Low-interest rates increase inflation

Article about Low-interest rates increase inflation

Oct 20, 2020

The price/earnings ratio of equities in the early 1980s was extremely low, yet equities were not undervalued relative to bonds. Evidence is that, in the ten years since then, long-term bonds have been more profitable than shares. Even after the crash of 1987, equities looked cheap, but it was not as bad as bonds. Nowadays, the reverse is the case. The price/earnings ratio of equities is at the upper end of the range but compared to bonds, equities are cheap rather than expensive. Anyone with a portfolio of shares and bonds should look for an alternative to bonds, not to shares.

Interest plays an important role in the development of the stock market and the economy. The level of interest determines the cost of raising debt capital. When the interest rate is too high, companies stop investing and pay off their debts. The economy stops growing and falls into recession, or even depression, as was the case in the United States between 1930 and 1941 and in Japan between 1994 and 2012. When interest rates are lower than the return that can be made with them, debts rise. An equilibrium is reached when the marginal cost of debt is more or less equal to the marginal return. When the interest rate is much lower than the marginal return, debt rises so fast that it cannot all be invested in new assets. It is much safer than buying up existing assets with borrowed money. Chances are that this financial engineering capital will be wasted, as higher prices for existing assets do not have a positive effect on the economy. There is inflation, but not inflation according to the current definition. It is also called asset inflation.

An optimal environment for investors is that there is no destruction of capital by too high-interest rates, but also no destruction of capital by too low-interest rates. Too high an interest rate leads to recession or depression; when interest rates are too high, the downside of strong asset inflation is ultimately a financial crisis. In a recession, equities are vulnerable, but bonds benefit. After a financial crisis, the value of assets must be kept high because of over-indebtedness. Expensive assets mean low yields and in the search for yield, non-productive assets ultimately benefit as well. These are assets where the return is not determined by a coupon or dividend, but purely by what the madman gives for it. At the right level of interest rates, it is mainly growth stocks that benefit. Innovations are stimulated. Capital is available, but goes to innovative and therefore growing companies that can make just a little more return than existing companies or on existing assets. The chance of a recession is small because the interest rate is not high enough for that The interest rate is not too low either, so the chance of overheating prior to a recession is often small. Growth stocks also benefit from such an environment. A rising price/earnings ratio is therefore a signal of sound monetary policy and confidence in the future.

The Corona crisis marks a clear turnaround in monetary policy. A year ago, Modern Monetary Theory was still seen as extreme; now it has become almost mainstream. Monetary financing — financing the budget by printing money — is also widely accepted. Central bankers are no longer going to raise interest rates because there is inflation in the pipeline. Inflation is seen as the solution to a debt crisis. Interest rates remain low, even if inflation rises, if necessary with the promise of the central bank to buy up all bonds above a certain interest rate level. Too low an interest rate results in too much money, a sub-optimal allocation and even more asset inflation. At the end of the day, all the invested capital is actually consumed and, with a certain delay, it still creates real inflation. The economy overheats and the bubble bursts.

 


Articles authored by Robert Jan Teuwissen

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