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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 Volker 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.
Alasdair McLeod
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