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Low interest rates are here to stay, is a drum we’ve been beating for a while now. In this article an Extract from farrelly’s Dynamic Asset Allocation Handbook December 2014 we look at why raising interest rates any time soon is going to be hard.
Just how hard it will be to raise interest rates is starting to become very apparent. Japan has been stuck at close to zero interest rates since 1993; Europe seems to be toppling towards deflation from which it may find it hard to escape; in the United States, mere talk of an early tightening from the Fed sent the US dollar sharply higher and has killed any possibility of an early rise in the Fed funds rate. In Australia, five years into the recovery, the economy is still struggling, despite historically very low interest rates. With the market now thinking that the next move in interest rates is more likely to be down than up, the much anticipated return to normal interest rates seems a long way off in Australia as well. Even New Zealand, with its buoyant economic growth, seems to have come to the end of its tightening phase with the Official Cash Rate sitting at a lofty 3.5%.
While it is one thing to suggest the central banks may struggle to lift interest rates over the next 12-18 months, it is quite another to suggest that, as a result, rates are going to still be low for five or even 10 years or more. However historical evidence suggests that this is a real possibility.
In a paper released in April 2012, Ken Rogoff and Carmen Reinhart looked at the behaviour of interest rates during past deleveraging cycles. They examined a number of different events with the key ones being the deleveraging processes following the panics of 1870, 1929 and 1990 in Japan. Their key findings were that, in these periods, interest rates tend to stay very low for a very long time – in fact, 23 years on average. In 2025 – 10 years from now – some 18 years will have past since the start of the Global Financial Crisis. We expect that interest rates around the world will have normalised, even if it is to a new, lower normal.
Won’t governments try to inflate away from debt?
Governments have historically relied on inflation to reduce their debt. In fact, the way that real debt reduction is achieved is by keeping real interest rates low or better still, negative. Inflation at 8% and interest rates at 10% makes borrowers 2% a year worse off. Interest rates of zero and inflation rates of 2% makes governments 2% a year better off. It’s not the level of inflation that matters, it’s the level of inflation compared to interest rates. Or, more accurately, it is GDP growth rates compared to interest rates that is the key.
The dilemma facing governments is how to keep economic growth rates up and interest rates low. Inflation tends to be bad for growth and, in an era of somewhat independent central banks, is also very bad for real interest rates. The last thing a government wanting to reduce its debt needs is inflation. Instead, governments that want to reduce debt and be re-elected should be – and generally are – hell bent on keeping growth positive, inflation low and real interest rates negative. From a macro-economic view, the best way for an overly indebted government to check inflation in the event of a runaway economy caused by too low interest rates is fiscal restraint (raising taxes). It is slow but effective and has the benefit of reducing both the deficit and debt.
Next time you hear about governments wanting to inflate away debt, you have two choices. Tune out, or rush out and buy gold. We strongly recommend the former.
What of deflation?
This is an interesting question. From the point of view of reducing debt, deflation is clearly undesirable. Over-indebted governments are much better off with 2% inflation and zero interest rates than 2% deflation and zero or marginally lower interest rates. It is bad news.
Beyond that, we have long been of the view that concerns about deflation are vastly over done by economists worried about a re-run of the Great Depression. Fighting the last battle has never been a brilliant strategy. Here is our read on the impact of deflation.
Firstly, deflation is predominantly a symptom rather than cause of economic malaise. When an economy is depressed to the extent where demand is insufficient, prices will fall. The problem is insufficient demand – falling prices are just the symptom. Nonetheless, shrinking economies are really bad news for those with too much debt.
Second, falling prices do not cause a fall in demand. In the 1930s, they may have done so. That was in an age where credit was scarce – credit cards didn’t exist – and thrift was seen as a virtue. Culturally, the Western world has moved a very long way from that point. Instant gratification is the dominant ethos.
Falling prices in electronics, automobiles, clothing and white goods have been with us for years without causing any noticeable decline in demand. And, it is not just about consumers. Will corporates defer projects if they think they will cost 1% less in a year? We doubt it. They defer projects because of concerns about lack of opportunity. If investment was deferred due to lower investment costs, no business would have bought a computer or a truck for the past thirty years. This one is a complete furphy.
Third, deflation is, however, tough for employers and therefore for employment. In a period where inflation is running at 2% to 4% per annum, no pay rise is a big pay cut. This makes adjustment of employment costs much easier than in an environment where prices are falling and where no pay rise is a big increase. In a downturn, employers just don’t need adjustments to be even harder than usual. The end result tends to be lower profits and somewhat lower employment. This is clearly bad.
And finally, while deflation is bad for government debt, it is not catastrophic. The impact on the size of the debt of 2% deflation and zero interest rates is no worse the impact of 2% inflation and 4% interest rates. As an aside, the cure for deflation is to forget about prices and solve the real issue – insufficient demand. In an environment where confidence is lacking, substantial and worthwhile infrastructure spending is usually the answer. While interest rates are low or zero, why not borrow long term and get worthwhile projects done? Sell the projects off later if need be. Politicians understand this, but seem to be too timid to act.
What would it take for rates to normalise?
If we accept that low real rates and solid growth remain the goals of deleveraging governments
around the world, just what will it take to get rates higher? Unsurprisingly, the answer appears to be the obvious one – core inflation breaking above central bank target ranges which tend to be in the 2% to 3% per annum range. What will get us there will differ from country to country.
This Article is written by Asset consultant, Tim Farrelly, and reprinted here with permission. https://portfolioconstruction.com.au
