Will low interest rate expectations perpetuate deflation, recession, or worse?

By MBA, CFP® - Chief Executive Officer, Vernon C. Sumnicht on November 7, 2016

Many of you likely recall the high inflation and high interest rate economy the U.S. experienced back in the late 1970s and early 1980s.  There were families paying 14 percent interest on their 30-year mortgages, numbers that are unheard of among today’s homebuyers.  In 1982, President Ronald Reagan appointed Paul Volcker as Federal Reserve (Fed) chairman. Volcker realized that the Fed’s monetary policies had led to high interest rate expectations. This allowed both interest rates and inflation to spiral up and out of control.  Something needed to be done to reverse course.

Reagan and Volcker set out on a campaign to “break the back of inflation.”  In the first step to accomplish this radical change, the Fed made a well-publicized and historical reversal of monetary policy.  They decided to let interest rates go wherever the market took them and keep money supply in a tight, predetermined range.  Making the initial change was easy.  The more difficult task was to convince the public that the Fed would stick to the policy when things got tough.  Without credibility, the Fed’s new monetary policy would not achieve the objective.  It took time and a disciplined Fed, but interest rates began a long trend lower.

Today, we find ourselves in another extreme predicament.  In 5,000 years, interest rates have never been as low as they are currently in November 2016.  The central bankers’ efforts to stimulate the economy, by artificially bringing interest rates lower, may have helped for a very short period of time.  However, I believe that an extended period of low-interest rates can develop into deflationary expectations that become a self-fulfilling prophecy.  Much like inflation, it will take time, discipline and sacrifice to “break the back of deflation.” Even if the Fed moves forward on raising rates in December, there is still a long way to go to dispel these concerns.

The artificially low interest rates have been manipulated by central bankers across the globe, and it encourages countries, companies and consumers to take on inappropriate amounts of debt.  This central bank manipulation has led to historically unprecedented and destabilizing anomalies.  As an example, more than $8 trillion of global government bonds, or 40 percent of all global government debt, currently pays a negative interest rate.  Worldwide governments have increased their debt by trillions annually, and even emerging market countries have been encouraged to take on debt they can’t possibly afford to pay the interest on.

The effects are especially clear among large companies. Some have issued 100-year bonds to “lock-in” low-interest rates. Others have taken on marginal projects because rates are so low they don’t need much of a return on investment to show a profit.  Corporations are borrowing money at low rates even though they can’t put the money to work, and they are using the debt to repurchase their company stock, award bonuses, maintain excessive cash (sometimes outside the U.S.) and speculate in the stock market.  These inefficient uses of capital hurt U.S. and global economic growth and perpetuate the central bankers’ efforts to print more money in their preoccupation with stimulating economic growth.

The effects are also felt at every level. Retirees, looking for yield, are forced to accept riskier longer maturity and lower-rated bond investments. Consumers, chasing higher returns, rationalize more speculative investments.  Some investors are even borrowing at low-interest rates and putting the borrowed funds in the stock market.  For example, why pay off a 3 percent mortgage when the interest is deductible and the investor can put the money to work at a higher rate? Bankers encourage second mortgages “at these low rates” exacerbating consumers’ debt problems.  The most recent reports on consumers’ student loan activity indicate there is:

  • $1.26 trillion in total U.S. student loan debt.
  • $43.3 million Americans with student loan debt.
  • Student loan delinquency rate of 11.6%.

Much like in the late 1970s, when high interest rate expectations perpetuated  higher inflation, low interest rate expectations will perpetuate deflation, recession or worse.  Since 2008, a bubble has developed in equity markets, the Dow Jones Industrial Average is up over 98 percent, the S&P 500 is up 125 percent, and NASDAQ is up 203 percent.  The worldwide equity and debt bubbles, supported by central bankers from around the world, could end in disaster, just like the 2000 “dotcom” bubble and the 2008 mortgage debt bubble.  Government, corporate and consumer debt defaults could quickly deflate the stock, bond and real estate markets.  The deflation could quickly spread to currencies, energy and other commodities.

The Fed needs to develop a strong policy against deflation and they need credibility with the public to break the back of deflation—just like Reagan and Volcker broke the back of inflation by setting policy and sticking to it.

There would, of course, be pain and sacrifice involved.  As interest rates go higher, the debt bubble will break and bond prices will fall.  The bubble in the stock market would also break and likely cause a correction in stocks.  So in order to stop your dollars from becoming less valuable in periods of inflation, you should place the dollars in real assets. Real assets include basic materials, real estate, commodities, timber, precious metals, or stocks of companies that own real assets–all of which will retain purchasing power.

It will be difficult; however, the appropriate fiscal and monetary policy can lead the U.S. back to long-term prosperity.

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