Vol. 3, No. 4 — Interest rate holes in the hull
Vol. 3, No. 4 — Interest rate holes in the hull
Can higher interest rates cause higher inflation? Stocks look like fair value. Deficit spending and bank lending has supported America's economy. Value in Australian retail.
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In today’s issue
Cartoon: Lowe interest rates
Interest rate holes in the hull (4 minutes)
Cost of capital (3 minutes)
Global stocktake (3 minutes)
Rank and file (1 minute)
Credit creation, cause and effects (5 minutes)
Debt cycle monitor (1 minute)
Investment idea (16 minutes)
“Money is the measure of value, but to regard it as having value itself is a relic of the view that the value of money is regulated by the value of the substance of which it is made, and is like confusing a theatre ticket with the performance”
— John Maynard Keynes
Cartoon: Lowe interest rates
Interest rate holes in the hull
Can higher interest rates cause higher inflation? Paradoxically, yes.
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Economic lore tells us that the remedy for high inflation is to push up interest rates. Higher rates, economists say, limit lending and pull prices down. But the relationship is more complex than that. Higher rates can create inflation if there’s much debt. Workers demand raises to cover their mortgages. Companies hike prices to maintain profitability. And the government’s increased interest payments create new money.
Jerome Powell, the boss of the Federal Reserve, finds himself trapped between a rock and a hard place. He wants to increase rates to snuff out inflation. But rate hikes are a blunt tool and might even make inflation worse.
First, when rates rise, businesses pay more to borrow. A higher interest bill makes them lift prices to maintain profits. Price increases create inflation and lead to higher rates again. Federal Reserve data from 1955 shows that inflation tends to rise a year after the bank hikes. It could be that central bankers raise rates before inflation picks up. But that means rate hikes don’t work fast enough.
Second, elevated rates make mortgage and loan payments rise. Workers, squeezed by tighter budgets, push for pay raises. And businesses lift prices to cover the higher labour cost, creating inflation. The correlation between rate hikes and wages (+0.3) is less than consumer prices (+0.5), but it’s still there. Worker pay usually goes up within a year of rate hikes.
Third, higher rates make the government’s interest bill go up. Those interest payments create new money if the private sector owns the bonds. As the Fed pays its profits back to the Treasury, the state pays itself when it pays interest to the central bank. The right hand gives to the left—no new money. But if the private sector owns the bonds, the state creates money to pay the interest.
SIFMA, a financial industry group, estimates the Fed holds a fifth of all Treasury bonds. That means 80% of the state’s interest payments, which are now $853bn per year, go to the private sector. That’s $682bn, or 2.6% of GDP, of new money per year.
The relationship between interest rates and inflation is complex. When the central bank sells bonds, a process called quantitative tightening, rates go up. Economists reckon this cuts inflation. But if that pushes bonds into private hands and rates rise, the state creates more money to pay the interest. That adds to demand.
Currently, the Fed owns a large percentage of Treasury bonds. In 1996, for example, it held 9% compared to the 20% it has now. That growth capped the past impact of higher interest rates on money creation.
Jerome is stuck. If he sells Treasuries, rates will go up, and the state’s interest bill will stimulate demand. If he buys bonds, rates will drop, and the interest bill won’t add to demand. But this goes against economic orthodoxy.
The boat is filling up with water. Instead of plugging the leak and bailing water over the side, Jerome is drilling new holes to let it out.
Good luck with that.
Cost of capital
Finance’s most important yet misunderstood price is capital. Here’s what happened to the cost of money in the past fortnight.
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Stock prices rose last fortnight. The S&P 500, an index of big American companies, climbed 1% to 4,136. The market continues to rise from its October lows but is still 7% below where it was last year. I value the S&P 500 at 4,209, which suggests it is fair value.
The companies in the index earned $1,658bn in the past year, down $83bn from last fortnight. They paid out $407bn in dividends, bought back $884bn worth of shares, and issued $64bn of equity.
The forward price-earnings (PE) ratio dropped to 17. My 12-month forward earnings per share (EPS) estimate for the index rose from 237 to 244.
Government bond prices dropped. Yields, which move the opposite way to prices, rose with inflation expectations. The ten-year Treasury yield, a critical financial variable, climbed 38 basis points (bp) to 3.8%. Investors expect inflation to average 2.4% over the next decade. That's 10bp higher than the rate they expected last fortnight.
The real interest rate, the gap between yields and expected inflation, increased by 28bp to 1.4%. These inflation-adjusted rates are up almost two percentage points in the past year.
Corporate bond prices also went down. Credit spreads, the extra return creditors demand to lend to a company instead of the government, fell by 2bp to 1.5%. The cost of debt, the annual return lenders expect when lending to these companies, jumped 36bp to 5.3%.
Refinancing costs have almost doubled, up two percentage points, in the past year. But they’ve been declining since they peaked in October above 6%.
The equity risk premium (ERP), the extra return investors want to buy stocks instead of bonds, climbed 29bp to 5.2%. It’s now about the same as it was a year ago. The cost of equity, the total annual return these investors expect, also rose 67bp to 9%. These expected returns are a little above their long-term average.
