“Suppressing the rate of interest is a powerful way to boost an economy otherwise bound for recession, but it’s a dangerous one. It is to finance what opiates are to medicine, a distortion of perception disguised as a cure.”
Adam Rowe, Wall Street Journal
“Raising interest rates is not going to solve the problem of inflation it’s not gonna create more food”
Joe Stiglitz
“Despite the extremes in historically reliable valuation measures, we can be certain of one thing: investors don’t care. They never do at market extremes. If they did, the financial markets could never reach extremes like 1929, 2000, and today in the first place.….What’s odd is how adamant investors seem to be not only that profit margins will remain above average, but that they will not retreat even from current extremes. Have investors looked at where margins are here? They’re not just higher than the historical norm – they’re higher than every point in history prior to the past two years. Yet Wall Street analysts describe P/E ratios as “cheap” and “reasonable” without a moment’s hesitation about the denominator.“
John Hussman
The first two quotes above highlight the problem of relying too much on using interest rates as a cure for economic issues. For sure, the Fed’s inflation fight is to attempt to optimize the balance between supply and demand to meet its objectives. The problem is that the price mechanism has two sides but the Fed really only influences demand directly, and even then not without side effects.
What if chronic supply problems are overwhelming the Fed’s policy of demand destruction? What if demand destruction is just adding to the supply problem? This is Joe Stiglitz’s point from the quote above and there is a significant risk that energy supply problems could be made worse if higher interest rates disincentivize needed energy investment.
Then, in addition, government policy and geopolitical developments have contributed to problems. For example, the ECB cannot easily address Europe’s energy crisis in its framework. The explosion in German energy prices shown below amounts to an economic shock of unknown duration and intensity.
Are Interest Rate Rises The Way To Go?
Higher energy costs increase inflation and reduce growth. So, it is not clear that raising interest rates makes the situation any better. Demand has already taken a hit.
Even if a central bank wants to raise rates – as in the case of the Fed – it is now highly constrained by the scale of outstanding debt. If much higher interest rates are needed to reduce inflation that would be problematic for a range of reasons:
1. The increase in Federal interest payments. A 3% interest rate increase in a 30 Trillion National Debt is nearly $1 Trillion additional interest cost to the budget deficit.
2. This takes no account of corporate debt. Just take a look at the scale of “zombie” companies in the US economy in the chart below. Around a quarter of US companies meet this criteria. These companies are living on borrowed time. They’re dependent on creditors who are willing to lend them more money when their debt comes due. They might be banking on their businesses turning around as they burn through their cash… or they might have plans to sell assets… or issue shares of stock to pay down debt. The next recession is going to bury many of them. Zombies are already choking on today’s higher interest rates and inflation. An economic downturn will be the final nail in the coffin.
3. As previously shown, existing home sales fell below 2019 levels from record peaks. It is clear that interest rate rises just this year have already had a major impact on house prices and activity, as also in many other parts of the economy.
4. US GDP growth is already negative for the first half of 2022.
The Fed’s ability to materially raise interest rates further is highly constrained and so the benefit becomes increasingly questionable. The excesses that the Fed itself enabled, have weakened its ability to address inflation without significant economic damage.
Deep Supply Problems Cloud Inflation Outlook
The Fed, and central banks more generally, need to consider what they are able to do about supply problems. This year has brought about a pardigm change in international property rights and globalization. The impacts to investment and supply chains are very difficult to measure at this time but are clearly very significant.
The chart below shows concensus forecasts for inflation over the last 4 years. No matter how high inflation has gone, the forecasts for a return to 2% has remained. Does this seem like forecasting or goal seeking projections?
It is still hard to be sure that the peak in inflation is behind us when you look at the chart below.
“In the US inflationary pressures are broadening, with >60% of Core Services components experiencing a 6-month annualized inflation above 4%.“
Discounting the end of the inflation problem still seems premature.
The Fed’s Excesses Have Also Caused Massive Asset Price Distortions.
Market and economic policy support has been in place for decades. It is all most investors have ever experienced. So allocations remain high, even after this years’ poor performance.
A broad commitment to passive investing remains in place as financial assets have almost tripled relative to GDP in the last four decades.
Mathematically the best estimate of expected 12 year expected nominal return is around – 5% as shown in the chart below.
Economic Extremes & The New Paradigm Are Exposing The Weakness Of Old Policy
It is important to recognize that current conditions represent unusual extremes. For further examination, I recommend this discussion with Edward Chancellor about his new book “The Price Of Time”.
Summary
The Fed has clearly shifted to a rapid tightening policy since March this year and this appears to have shifted markets to pricing in a return to just over 2.5% ten year breakeven inflation rates, even though it remains unclear whether inflation has yet peaked. A great deal of inflation fighting success has been priced in but the main inflation problem is a supply side issue beyond the Fed’s control.
Cyclical growth globally remains projected to continue declining into 2023, and there still seems little sign of the Fed ending its tightening policy before next year at the earliest. With record high profit margin levels in US equities continuing to be pressured by rising or high costs and weakening revenues from growth, this is not an environment that appears to suggest positive expected returns into year end either.
Certainly, the chart below of the Eurodollar curve relative to the S&P 500 seems to confirm the outlook above, unless this time its different.
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