14 June, 2021

What does it really mean when money’s ‘on sale’?

Interest rate reductions are all about bringing demand forward. That is the core purpose of central bank rate cuts. When a central bank reduces interest rates, it is trying to trigger consumption and investment today rather than waiting for it to happen tomorrow. The objective currently is for this pull forward in economic activity to reignite the flame of inflation that has been dormant for more than a decade.

In practice, cutting interest rates is like having a sale on the price of money. For both businesses and consumers, it means that what was previously unaffordable can now be bought because the cost has been reduced. Economic models tell us that enough price cutting will generate an increase in demand that eventually leads to an increase in inflation. Economic reality however shows us that despite central banks steadily reducing interest rates over the past 35 years inflation has continued to fall.

The question can reasonably be asked, if they have been unable to create inflation via lowering interest rates in the past, why do central banks think that they would be able to do so today?

One recent economic paper suggests that the reason central banks have been unable to sustainably push inflation higher is because their own policy stimulus measures contain within them the very elements that guarantee their failure. The cutting of interest rates today to pull forward demand from tomorrow simply ends up reducing and suppressing future demand. The paper is appropriately titled “The Theory of Indebted Demand”.

For example, if interest rates fall from 20 per cent to 2 per cent then a borrower that might have had to save for years to buy a home would find themselves able to fund the purchase much more quickly. This apparent stimulus however has two consequences.

Firstly, it drives up the price of houses throughout the economy as homebuyers borrow larger amounts on their mortgage. Secondly, it creates a larger principal mortgage debt that the borrowers then need to service for years into the future. Absent any further stimulus, the impact will be to suppress future demand until the debt is paid off. Instead of holidaying or buying a new car, borrowers focus on repaying their mortgages.

Each round of stimulus followed by borrowing therefore creates a larger and larger obligation to pay into the future, and the size of that obligation means that central banks cannot raise rates very far during the next economic upturn because the increased size of the debt that needs to be serviced becomes an economic constraint much more quickly. 

This in turn has consequences for beleaguered fixed income investors and deposit savers. The flip side of cheaper borrowing is more expensive investing, and with interest rates near zero the choices available to investors are necessarily higher risk ones if they want to earn a higher return. Young investors today cannot rely on high deposit rates to achieve their investment goals. They necessarily have to take more risk and to own more equities to build their savings pile.

A new view on the impact of borrowing and spending

Some economists suggest that so long as you issue debt in your own currency, there is no constraint on the amount of spending that a government can undertake as it can never default on its borrowing. If a government needs money to pay creditors it alone holds the power of the printing press, and it thus has the infinite ability to repay them. Magically this means that spending can take place ahead of borrowing and there is never any need for the two to balance. This “Modern Monetary Theory” (MMT) has arrived at the perfect time and provided the perfect cover for some of the world's largest sovereign borrowers to further increase their debt loads by what are truly staggering amounts.

Whilst no governments are openly admitting to adopting and embracing the MMT philosophy, there appears to be little doubt that its attraction has taken hold in many parts of the world. To mangle a well-known saying about ducks, if it looks like MMT, sounds like MMT and is being used like MMT, then it’s reasonable to assume that it is MMT.

The major drawback with this school of thought is that the brake on spending is dependent on the government of the day raising taxes to annihilate the additional reserves that it previously created. It is very hard to imagine that even the most popular and most trusted politician in any functioning democracy will deliver on the necessity to raise taxes to slow an overheating economy - especially in an election year.

At the end of the day, our pixel based financial system operates on nothing more than trust. People are comfortable believing that their digital account balances and paper bank notes have value simply because everyone else believes the same thing. We all agree as a society to swap our goods and our services between each other and account for what's earned and what's owed in the form of a common currency. The backing for that currency is shared community trust. Nothing more.

Our faith and confidence in currency has been earned over the years by central bank and government stewards that don’t abuse the power of the printing press. To do so is to put at risk the very foundations of the fiat monetary system, and to create significant risks to financial stability. Confidence in a sovereign currency issuer takes generations to earn, but loss of confidence happens fast, and you don’t have to turn very far back in the pages of history to find recent examples of what happens when confidence evaporates.

Modern Monetary Theory appears to be a wonderfully simple solution to the world's problems, but its embrace is not without peril. It is not at all surprising that as Google searches for “MMT” have increased, so too have the number of investors looking for non-currency linked hedges such as digital tokens, scarce physical assets such as artworks or other collectables, or towards more traditional mobile hedges such as gold and precious metals.

MMT is too easy an option for it to be ignored by most politicians and so we would expect that the global liquidity spigot will remain open and that governments around the world will continue to print money. That behaviour will continue to support equity markets, even as central banks start to slowly increase interest rates. Investors need not fear that rise, given that the size of the rate increase will not be large when compared with prior cycles. Higher bond yields will also give investors an opportunity to diversify their portfolios, reducing the need to hold much heavier equity weightings in an effort to achieve their long-term investment goals.

The information and commentary in this publication is provided for general information purposes only and does not constitute financial advice. We recommend the recipients seek financial advice about their circumstances from their adviser before making any investment decision or taking any action. For information about Jarden’s financial advice service, please refer to our publicly available disclosure statement which is available here.

All media enquiries, please contact:

Jill Valentine |  M. +61 416 189 554 |  [email protected] 

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