Going through practice questions on the CFAI website, and a question asks what the expected returns of cash would be in a contracting economic environment with disinflation and possible deflation over the next 12 months. My thinking is that cash would increase in value because inflation is lower - higher purchasing power than if inflation continued at its long term term growth rate. The CFAI answer states the following:
The fund benefits from its cyclically low holdings of cash. With the economy contracting and inflation falling, short-term rates will likely be in a sharp decline. Cash, or short-term interest-bearing instruments, is unattractive in such an environment. However, deflation may make cash particularly attractive if a “zero lower bound” is binding on the nominal interest rate. Otherwise, deflation is simply a component of the required short-term real rate.
Can anyone explain why holding cash would produce negative returns?
The concept is straightforward, during poor economic conditions, the federal reserve or central banks will take actions to spur the growth in the economy by decreasing short term interest rates “think of COVID-19 during 2020 and what were the actions taken by the federal reserve” they decreased the interest rate to 0.25%, thus resulting in low returns on your cash investment “bank deposits”
Thought it through and I think it makes sense now. So basically the short term instruments will roll into new lower rates producing a lower return. But if real rates declined enough to become negative and there was deflation, holding cash would become beneficial?
No, then you would most likely pay the interest to have your money deposited at the banks, same thing in Europe… Central banks will apply a quantitative easing program
Can you elaborate on this portion: “However, deflation may make cash particularly attractive if a “zero lower bound” is binding on the nominal interest rate. Otherwise, deflation is simply a component of the required short-term real rate.” I understand that in practice people don’t actually withdraw their cash from their account in a period of negative rates, and instead choose to pay the negative interest due to the security and ease of transferring funds provided by the financial institution.
However, my interpretation is that the zero-lower bound makes the deposits earn at a minimum the same return as holding physical cash - can you confirm that it is saying in a period of deflation / negative rates, it would be beneficial to either hold physical cash or deposit your cash in an account with the zero lower bound?
Thos is how I understood this. As long as interest is in the positive territory, holding cash would earn a +ve risk free rate. If rates turn -ve, that would make it equivalent to paying the risk free rate for holding cash.
Real interest rate = Nominal interest rate - inflation
in an environment where inflation is negative (deflation) and nominal rate is floored at zero, the real interest rate you get from holding cash would be positive
However same cannot be said if the nominal rates can also be negative
I think that in this situation, deflation will cause a deflationary loop - people are trying to keep money, manufacturers start to make discounts and do not receive additional profits, cut production, the situation becomes tense, people try to keep money.