Interest rate curves generally help assess the state of an economy. In the US, the recent flattening of the yield curve, has done enough to keep investors alert to the possibility of a future recession.
An interest rate curve, more specifically a yield curve, generally plots bonds of the same credit quality at differing maturity points.
When a central bank intervenes on interest rates via monetary policy, the short term end of the yield curve is generally affected, more specifically the credit maturities below one year. Hence the recent rate hikes of 25 bps by the US Federal Reserve for example, has lifted the short end of the yield curve.
Now the total effect of the curve also depends on the long end. Shifts on this end are determined by demand and supply, investor’s inflation outlook, which in turn determines the state of an economy.
Generally, higher inflation expectations, lead to higher nominal interest rates. Investors would require higher nominal rates of return on an investment to avoid inflation reducing the value of their saving cash flows.
When investor future inflation expectations weaken, the flattening of the yield curve scenario presents itself, especially coupled with rising interest rates as a result of restrictive monetary policy measures.
When long dated interest rates eventually drop below short term interest rates, signalling falling inflation expectations, this can be a sign of an impending recession.
Inflation has some advantages but like everything in life, too much of a good thing also has negative consequences.
Many investors and economists perceive inflation as a contributor to GDP growth. It is partly true, a country in deflation, would suffer lower growth, lower wages and lower prices as a result of consumers delaying purchases on the belief prices will continue to fall. In turn, this leads to higher unemployment and a fall in domestic demand from the lack of purchases.
Inflation up to an optimal level helps boost growth and real wages, which in turn also helps attract employment and preserve demand for goods.
Once the optimal level is breached however further economic growth and price increases become unsustainable and can make a country’s economy uncompetitive.
Understandably, the disparity between inflation and wages, reduces the purchasing power of consumers, hampering consumption, notwithstanding, inflation that exceeds nominal interest rates, negatively affects savers investment income.
Furthermore, on the international scene, a country with high domestic goods prices is seen as uncompetitive in the eyes of global peers. Exports would fall adding to the drop in domestic demand from the above mentioned factors.
To mention an example, Venezuela is currently going through its own period of hyper-inflation where the economy finds itself at a standstill of investment, which has led to shortages of basic necessities, mass protests and social unrest.
Many developed economies in their policy decisions generally have an optimal inflation target in the range of 2% that is the point at which further inflation is perceived to not be beneficial or sustainable. In fact fiscal and monetary policy actions are taken to curb inflation to within the 2% target.
Whether the 2% inflation target is an ideal target is debatable, as many economists have argued, though that is an issue to let them handle.
This article was issued by Mathieu Ganado, Junior Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt.The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.