Inflation and Interest Rates are Natural Regulators of Economic Cycles
Not too long in the distant past, when there was no such thing as quantitative easing, and when money could be exchanged into certain quantities of gold, inflation and interest rates often dictate economic cycles. Let’s say if today, aggregate demand is increasing faster than aggregate supply (Remember your “A” Level economics), inflation will rise from 2% to 5%. Aggregate demand rises when people and businesses feel too optimistic and spend more than the available goods on offer. People would not put money in banks if the deposit rates were < 5%. Banks will then have to raise deposit rates > 5% to keep the deposits. In turn, banks will have to raise lending rates to a spread above the deposit rate. E.g. if deposit rates were 6%, lending rate will probably be between 7 – 8%. Businesses and consumers will borrow less because to make business sense, the investments will have to make > 8%. This in turn will lead to less investments and spending. The economy will then slow down because everybody spends less. Jobs will be lost. Aggregate demand will fall while supply remains constant. This causes price levels to drop.
A recession normally follows and inflation may fall to 1%. Suddenly, the deposit rate of 6% will look attractive and everybody will be flooding banks with money. Banks will lower deposit rates to 2% just to make sure that they are not flushed with too much cash because in a recession, there are few borrowers! In order to lend money out so as to earn interest income, banks will lower borrowing costs to say 3%. A lot of investment projects will suddenly make more business sense. The economy will expand because people will spend more, businesses will employ more. The economy reflates.
Without QE, there is an “invisible hand” that regulates the economic cycle, to ensure it neither gets too “hot” or too “cold”.
QE Distorts Capital Flows and Causes Bigger Bubbles In Future
But QE distorts the movement of capital. Even if inflation is at 5%, the central bank keeps interest rates unnaturally low, at say 1%. Banks could borrow from the central banks at 1% so there is no incentive to offer 6% for deposits. Banks will then lend money at 3% because every other bank has the same access to central bank’s cheap money. What happens to depositors? They will think that 1% deposit rate when inflation is at 5% is downright unreasonable. They will be forced to search for yields, from real estate, dividend paying stocks, bonds. This will force up the prices of risk assets to unreasonable levels, or form “bubbles”. Imagine when inflation is at 5%, you will not wish to buy properties unless the rental yield is 6% and the property cost $1m. But with QE, deposit rates are at 1%, so you don’t mind paying $3m for the same property as long as rental yield is 2%, or higher than FD. The same goes for bonds. Under normal circumstance, you’d require a 6% return from a bond of 5 years. Now, you’ll readily buy it at 3%. Businesses will invest in projects that give returns as low as 4%. Previously unprofitable projects will become profitable projects. The quest for raw materials to build the projects, or real estate will cause material prices to skyrocket. Workers on fixed salaries will clamor for pay rises that keeps up with inflation. In some countries, there could be riots due to low wages, food prices rising out of reach of the masses. The deadly combination of wage and raw material costs spiraling out of control will cause inflation will rise even higher to 10%.
The music stops when output cannot increase in line with inflation. What happens when inflation rises to 10% but GDP or output cannot increase > 10%? After all, there is only so many restaurant meals you can take, so many cars you can afford, especially when your wages are being eroded by inflation. Stagflation sets in. Ultimately, if central banks continue this dreaded path, the economy will plunge into a recession with high inflation. That is when money printing has to stop to contain inflation. That is when the “proverbial faecal matter hits the fan”.
What will happen to all the real estate that you chase until the yields drop as low as 2%? Once money printing stops, banks will not be able to borrow from central banks at 1%. Instead, interest rates will climb swiftly to 5%. Deposit rates will follow suit to rise to 5% and borrowing cost rise to 7%. Suddenly, that bond that you purchase at 3% is no longer attractive and everybody will dump it, causing bond prices to crash. Real estate prices will fall as well because the mortgage rate of 7% is much higher than the rental yield of 2%. To achieve a rental yield of 7%, prices will have to tumble by 71%.
We shudder to think of what will happen to risk assets / bonds that give pitiful returns, often below inflation rate. Today, Singapore’s real estate is giving only 3.2% of yield on average, lower than the inflation of 3.9%. bonds are giving on average 3% and may suddenly seem not like a “safe haven” when inflation flares.
Doomsday or Optimistic Scenario, Take Your Pick
This “doomsday scenario” could unravel quickly or slowly, depending on how responsive the central banks are to inflation. If they choose to ignore inflation slowly creeping up, they could be in for a rude shock when they wake up to find that prices are rising at 6% and they can’t contain it. If they take they foot off the pedal once every now and then when prices rise, it will probably cause a series of “shocks” to the economy. Long periods of weakness in the economy without the acute plunges in output.
The “optimists” will say, “this time it’s different and we can have growth without inflation. It is a wish that could come true if productivity rises faster than output. However, we still have to deal with the inflated assets like properties, bonds, some types of equities where yields are at 2 – 3%. Eventually the QE has to end and interest rates cannot stay at zero forever. What happens when reality sets in? At best we could see asset prices slowly trend downwards until they reach normal levels, i.e. if an issuer’s bond used to pay 4.5% per year over the last 20 years and it’s paying 3% now, it will revert to the mean. If a property pays 4% rental yield over 20 years and is giving 3% yield now, it will revert to the mean. All bubbles will eventually deflate. It is the mess that is left behind post bubble that causes nations to go through turmoils. Remember 1997 Asian Crisis, the Tech Bubble of 2000 and the Property Bubble in the US in 2006 – 08? Much wealth will be lost by the undiscerned.
Where do we then park our funds to prevent massive erosion to our wealth? We’ll cover this in the next post
