Are your investments between
a rock and a hard place?
T
he phrase “between a rock and a hard place” literally means what it says, and that is where the Fed, and many other central banks, find themselves today.
Interest rates are the traditional tool to keep inflation in check to ensure price stability or, put differently, to not allow our purchasing power to run away from us too quickly. I say “too quickly” because based on a long-term (±100 years) South African inflation rate of around 6.0%, purchasing power halves after 12 years (that is already a scary thought). This begs the question: Do central banks allow inflation to run and continue to deplete your purchasing power, but at a higher pace, or do they increase rates? The world currently has a debt-to-GDP ratio fast approaching 400%. With this amount of debt all is fine and dandy when interest rates are at their lowest in 4,000 years, but the moment inflation rises you start to run out of options and hence are caught “between a rock and a hard place”. Higher rates will rapidly crowd out spending on government budgets that are already running large deficits, they will place pressure on fragile personal and corporate budgets that are under pressure, and they could cause asset prices (wealth) to fall too quickly. At this juncture it is important to note that central banks can monetise debt by printing money and lending money
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(by buying bonds) to central governments. This means that, in theory, central banks can continue to create money out of thin air, as long as the world still trusts its governments to be creditworthy and repay such debt, and investors still see value in owning those bonds. The real yields of 10-year treasuries in the US and the Eurozone are already negative. The moment investors decide that other asset classes are more attractive and start to sell those bonds, the central banks will become the default choice (the buyer of last resort), creating all kinds of problems in the devaluation of the currency, reducing purchasing power and hence causing runaway inflation. The other factor that we need to consider is political will. Is it more popular (votes) to stimulate growth through lower interest rates and other accommodative fiscal policies or to increase interest rates and taxes to provide price stability and reduce the need for debt? The answer is quite obviously to stimulate, especially if you cannot afford to increase rates (as mentioned above). If governments get their way, the most probable route out of this scenario is financial repression where inflation is above interest rates allowing governments to effectively inflate away their debt over time (i.e. reducing the value of the debt). Any increase in rates will most likely be very slow and take place over a fairly long period of time. In a world where inflation will potentially continue to be higher for longer
