Inflation, interest rates and an underappreciated investment scenario
Inflation is an ugly beast, and such is writing about it. The more you think you know it it seems, the less you understand it. The ones that should know, the economists, seem to be quite divided and are not much of a help either. Yet we do need to understand some basic concepts to question and validate our investment decisions. So let’s give it a try.
While the term inflation is predominantely used to describe an increase in price, I find that to be somewhat irritating. It is the amount of money that is inflated, which is then supposedly increasing the prices of goods. Still inflation is widely used to mean “price increase” so we’ll follow that nomenclature.
If we consider all goods that exist in an economy and a certain amount of money, then all those goods should have a certain price level. If we increase the amount of money, over time it should lead to higher prices because it is the same amount of goods and just more money to buy them. So a relative increase of money leads to higher prices. That idea is described by the quantity theory of money.
While that is likely true in the long run, it sadly is not that easy.
The creation of money
We do have central banks and they can create money. Additionally all banks can create money too by giving credit. This fact was widely unknown until after the financial crisis of 2008/09. Banks basically book the promise of repayment and hand out newly created money in the simple act of a balance sheet extention. Governments finally tell them how much money they have to hold as a reserve. For example if the reserve is 10% they can create money that is equivalent to the 90% they do not have to own.
If this trio (central banks, normal banks and government) overdoes it, there can be a situation that generates too much money. Too much in this case is usually defined as more than we add in goods in the same timeframe.
Velocity of money
Money has a speed of circulation that can vary. If people use money to do business the available amount of money can be higher overall. One person gives it to the next, so there is more business on the same overall amount of money in an economy. If the money was just held as a means to store value and not spend, the time it would be held is higher, its velocity lower. On shorter timeframes the amount of money alone is therefore not the only variable that determines inflation.
Inflation as deliberate confusion
When you hear or read “inflation” what is usually meant is the consumer price, that is measured in a consumer price index. The rules by which it is determined are free to choose by those that create it. It measures what it is supposed to measure, and to be clear, it does not measure what it is supposed to not measure. As a consumer many people feel this measurement to be wrong, because it does not align with their experience. (I do not want to go deeper into the basket of goods and services or hedonic quality adjustments.)
It is important to note that it excludes certain things that are still needed, or at least wanted as a consumer.
Let’s say bread got more expensive, but luxuary vacations got cheaper. There is no increase in prices for you. Well as long as you consume your allotted luxuary vacation that is. The same is true if you want to buy a house. They rose in price considerably, but are not considered in this index. Furthermore that is only relevant if you do buy a house, so your problem is quite rare in comparison and while it is very relevant for you, it is not that relevant overall.
So what you hear about inflation can indeed be very far from your reality, your specific “inflation”.
Increasing prices
There are two base scenarios to consider when thinking about price increases. They can either be induced by increases of demand or by increases in cost. So inflation (meaning prices) can be pushed higher by increasing costs or pulled upward by higher demand for a good, the latter being an assumption that is implicit when considering the effect of higher amounts of money on prices.
Prices of input goods to the production, tarif or tax increases can create inflation as they increase prices. The corona pandemic on the other hand increased the demand for disinfectant increasing its price as a consequence.
The flow of money
We established that a certain amount of money is considered to lead to a certain price level. Now if the amount of money in a system is increased the person that first has access to it can satisfy his demands, the others that come after him will slowly be affected by the price increases the increased amount of money has induced. Whoever is touched last by the wave of new money will find its value, its buying power, diminished already before being able to put it to use. This effect is called the Cantillon effect. Additionally the amount of money he might have had before now buys him less.
Inflation is not inflation
With all the money that is created a resonable question would be why consumer prices are not increasing. The simple answer is that there is no overall added demand for the goods that are considered with regards to consumer prices. For some higher productivity leads to a decrease in price. Lastly with insecurity the savings rate increases.
The money created by central banks and given to banks, largely ends up with states or big corporations. They don’t eat, or make vacations, so they do not create demand for a variety of consumer goods or services. They either keep the money, or they invest money in companies (Keynes called this “hoarding” of money), so this is were the money currently goes, leading to price increases in those areas.
In this game you would want to be the first to touch new money, but you are not. You are not a state and not a big corporation. But you could be interested in buying a house. So by the time the amount of money increases, in our case as the interest rates begann to fall, you could have asked for a credit to buy a house. If you were among the first to buy a house during a new money wave you could buy, then others bought and your house increased in value as the price for real estate increases. Later refinancing would decrease your credit cost more and more as interest rates continued to fall, making this an even better investment.
This sadly was inceasingly limited to those that already had assets that could be used as security for a loan. So if you had a loan-free house you now had two and a credit. Other people were left with a situation in which real estate prices potentially increased faster than they could save equity, for some prolonging the saving phase to get enough equity, for many even prohibiting them from owning their own house. What they will likely be able to enjoy though are increasing rents after a while. This exclusion process is a driver of inequality in our society. Real estate is the dominant asset of the middle class that is now being split into two big groups. Those with and those without assets.
The price of money vs. the value of money
If there is more supply of a good but not more demand for it, in a standard supply and demand relationship this leads to a new equilibrium at a lower price. Interest rates can be considered the price for money. Central banks buy government securities, thereby giving more money into the system, leading to higher prices for the underlying securities which reduces their interest rate. Central banks actually can’t just say what interest rate they want, they have to perform open market operations, so buying or selling until a certain price (interest rate) establishes.
As long as the (central) banks don’t just “print” money, there is no real dilution of a currency. Imagine the romans taking off the outer part of their gold coins to create new lighter versions of them. There is a real loss in gold per coin. Central banks as well as banks take in promises of repayment in exchange for money they create. Therefore it is relevant what kind of promise or repayment they take in.
The financial crisis 2008/09 for example was in its core born out of taking in promises of repayment with a decreasing quality, so a decreasing likelyhood of actually being repayed. The name for this was “sub-prime” morgage. So the new amounts of money they gave out had a lower propability of repayment than before. The same concept can be applied to central banks.
Evading inflation through foreign currencies
Latest research seems to suggest that hyperinflations can only happen due to interaction with other countries and their currencies respectively. So if your central bank pumps money, they have to buy something in return. If what they buy is worthless, what the money stands for becomes less desireable, so people start to anticipate and change their money into more valuable and therefore more stable currencies. The same is true for real assets, like real-estate, oldtimers, often gold or valuable art objects. Once the inflation is over they can change their money back with a gain, or to put it the other way, with lower losses to its buying power.
Funny enough the current monetary expansion is a concerted effort worldwide. The big central banks expand their monetary base simultaniously so you cannot evade. Even smaller central banks have to join in to prevent bigger changes in currency exchange rates that would see their countries exports implode, ruining their economy in the wake. So there is basically no real way to just go into other currencies to evade dilution, but there are still differences.
Some spend the fresh money on sub-prime promises of repayment e.g. italian or greek government bonds, like the ECB. On its own a highly questionable investment at current interest rates. Others print money and use the difference between creation costs and nominal value of the money to buy Apple stocks with it, like the Swiss National Bank. They do not just “print” money from nothing, but they take in another form of promise for repayment.
The research also suggests that inflation is linked to the solvency of a central bank and its ability to defend exchange rates. I wonder what markets would stop buying of the hands of central banks first. Italian government bonds or Apple stock. Which currency would you like to own?
If that logic holds true there would be an argument to favor Swiss Franc vs. the Euro, as the Swiss National Bank takes in better repayment promises than the ECB.
Nominal vs. real interest rates
The interest rates we look at in the news are different from the real interest rates if we include the difference in buying power of the underlying currency. If the interest rate is zero you do not get money for giving it away. If the inflation is higher than zero, what you will get back is buying you less than it would have when you gave it away. So what really matters is the real interest rate you can expect.
Currently the ECB targets an interest rate of close to zero but an inflation that should be 2% on average. To paraphrase Christine Largarde, the current President of the ECB: “We are not here to close spreads”. So what they target is a 2% loss in buying power per year on average. On average means it could be higher than 2% for a while, because inflation was lower for quite some time. Therefore the Germans favorite game, saving money, is planned to be a loosing game. What we should expect is an increasing interest for evasion, and as we noted that fleeing into another currency is hard for the moment, real assets moved in the focus.
Return to the mean
Often people have a tendency to extrapolate past experience into the future. The interest rate is no exeption. Assuming that we return to former average interest rates, all assets are too expensive so they are prone to decrease in price.
Let’s take an example. Real estate in Munich reached valuations of (price to earnings ratio) PE 30–40. That is more than twice the historic average. Calculating myself I found cases in my area that range between PE 60–100 if you consider additional costs from the buying process and operating expenses. That seems to map with results of consultancies that see a portion of private investors already having negative returns in real-estate.
It is not unreasonable to assume that this is an overheated market and prices are likely to fall dramatically, if interest rates rise again.
An underappreciated scenario
Many “retail” market participants seem to assume that rising (real) interest rates are inevitable. Even if that is true, does it matter if it’s not happening for the next 10 years, or 20 years or not in your lifetime?
In the media scenarios can often be found that consider crash, hyperinflation and chaos. What if the central banks are actually able to do what they say they want to do? We would have comparably low interest rates and a higher inflation, so negative real interest rates.
Considering the fact that pensions in Germany are in decline there is a real need for other means of compensation and saving would not be too good a choice in this scenario.
We saw before how far real-estate prices increased and most people would assume they have to come down. If interest rates would not see a relevant increase, why would they massively decrease in valuation from this factor?
Now consider this. What if real-estate is front running a price development that over time will reach other asset classes as well? What if the everything bubble just began to inflate? Then real-estate prices are not coming down as much as other asset prices should increase, specifically stocks that still trade for much lower PE ratios.
Clearly this is only a scenario and noone can say how high the probability is this will acutally occur. Also it is not only a financial risk but as well a political.
What you should consider is, if you can affort to ignore this scenario, stay uninvested and find yourself in a world were all asset prices appreaciated cementing a new equilibrium.
Disclaimer: I wrote this article myself. What I write is my personal opinion. I am not a professional finance consultant and this is not an investment advisory. I am not receiving compansation for this (besides maybe medium).
A certain development in stock market price cannot be guaranteed. Buying stocks can potentially lead to a loss of money up until loosing all of the invested money. All information is subject to error and could be outdated once you read this. The information I am giving does not replace an individual professional advisory that is considering your personal situation, goals and your ability to bear risk. Any liability or guarantee for the correctness of information given in this article is excluded.