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.