Updated: May 19
It is generally agreed that a little inflation (in the order of 2% per annum) is a good thing. Anything higher than this impedes private sector investment decisions. Anything lower is, according to the Federal Reserve, "associated with an elevated probability of falling into deflation." Therefore, a level of 2% is neither too hot nor too cold, but just right.
"Credit creation has been delegated to commercial banks"
The problem is that in the past it has been extremely hard to keep inflation at this "Goldilocks-like" level. For only one third of the time since 1774 has 10-year annualised inflation in the US been between 0% and 3%.
Furthermore, it has been hard to sustain the rate at these levels for more than a few years. The recent run of 16 years smashed the previous record of 14 years held by 1957 to 1970, which itself had edged out the 13 years of 1904 to 1916.
If history is anything to go by, inflation is either about to rise sharply or fall sharply. Here is my take on which to expect and thus what might happen to interest rates.
Milton Friedman said that inflation "is always and everywhere a monetary phenomenon" suggesting that by adjusting the price or quantity of money, central banks can generate whatever level of inflation they desire. So why has it been so hard to keep it "nice 'n' low"?
Financial historian Russell Napier thinks the reason is that: "In fiat systems, money is created by commercial banks and not by central banks."
So while Friedman may be right, the reality is that there isn't much central banks can do if credit creation has been delegated to commercial banks.
Despite the massive quantitative easing programmes that have been implemented in recent years by the world's four major central banks, inflation pressures remain very subdued.
Napier points out that the world GDP deflator, arguably the best measure of global inflation, is at the lowest level since the mid-60s. Having rebounded to around 6% during the three years following the financial crisis, it has since slipped back to 2%.
Growth rates have also been slipping across both the developed and developing world. Particularly worrying are the world's two largest economies, the US and China, where recent GDP data have been disappointing. If both growth and inflation are slipping below desired levels, the natural conclusion should be that monetary policy is still too tight. And yet Fed chair Janet Yellen continues to talk about increasing interest rates this year.
This apparent inconsistency may have a rational explanation; however, while Yellen talks of increasing rates, she may be in no position to do so.
The problem lies in the Fed's mandate, namely to promote price stability. Often, preventing consumer prices from falling means lighting a rocket under asset prices. There isn't much the Fed can do about this, other than threaten to increase interest rates. This is precisely what I think is happening at the moment.
Furthermore, even if inflation does start to rise towards 3% and perhaps even beyond, which I doubt will happen, I think the chances of interest rate increases are slim.
Towards the end of 1936, both monetary and fiscal policy were tightened, following four or so years of modest growth following the 26% contraction from 1929 to 1933.
The Fed's balance sheet had peaked in June 1936 at 13% of GDP and fell to 10% a year later (to put these numbers in perspective, the Fed's balance sheet today is equivalent to around 20% of GDP).
The rate on short-term Treasury Bills increased from 0.1% in October 1936 to 0.7% in April 1937.
The result? In 1938, the economy contracted by 3.3% and between early 1937 and early 1938 the Dow Jones Industrials Index halved. The next time short-term rates rose above 1% was in 1948.
Furthermore, although to a great extent war-affected, the rate of inflation averaged around 6% from 1939 to 1948, so real interest rates were substantially negative during this time.
I suspect Yellen is keen to avoid tightening prematurely given what happened back then, and so given the choice is likely to let inflation run above target.
Another interesting point to note is that even when monetary policy started to normalise in the late-1940s, the Fed never subsequently shrank its balance sheet. They just allowed it to get inflated away. From December 1948 to January 1981 the monetary base increased from US$33.3bn to US$140.6bn. As a percentage of GDP, however, it decreased from 12% to 4% as inflation averaged 4% per annum.
Indeed, the current size of the Fed's balance sheet may well restrict the extent to which interest rates can be increased. There has been talk of paying interest on reserves held with the central bank, but I can't see how this would help.
The Fed Funds rate is the rate depositary institutions lend excess reserves to each other. When actual reserves are close to required reserves, this rate matters.
However, actual reserves are currently 32 times required reserves, the result of quantitative easing, so banks do not need to borrow.
In summary, interest rates are very likely to remain low in the US and elsewhere, despite what the Fed is saying. This is certainly good news for equity markets, where valuations are still reasonable.
As for bonds, I don't see inflation rising substantially any time soon, which should provide some support. However, real long-term interest rates are either close to zero or negative, so there isn't much upside either.
Published in Investment Week
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.