Alasdair Macleod – 7 March 2011
The low interest rate honeymoon is coming to an end, and we can now expect rates to rise and continue to rise for the foreseeable future. For Western economies and their banking systems it is the worst possible time for this to happen. The reason interest rates will go up is because inflation, not deflation, now presents the greatest danger and a policy response is required.
Agricultural commodity prices have been rising for some time, and the central banks have dismissed them as being due to special factors and too small a part of the CPI to worry about. To this inconvenience can now be added the political revolutions in the Middle East and their effect on energy prices. It is perhaps this development that forced Jean-Claude Trichet to break ranks last week and admit that the ECB will have to consider an interest rate rise.
There is no such admission from Mr Bernanke and Mr King, the latter still denying that an official UK inflation rate of over 4% requires remedial action. And this high inflation rate was recorded before the current jump in energy costs. All three central bankers have been effectively caught on the hop by events. They have been ignoring inflation while wrestling with two immediate problems: financing government budget deficits and keeping the banking system alive. For these reasons the Fed and the BoE have been simply printing money by buying government debt. What made this strategy attractive is that it lowered the cost of government borrowing below that demanded by the free market, making government finances appear far better than they would be without this intervention, and at the same time it gives valuable breathing-space to the banking system.
Consequently, there is money in circulation that will have to be neutralised if inflation is to be controlled. It will require the central banks to sell back into the markets much of the government stock they have accumulated, at the same time as government borrowing continues at its high pace. This will force governments to bid up against their own central banks in the market for private sector savings. The increase in interest rates along the yield curve would therefore be sudden and brutal, and theoretically only stop when enough consumption is switched into savings, attracted by the high rates.
For this to happen when economies are fragile is the last thing the central banks need. Any hope of economic recovery will be quickly replaced by expectations of a slump, leading to deterioration in government finances everywhere, as tax revenue estimates are adjusted sharply downwards and welfare commitments sharply upwards. Add to that increases in the cost of government borrowing from higher interest rates, and the sudden collapse in government finances becomes truly alarming. The dramatic moves in the prices of precious metals are, perhaps, an early warning of this escalating risk.
The prospects for precious metals will ultimately depend on the central banks determination to control inflation. If only it was so simple; but a higher interest rate environment will break the banks, which are full of dodgy loans dating from credit-crunch days. So what does a central banker do? Does he squeeze inflation out of the system, while governments slash their spending, or does he find another way of rigging the markets, while governments dither over their deteriorating finances?
Paul Volcker faced up to the problem and picked the former course thirty years ago, but this time the levels of private and public sector debt are a whole magnitude larger and government spending is a far greater problem. This time, embarking on austerity and interest rate plans sufficient to control inflation is simply too painful to contemplate in social democracies. The markets are beginning to understand this, having now been kicked awake by escalating energy prices.
History never repeats itself precisely, but there are similarities to late 1973, when inflation was on the rise and the Arab oil-producing nations imposed an oil embargo on Western nations, leading to considerably higher energy prices. This gives us perhaps a basis for divining today’s outcome, but there were notable differences.
US Inflation, on a comparable basis, is now running at about 5%[i] compared with 6% then, but interest rates are now close to zero compared with 7% in October 1973. An inflationary kick from higher oil prices could therefore lead to a much greater interest rate increase today. Government finances were far stronger then, reflecting economic growth, compared with the serious and deteriorating situation now. So rather than higher oil prices occurring at the top of the economic cycle, today it is happening when the world’s developed economies are struggling to recover.
The pick-up in inflation today is therefore more directly a function of monetary developments than excess demand. Arguably, this makes it more considerably serious than that faced in October 1973, which was easier to diagnose. It is a direct consequence of the monetary expansion that is the bedrock of economic policy. This is not welcomed by the establishment, which seems to think inflation can only occur as a result of excess demand. That is perhaps why the Mervyn Kings and Ben Bernankes of this world turn a blind eye to inflationary pressures, because so far as they are concerned it should not be happening until later in the cycle.
This unfortunate result of current monetary policy gives them an uncomfortable dilemma, because the consequences of stopping or even slowing the printing presses are too ghastly for them to contemplate. The truth is that there are not enough lenders, other than the central banks themselves, to finance government deficits at anything like current interest rates. To stop printing puts government finances in deep crisis and runs counter to cherished Keynesian and monetary theories, so it is hard to see how central bankers will take the initiative to jack up interest rates and bring inflation under control.
This phase of the inflation crisis has been brewing since the Lehman bankruptcy, when the Fed first dramatically expanded its balance sheet to rescue the American banking system. The policy since then has been to muddle along, printing more money to cover deficits and to get the economy recovering. But the crisis in the Middle East is putting an end to that approach and control of the markets is therefore shifting away from the authorities. The markets will raise interest rates against inflating governments whether they like it or not, and their currencies will suffer if central banks are slow to respond. At long last, markets will make governments face the reality they have been so keen to avoid.
The effect on asset prices will be dramatic, and share and bond markets, currently reflecting zero interest rates, are likely to be badly hit. Property is similarly vulnerable, with the end of any pretence that over-leveraged homeowners can afford their mortgages and commercial property tenants their rents. Values for collateral held by the banks against their loan books will therefore be further undermined, putting into doubt the banking system’s survival.
This new phase is stagflation, pure and simple. Asset prices fall, while the prices of goods rise. It is an outcome that has been obvious to some of us since the printing-presses were first cranked up after the credit-crunch. It will now become obvious to the wider public, because the authorities are finally losing control of the markets.
[i] See www.Shadowstats.com, which removes most of the “adjustments” to the CPI that have been made over the last thirty years.