Free Money!

One of the cases often made by market bears is that the economic recovery, such as it is, is largely illusionary, thanks to lots of cheap money and inflated real estate prices. There’s certainly a lot of truth to that, although I think too many bears overstate the case.
But they’re exactly rights about loose money. The chart above shows a good historical perspective. It charts the growth of an investment in Treasury Bills, adjusted for inflation, since 1953. In other words, real short-term interest rates. Over the long-term, real rates are rather puny–about 1.2% to 1.4% a year.
The problem with inflation is “some” begets “more,” and it can easily spiral out of control. If the cost of borrowing falls below inflation, then borrowers are being paid to borrow money. That’s what happened in the 70’s and you can see that the blue line headed down. In other words, real rates were less than 0%.
What’s interesting about this chart is that in the 80’s, the line appeared to revert to its long-term trend. But the trend was snapped again four years ago. I was shocked to see how much of a departure from history the last four years have been. Real short rates have been running about -1% a year since 2002.
The chart (based on Ibbotson numbers) runs through December 2005, although it looks like rates have stayed negative this year as well. For the first four months of 2006, the CPI (which may be understated) is up about 2.4%, or 7.3% annualized. Since January, the three-month Treasury yield has climbed from 4% to 4.7%.

Posted by Eddy Elfenbein on June 7th, 2006 at 11:36 am

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