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  • Inflation and Interest Rates

    Posted by David Foster on October 8th, 2006 (All posts by )

    Most investors and analysts seem to have concluded that inflation is not a serious problem, and that long-term interest rates will stay low for a considerable period of time. (The 10-year Treasury rate is now at 4.696%.) Writing in Financial Times (9/21), Joachim Fels, managing director and chief global fixed income strategist at Morgan Stanley, argues that such thinking is incorrect.

    The conventional view, as Fels summarizes it, rests on two pillars: the alleged “savings glut” caused by high savings rates in Asia, and the vast supply of low-cost labor in China, India, and other countries, which helps to hold down the prices of manufactured goods and hence overall inflation.

    Fels argues that low interest rates have been caused, not by a savings glut, but rather by “a global liquidity glut that is now receding…A better explanation for depressed long-term interest rates is that central banks cut short-term interest rates to extremely low levels during the equity bear market of 2000-2003 and the following deflation scare and thus flooded the financial system with excess liquidity. The resulting yearning for yield dragged long-term interest rates lower as investors moved out along the yield curve.”

    Fels also argues that “Globalisation has made capital scarce relative to the huge supply of labour in the emerging world. Employing this labour will require a larger stock of capital, which implies very high rates of investment in fixed assets for years–infrastructure in India and machinery and equipment in China.” I’d make the point, though, that the amount of capital required to employ a given number of people is highly variable. A factory in the US may easily require three times as much capital per employee as a factory in China which is making the same product–because the higher wage rates in the US factory make it rational to automate tasks which are rationally done by hand in the Chinese plant. Hence, capital investment in the developing world will be a function of how quickly wage rates rise in those countries, as well as the raw numbers of people being put to work.

    Fels also argues that “High savings ratios in Asia are likely to fall as income prospects improve and governments build social safety nets.” True–but at least some of the provision of social safety nets will be done by investment, via corporate or governmental pension plans–which should have the same effect on capital supply as would equivalent direct investment by individuals. This doesn’t negate the point that Fels is making, but does dampen it somewhat.

    Fels continues: “Moreover, inflation has been depressed since the mid-1990s by several factors that are about to dissipate. Deregulation in many sectors lowered prices, but has largely run its course. The information technology-induced US productivity acceleration, which kept unit wage costs low, is ebbing. Downward pressures on manufactured goods prices from globalisation are waning, too, as higher raw materials and accelerating wage costs in China induce exporters to raise export prices. Energy and food prices should continue to be boosted by globalisation, raising headline inflation rates around the world…With the output costs of squeezing inflation likely to be high in this new environment, monetary policymakers will probably accommodate moderately high inflation over the next few years.”

    I basically tend to agree with Fels’s position. The issue, of course, is timing–we could easily see several more years of low interest rates and inflation before the factors Fels is discussing really start to kick in. I’d love to see some good discussion of this matter.

    For people interested in learning about the bond market, see my post The Bare Bond Basics

    Nothing that I post here or at Photon Courier should be considered as investment advice.

     

    6 Responses to “Inflation and Interest Rates”

    1. ZF Says:

      Interesting. The other really big thing this analysis should teach us is just how large the suppression is savings is, which is caused in Western countries by government ‘safety nets’. Just imagine how prodigious our saving would be, with Chinese propensities to save and our own income levels. We would be a fabntastically richer country.

    2. Tom Grey - Liberty Dad Says:

      I recall reading that, prior to ’89, Japan had a very high savings rate — but the US economy had a much better record at investing.

      The rate of return on investment is what I’m missing in the above analysis, and I submit that China and India can both develop quite quickly without slurping up too much capital thru wiser investment.
      (Aid, of course, often has no return on investment, and in fact a negative return in that it teaches corruption.)

      Investing in good projects, or a high yield portfolio (1 in 5 making 10x returns, perhaps) of projects is exactly what creates wealth.

      Grameen bank-style micro-loans both have good returns and hugely increase the velocity of the money as well as the production quantity, especially for local consumption.

    3. david foster Says:

      Tom…I’ve read in a couple of places that a lot of the investment in China has a very low return on capital. Possibly due to a combination of excessive private investor optimism, combined with governmental meddling.

      I agree that Grameen-style microcredit has much to be said for it…wonder if any of this is going on in China?

    4. Jonathan Says:

      If Chinese and Japanese investors would rather receive 0-5% on their money than put it into potentially higher yielding investments, what, if anything does that fact imply about the fundamental strength of their economies as compared to ours?

    5. david foster Says:

      From today’s FT: Indian companies now have an investment pipeline of about $150B compared with a pipeline of only about $50B three years ago. The $100B swing is not huge in the context of the world economy, but is interesting directionally.

      The Indian PM says the country needs $320B in “infrastructure” investment over the next 5 years to lift growth to 10%/yr. Not clear if the $320B includes all of the $150B, or not.

    6. John Says:

      “what, if anything does that fact imply about the fundamental strength of their economies as compared to ours?”

      At least in the case of Japan, nothing. A couple of barriers in the Old Boy network of Japanese finance keep private investors from fully participating in the market there. First, the powers that be really don’t want to be beholden to small shareholders, so in many cases it is difficult or impossible to buy less than 100 shares at a time – making investing expensive and riskier for individuals by decreasing the ability to diversify. DRIPs were unheard of when I lived there about 5 years ago.

      Real Estate is still held closely by developers and the descendants of the samurai class. the Japanese long prided themselves on their post war egalitarianism, but in reality the rich hide their wealth. A minor samurai family I know used to have a very small estate in Edo, about 40 acres. It is now in a business district in Tokyo, and the businesses now located there provide the family with millions of dollars in income. In that kind of market with huge population pressure and the remnants of feudal landholding still in evidence, real estate is not a truly free market, so small investor money can’t flow there for higher returns.

      Add to all of this the Japanese tendency to avoid risk and follow the crowd, you find that most people invest in big banks at low (less than 1% when I lived there) interest, or, in the case of the Post office (WTF* is the post office doing in the banking business anyway?!?) zero point zero interest, and you need to save at a tremendous rate in order to build any retirement wealth because your ROI is diddley times squat.

      Sure they would prefer to get higher interest, but there is no alternative – the banks are a big oligopoly (even more so after the 2002-4 spate of mergers); the Post Office used to regularly make loans to state-identified critical business at zero percent interest, and thus could not give any ROI to the investors, and most Japanese are too frightened of risk to go offshore for higher yielding instruments. Those who might be less risk averse are usually wealthy enough to get in on sweet deals afforded by the domestic Old Boy network.

      * I know the historical answer to this question, but it still boggles my mind, even if the Japan Post is about an order of magnitude more polite and efficient than ours.