The upcoming increase in interest rates

by Alasdair Macleod, GoldMoney:

Last week, both Janet Yellen of the Fed and Mark Carney of the Bank of England prepared financial markets for interest rate increases. The working assumption should be that this was coordinated, and that both the ECB and the Bank of Japan must be considering similar moves.

Central banks coordinate their monetary policies as much as possible, which is why we can take the view we are about to embark on a new policy phase of higher interest rates. The intention of this new phase must be to normalise rates in the belief they are too stimulative for current economic conditions. Doubtless, investors will be reassessing their portfolio allocations in this light.

It should become clear to them that bond yields will rise from the short end of the yield curve, producing headwinds for equities. The effects will vary between jurisdictions, depending on multiple factors, not least of which is the extent to which interest rates and bond yields will have to rise to reflect developing economic conditions. The two markets where the change in interest rate policy are likely to have the greatest effect are in the Eurozone countries and Japan, where financial stimulus and negative rates have yet to be reversed.

Investors who do not understand these changing dynamics could lose a lot of money. Based on price theory and historical experience, this article concludes that bond yields are likely to rise more than currently expected, and equities will have to weather credit outflows from financial assets. Therefore, equities are likely to enter a bear market soon. Commercial and industrial property should benefit from capital flows redirected from financial assets, giving them one last spurt before the inevitable financial crisis. Sound money, physical gold, should become the safest asset of all, and should see increasing investment demand.

Assessing potential outcomes of this new phase of monetary policy is a multi-dimensional puzzle. There’s the true state of the economy, the phase of the credit cycle, and the understanding, or more accurately the lack of it, of the relationships between money and prices by policy makers. This article is aimed at making sense of these diverse factors and their interaction. We start by examining the intellectual deficit in economic and price theory to improve our understanding of where the policy mistakes lie, the resulting capital flows that will determine asset values, and therefore the likely outcomes for different asset classes.

Interest rate fallacies

The most egregious error made by central banks and economists alike is the assumption that gradually raising interest rates acts as a brake on the rate of economic expansion, and therefore controls price inflation. Economic commentators generally regard interest rates as the “price” of money. It is from this fallacy that the belief arises that manipulating interest rates has a predictable effect on the demand for money in circulation relative to goods, and therefore can be used to target price inflation. This line of reasoning makes even a sieve look watertight. Interest rates are the preserve of the future exchange of goods relative to today, and have nothing to do with the quantity of money. They only determine how it is used. In a free market, rising interest rates tell us that demand for credit is increasing relative to demand for cash, while falling interest rates indicate the opposite. What matters are the proportions so allocated, and not the total.

Therefore, if a central bank increases interest rates, it will be less demanded in the form of credit. In the past, before consumer credit became the dominant destination of bank credit over industrial production, increasing interest rates would discourage marginal projects from proceeding, and it would make many projects already under way uneconomic. Raising interest rates therefore acted to limit the production of goods, and not the demand for them. In the first stages of a central bank induced rise in interest rates, the limit placed on the supply of goods is even likely to have the effect of pushing prices higher for a brief time or encouraging import substitution, given the stickiness of labour markets because a rise in unemployment is yet to occur.

It should be apparent that management of interest rates before consumer debt came to dominate credit allocation was never going to work as a means of regulating the quantity of money, and therefore price inflation. Nowadays, new credit allocation is less angled at increasing and improving production, and its greater use is to finance mortgages and consumption. This is particularly true in the US and UK, but generally less so elsewhere.

Therefore, the consequences of managing interest rates are different from the past in key respects. Raising interest rates does not, in the main, reduce consumer demand for credit, except on mortgages, which we will come to in a minute. Credit cards and uncollateralised bank overdrafts typically charge as much as 20% on uncleared balances, even at times of zero interest rate policy, demonstrating their lack of interest rate sensitivity. The same is true of student debt.

Interest on motor loans and similar credit purchases are set not by central bank interest rate policy, but by competition for sales of physical product. Manufacturers have two basic sources of profit: the margin on sales, and the profits from their associated finance companies. It matters not to them how the sum of the two add up. If wholesale interest rates rise, squeezing their lending margins, they can subsidise their finance operations by discounting the price of their products. Alternatively, by expanding credit, and assuming they have the capacity to do so without committing additional capital, the marginal cost of that credit expansion is tied to extremely low wholesale deposit rates. This is the benefit to a manufacturer of having a captive bank: expanding credit out of thin air to finance sales is low cost.

However, changes in mortgage rates do influence demand for consumer credit. Mortgage repayments for most home-owners are their largest monthly outgoings, and therefore a rise in rates restricts spending on other goods and services. Furthermore, house prices are set in the main by the cost of mortgage finance, so a rise in interest rates on mortgages has a negative impact on house values. Falling house prices are likely to make consumers more cautious.

The last thing the Fed and the Bank of England will wish to entertain is raising interest rates to the point where a house price collapse is risked. Understandably, they are very much aware of the economic consequences. In the US, roughly two-thirds of consumer debt is home mortgages. Furthermore, the last credit cycle crash was so obviously centred on residential property that central bankers and bank regulators are sure to be sensitive to trends in mortgage lending. But this is the only form of consumer borrowing that responds to increases in interest rates.

The belief that interest rates correlate with the rate of inflation is unfounded, as demonstrated by Gibson’s paradox. It springs from the fallacy that an interest rate is money’s price. The basis of monetary policy is therefore fundamentally flawed.

It should now be clear that there is a lack of knowledge at the most senior levels in central banks about the economic role of interest rates, and therefore the whole basis of monetary policy. A second fallacy is the belief that demand for credit can be micro-managed through quarter point changes in interest rates. Not only is this a reactive policy that seeks to close stable doors after the horses have bolted, but it ignores the reality that the credit cycles engineered by the central banks are the root of the problem. They cause a build-up of non-productive borrowing and investment that is only viable at artificially suppressed interest rates. Increases in interest rates, however small, will eventually trigger the sudden recognition of these distortions in the form of an interest-rate induced economic crisis. The point is that the moment a central bank begins to stimulate credit through monetary policy, it begins to lose control over subsequent events. How they then play out is our next topic.

The price effects of credit expansion

The link between changes in the quantity of credit and the effect on prices is far from simple. Credit expansion leads to balancing increases in deposits held in bank accounts, but the category of deposit-owner determines where price inflation occurs.

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