even if we take them at their numbers, and presume correlation equals causation (because, they’ll tell you, they do account for the difference when regressing variables), you should still end up wondering why they even bother with this stuff.

Purchase bonds equivalent to ten percent of GDP, and rates are at most half a percent lower?

Talk about underwhelming; not exactly the powerful printer, the massive “accommodation” and “easing” told about in every mainstream media article on the subject. Link,/a.

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There is broad agreement that QE lowers interest rates and hence raises bond prices. It is what happens next that becomes interesting and contentious. It is not just the first order effects that count.
KeithW

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by Audaxes | 8th Mar 21, 5:08pm
The tweak comes as bond yields in New Zealand and around the world rise (as per the Kiwibank economists’ graph below) and financial conditions tighten:..
This price service claims the 10 yr closing price today is ~1.90%. A significant fall in price from a low yield recorded at 0.498% on 13th May 2020, despite non stop LSAP actions from $10.377 billion on that date to $48.478 billion today.

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If interest rates and inflation take off many may call this NZ second 1987 meltdown and then what will the sheep invest in.
The slaughter house looks to be hiring for the many who follow each other in the house ponzi.
I feel sorry for FHB if this happens but also will teach many a lesson and not to follow the pack.

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You're insinuating people learn from their mistakes? Reminds me of a Split Enz song.

♩ ♪ ♫ ♬ History, never repeats ♩ ♪ ♫ ♬

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That of course assumes that shares are not a similar ponzi scheme, massive inflation through cheap money.
Watch them sink like a stone as interest rates rise, same as the houses would.

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Absolutely, there isn't a single market operating under capitalism right now it seems. The closest thing to a free market at the moment might just be crypto.

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When you inject $100 Billion into an economy the size of NZ you have to expect inflation , currencies around the world are dying and NZD is no exception in the next 10 years. The history of currencies is paper currencies last approx 50 years and then change. This is coming the nz dollar is devaluing thats why we are seeing house price inflation Mr Orr just pumped $100 Billion made up dollars into nz what did they think was going to happen. Buy assets that produce an income and hold onto it because by the end of this decade that asset will make you very wealthy. The government can throw whatever taxes at ya but the truth is inflation of the asset at 2031 will far out way the taxes you had to pay. Good Luck.

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Quantitative Easing (LSAP) does *not* change the broad money supply in the economy - it just changes the type of broad money in the economy (from reasonably liquid bonds to slightly more liquid cash). So, Mr Orr has *not* put $100bn into the economy. What has happened is that banks have pumped loads of cheap credit money into the economy (thanks to low interest rates and consumer confidence) - this has led to a significant increase in house prices. The other asset bubble is the share market - the result of investors being flush with cash from selling bonds at a profit to RBNZ, ploughing money into shares.

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Without QE, the Government deficits would be financed from within the market. With QE, the deficits have been funded by the financial institutions who knew very well they would be on-selling to the RB. So the net effect is that the Government deficit is financed by the RB. And there lies the increase in the broad money supply. Right now, much of that increased money is not circulating but ends up as bank deposits and hence bank reserves. As a consequence there is great capacity for credit creation at low interest rates. If this demand-driven credit creation occurs then the inflationary forces will have been truly released. The constraining factor right now is that businesses do not wish to invest and so the inflationary embers are semi-contained. The new housing policies in NZ may further constrain demand-driven credit creation. So that tells the essence of demand-driven inflation. Cost-driven inflation is the other issue to be factored into the equation.
KeithW

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by Audaxes | 9th Mar 21, 10:25am
In Canada, they also have a hot housing market fueled by vast QE cheap money and spurring comparisons to earlier bubbles.

A recent Bloomberg article described central bank easing with the phrase “pumping money into the economy.”

That’s a misconception. Monetary easing (QE) is actually an asset swap. The public was holding savings in one form, and now it holds it in another. The Fed buys Treasury securities from the public, and replaces them with currency and bank reserves (base money) that someone has to hold, at every point in time, until the Fed sells its bonds and retires the cash. All monetary policy does is to change the mix of government obligations held by the public. Only fiscal policy – specifically deficit spending – changes the total amount of those obligations. Link

The fuel is bank lending. Banks have migrated away from lending to productive business enterprises because the risk weights can be as high as 150%.

Thus around 60% of NZ bank lending is dedicated to residential property mortgages held by one third of already wealthy households.

Bank lending to housing rose from $50,788 million (48.36% of total lending) as of Jun 1998 to $295,957 million (60.02% of total lending) as of December 2020 - source.

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It is indeed an asset swap when looked at in the narrow context of financial institutions selling their Treasury bonds to the RB. But that is only one part of the story. The RB money that the financial institutions receive simply repays the money those institutions used to buy the Treasury bonds. At the 'end of the day' the Govt has had its newly minted Treasury bonds purchased by the RB and that is with newly created money. The financial institutions are, apart from the intermediation fee, in exactly the same position they were in before the sequence started.
KeithW

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The RB money that the financial institutions receive simply repays the money those institutions used to buy the Treasury bonds.

That's not how the RBA understands the matter - Deposits and money are primarily born of credit

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Audaxes,
I am reasonably confident the RBA would not disagree with me in relation to the particular point I made. I certainly do not disagree with the RBA statement that deposits and money are born of credit. Treasury bonds are themselves a form of credit. But looking simply at one part of the system, being the asset swap between financial institutions and the RB, and looking at that in isolation, does not capture what is happening in the system.
KeithW

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"Without QE, the Government deficits would be financed from within the market. With QE, the deficits have been funded by the financial institutions who knew very well they would be on-selling to the RB."

I would write this as: 'Without QE, financial institutions would be holding more Govt bonds, and banks would have less cash in their reserve accounts at RBNZ.' Govt deficits aren't financed by anyone - they are created when Govt spends, and deleted when Govt collect taxes. Bonds are used to drain reserve accounts - reducing the liquidity of financial assets held by financial institutions, providing a risk-free return for investors, and some would argue shaping long-term interest rates.

"So the net effect is that the Government deficit is financed by the RB."

I don't think this is accurate. The RBNZ might buy $100m of bonds in the secondary market - this puts $100m on the liability side of the RBNZ balance sheet and $100m of bonds on the asset side of its balance sheet. This inflates the balance sheet of RBNZ, but, in effect, the Govt deficit is unchanged - the bond seller is just holding $100m of the deficit as cash instead of bonds.

"And there lies the increase in the broad money supply. Right now, much of that increased money is not circulating but ends up as bank deposits and hence bank reserves."

Yes, agree with the point about money not circulating. But if you do the balance sheet analysis for LSAP (page 5 of https://economic-research.bnpparibas.com/Views/DisplayPublication.aspx?…), I am not sure that you can claim the broad money supply has increased when the commercial bank has a balancing liability. Doesn't effect it's capacity to lend etc. The bond seller has cash instead of bonds, but bonds are pretty close to cash on the liquidity scale anyway.

"As a consequence there is great capacity for credit creation at low interest rates."

My banking mates in England tell me that banks never run out of capacity for credit creation - and don't anticipate being constrained anytime soon. What limits credit creation is the risk level and demand for that credit. The NZ banks have ridiculous excess reserves at the moment, so I am presuming they are in the same boat.

"If this demand-driven credit creation occurs then the inflationary forces will have been truly released. The constraining factor right now is that businesses do not wish to invest and so the inflationary embers are semi-contained. The new housing policies in NZ may further constrain demand-driven credit creation. So that tells the essence of demand-driven inflation. Cost-driven inflation is the other issue to be factored into the equation"

Agree with this broadly. What does frustrate me about the inflation debate though is that people talk about it in broad terms. Inflation tends to arise around particular products - e.g. rent, oil, etc and the response to inflation should therefore be more targeted (certainly more tweaking the OCR). I think market-oriented economists also under-estimate the ability of Govt and central banks to influence inflation - Govt control so many of the influential variables (OCR, minimum wage, bond yields (to a degree), public sector pay, public service contracts etc). Govt should perhaps be thought of as the monopoly issuer of money - and even the most neoclassical economist would recognise that monopolies are price setters.

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Thanks Jfoe,
I won't respond to all of your points here but they may influence a future article.
A couple of points:
1) We need to focus not so much on the balance sheets but on the actual flows of money
2) A focus on the actual flows leads to the perspective that Govt deficits financed by the RB (with financial institutions acting as intermediaries) lead to more deposits held by citizens, both individually and in their businesses, which itself leads to more reserves held by the banks at the RB.
KeithW

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The "actual flows of money" fail to illicit the required remedy, forecast by central banks.
Graphic evidence #1
Graphic evidence #2
Graphic evidence #3
Article Link

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Keith - I appreciate you spending the time to respond even partially! Thank you.

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Unless you tax back $100 billion... just saying

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Raising interest rates will be the last Hail Mary economic move. Anything but that.

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Having looked at the pie chart and weighting’s given to each good and services that make up nz’s CPI calc , and experiencing cost increases in nearly all of those areas to the kiwi consumer like myself this year. Surely ol mate Adrian’s hands will be tied in the not too distant future to stay within the 2-3 % inflation target remit??? Could Retail mortgages back in the 4-5% range be not that far off again ?

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We all know the CPI calc is flawed and they should fix it. Just because its what they have always used doesn't mean its right. Things like house prices and hence mortgages have changed significantly and this is now a huge percentage of your take home pay. Inflation is already running way above the "Target" but the calc is hiding the true figures. Pretty much impossible to manage the economy and take the required action using the wrong metrics, its going to come back and bite us in the arse. Interest rates should already be rising as a signal to the market.

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Totally agree...about the only metric in the cpi formula that I thought may not have increased much is some utility costs .. ie broadband/power. Every other metric : transport, food, trade services, is going through the roof. How long can RBNZ keep saying its within range? , 2-3% ( Tui billboard )

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As inflation rises, we will hear increasing emphasis on stabilising the inflation rate to 'two percent over the cycle' . Therefore the RB will not be quick to act as they will feel entitled to make no move until the current inflation is well over 3%
KeithW

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Or at least no move until they're forced to accept they can no longer downplay the fact that we are already well over 3%

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And let's not forget that any move they make in the face of global markets at that stage, will be akin to spitting into a hurricane force wind. Which I'm sure will be their riposte.

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I hope the govt leave the interest write off for new builds in place. You want to be careful about how much damage you do to the economic animal spirits of the population.

What happens if world interest rates rise but there is no consumer demand in New Zealand to support price increases for products? Deflation not inflation no?

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I have always believed inflation was simply fiat money deflation (aside from something becoming scarce). That dollar you have today, stored away for 10 years will be worth nothing. QE, money printing, or excessive bank lending all lead to more dollars chasing the same amount of assets. If you look at wages or income you will see that the exact opposite has occurred. Relative to assets, incomes have been severely devalued. The only way to support high asset prices on low wages is with extremely low interest rates. Should we really expect interest rates to rise while wages stay low or even decrease due to Covid 19. I wouldn't hold my breath if I were you. In the USA some people refer to QE as QE Infinity.

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Bitcoin News:

New Zealand Funds management Ltd (NZ Funds)'s Kiwisaver Growth fund has invested 5% of its capital into Bitcoin
They have around $NZ 350M in assets, so at some point in the last 4 months possibly, they put around $17M into Bitcoin
Do you know where your Kiwisaver invests.?

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