High interest rates ‘could lead to high inflation’

Efficient Group economist Dawie Roodt. Image Efficient Group

From Dawie’s Notes: Never have we seen so much money globally. Since the financial crisis, major central banks have cut short-term interest rates to never-thought-possible levels. When that did not have the required impact on asset prices, they simply started to buy assets until prices went up.

By implementing such dramatic monetary stimulation, central banks hoped to achieve several objectives. The lower cost of capital was supposed to lead to an increase in the demand for assets, and hence to higher asset prices. Higher asset prices were supposed to lead to wealth effects, and hence more spending. This did not really happen. Sure, some (equity) prices did go up but central banks took no chances and forced the process by actively buying trillions of dollars, euros and yen of financial instruments. Typically, state debt instruments were targeted, but other private financial instruments like mortgage-backed securities were also on the buying list. The result was higher asset prices and lower yields.

Apart from more spending, lower interest rates were also supposed to incite businesses to invest in new – and revamp existing – production capacities. With all this new spending and investing, economies were going to grow, employment and wages were going to go up, and of course, inflation was going to rise and eventually get “too” high. That was the thinking, but it was wrong.

With all this happening, nobody could blame anyone for piling into the only real inflation hedge they know – gold!  So, interest rates went down and gold went up  – but still no inflation. Eventually, the gold bulls lost their cool and gold came down again, and inflation remains low… Could it be that low interest rates caused lower inflation? I think that perhaps it did.

The biggest mistake any economist can make is to think that a formula, any formula, can predict human behaviour. It may be sensible to think that cheaper money will result in more borrowing, but none of these “logical” thoughts are guarantees. Humans are herd animals; one day we all love platform shoes, and the next day nobody does, no matter the price.

We are also kind of rational, however. We mostly just hang around, but we usually do react to different environmental factors or subtle forces, like interest rates (but usually slowly). The current subtle force remains low interest rates, which nudges us in the direction of taking on more credit. Yet, nobody is really lunging head-over-heels into credit.

Borrowing cheap money is very tempting, but investing in new ventures is always risky, and very few businessmen are bullish on future economic performance. Additionally, investing in new capacity is a significant hassle and hard work! But any businessman provoked by cheap money will obviously do his calculations: how can I use this cheap money without taking undue risks by investing in a future that does not seem that bright?

The simple answer is that businesses are borrowing money, not for risky investments and expansions, but to buy their rivals – because the associated (perceived) risks may be significantly lower, while the hassle factor is probably also lower. The result is a lot of financial transactions,  but disappointingly low investments in actual capacity. So, share prices go up, stimulating even more mergers and acquisitions (M&A) but it also means few other price pressures, sich as consumer inflation and wage prices.

Central banks, especially the Fed, are getting a wee bit worried that unemployment is too low, because it is supposed to signal an imminent increase in inflation. In central bank thinking, it means that the time might be right to jack up rates a bit to more normal levels. That is what they are doing — short rates have been going up, and further increases are likely.

Dearer money means that it will become a little more difficult to lock in guaranteed financial gains through financial transactions, and we may have to look to alternatives to support our share prices, despite a probable increased hassle factor. This may mean actual investing, research and development, competing for customers – and more importantly, competing for the best employees.

Quite ironically, an increase in interest rates can lead to less M&A, as businesses switch from more certain financial investments to the conventional kind – of building new capacity and hiring workers. That also results in wage inflation and eventually general consumer inflation.

The next time a defunct economist suggests that higher inflation results in higher interest rates, think about it; it may be the other way around…

Dawie Roodt is the Chief Economist at the Efficient Group. 

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