A few weeks back I considered the deflationary risk weighing on the global economy. A discussion on the This Is Money podcast, and comments from the BoE have taken me in the other direction this week. Why would we end up with high inflation and high interest rates?
First we need to talk about debt. Consumer debt has actually seen a record fall since the start of Coronavirus, something to do with not being able to spend and no need to keep up with the Jones’ (1). The same can’t be said for Government debt. As I write this The Economist’s Global Debt Clock is rising through $61,594,467,000,000 (2). This was a problem before COVID-19. 2019 saw record global debt to GDP ratios (322%), following slight falls in 2017 and 2018 (3, 4). China’s ballooning debt was of particular concern, with plenty of tenuous business loans supporting growth (4, 5).
The word addiction had been bandied about with reference to debt. Below is a favourite short that I use to explain addiction when doing teaching sessions about the dangers of gambling and drugs. You come to rely on the object of abuse to feel normal. Credit cards and lifestyle anyone?
Credit: Andreas Hykade, Filmbilder & Friends (6)
The reasons for increasing debt woes are country specific. In Europe and the US it’s a combination of household spending, QE and zombie companies. There’s the massive junk bond bubble scare brewing; corporations kept going in 2008/9 through borrowed money now being refinanced, on the verge of reaching junk bond status, at the same time low yields push people to riskier bonds in aid of returns (7, 8, 9). Yet people keep buying bonds (10). China is just straight up building infrastructure projects that are getting abandoned or never used, while Japan can’t get it’s GDP to grow (11). Individual investors continue to seek returns. Interest rates on savings are minimal, with decent returns disappearing (12, 13). Bizarre investment structures, like this Buy-to-Let-Cars scheme, hoover up those desperate for income on their holdings (14).
And then there’s COVID-19. The Government were very happy to deny a massive money tree for the NHS/ social care. Then they’ve opened their metaphorical chequebook and are handing round a whole forest of blank cheques. Which is needed. But the cost could be £298 billion in debt for Apr 2020/21 alone (15). Analysis from the Resolution Foundation suggests that currently £80 billion has been raised with no deterioration in cover ratio (16). Predictions therein suggest a further extension to QE in June (16).
Image Credit: Resolution Foundation (16)
So we’ve got a mounting pile of government debt as we borrow our way out of trouble. Low, or even negative interest rates are helpful for the Gov here. Favourable to continue borrowing. As TA at Monevator covered this week, we’re seeing some negative UK bond yields (17). The noise from the BoE is that proper negative interest rates are unlikely, but not impossible (18). Certainly there’s no push towards an interest rate rise (19).
Why should there be. Inflation sits at 0.8% for April 2020,(20) well below the BoE’s goal 2.0%. We’re worryingly close to stagflation; rising prices due to rising demand with static growth (21). There’s an argument that there’s a lot of pent up demand due to lockdown, with limited supply also thanks to lockdown. The QE money creation rears it’s head. Deflation is a feedback loop international governments definitely do not want (22). It will only increase their debts.
The magic bullet
So what about inflation. Measures of inflation like the CPI may not have spiked since the 2008/9 financial crisis because Joe Bloggs in his northern terrace has practically seen little inflation of prices. Consumer goods have probably decreased in cost. But the high ticket items like sports car, larger houses in certain postcodes, watches, wine, art and even gold have all risen in price.* The QE wealth got stuck on it’s trickle-down in high net worth owner’s assets. It created a high net worth inflationary micro-environment.
How are we getting out of this mess? A survey of top UK economists suggests that they feel there is no need to tackle public debt soon, and tax increases may the best method in the end (23). We can keep borrowing in the short term. In the long term there is the suggestion that inflation is the only sensible answer (24). QE and other factors are likely to push towards inflation anyway (25). Running inflation higher than 2.0% would reduce that Government debt burden. This method has been used before; after the second world war inflation ran at 4-5% for a good couple of decades (26).
My generation is just not used to that sort of inflation. One of my takeaways from The Intelligent Investor is the change in financial policy/climate. Graham wrote in a period where 4-5% inflation was not unheard of, and savings accounts could yield 5-7%. I vaguely remember those sort of numbers from my childhood building society, but I’ve never been conscious of that financial world. The risk of a 1970s/ Weimar Republic style inflation spike is present (27). The fear of that sort of inflation seems greater than the 1950s 4-5%, maybe due to recency bias, or because those with the most to lose are those who remember the 1970s (28).
Ultimately it seems we’re unlikely to see interest rates or inflation change in the short term. But maybe, in the medium-long term, we’ll see 5% interest rates again. We’re preparing for such eventualities (29). We can tolerate up to 12% on our mortgage with some belt-tightening. I’m sure many can’t. Those zombie companies would go to the wall. The BTLs may struggle. Perhaps a period of 4-5% inflation is the economic reset we need.
Have a great week,
*Gold is slightly more interesting because of just how much the price has rocketed, the argument for it’s use as a hedge, and it generally being the ultimate lesser fool’s gambit (30, 31). No-one wants to be left holding the hottest potato.
N.B. Again, as a more involved speculative post, I would love feedback and opinions on these thoughts.
- A decent meta-analysis and systematic review in the Lancet of physical measures to reduce COVID-19 spread (32)
- House prices are unsurprisingly falling in response to lockdown (33)
- Jase at FIRE Lifestyle has his May financial update (34) – With a massive savings rate to boot
- As does Firevlondon (35)
- And the Saving Ninja in report #23 (36)
- Early Retirement in the UK (37)
- Playing with FIRE (38)
- The Obvious Investors P2P investment monthly updates are always interesting (39)
- While Michael at Foxy Monkey has a review of his Property Partner investing so far (40)
- While back on the May updates, here’s Weenie’s (41)
- And Money Mage’s (42)
- The Ways, at A Way to Less (43)
- The Squirreler’s (44)
- And Sam from A Simple Life with Sam (45)
- The DIY Investor UK adds McPhy Energy to his portfolio (46)
- The IT Investor looks at 20 Global Investment Trusts (47)
- Life After the Daily Grind looks at buying second hand to avoid depreciation on household items (48)
- TI at Monevator on the flood of new investors (49)
- The Banker on FIRE tries to shed some light on the market nonsense, and behind closed doors trading (50)
- And why you won’t become a grizzled executive, and that’s no bad thing (51)
- MedFI explores inflation and it’s effect on it’s finances (52) – A nice combo with this post
- Monevator’s weekend reading has a brief comment on the current market upswing (53)
- Igniting FIRE is focusing more on the things they enjoy (54)
- Dr FIRE reflects on the financial successes of their 20s (55)
- Money Side Up has some thoughts on he effect of Coronavirus on the FIRE movement as a whole (56)
- Hustle Escape examines hindsight bias (57)
- And, finally, John at UKVI runs through the importance and methods of assessing dividend coverage (58)