It Starts With Inflation

It Starts With Inflation: How Inflation, Interest Rates, Markets, and Economic Growth
Relate to Each Other and What That Means for What's Ahead

In this post a) I will very briefly explain how I believe the economic machine that determines
inflation, interest rates, market prices, and economic growth rates works, and b) work with
you to apply current circumstances to that machine to come up with our expectations for the
future.

How It Works

Over the long term, living standards rise because of people inventing ways to get more value
out of a day's work. We call this productivity. The ups and downs around that uptrend are
mostly due to money and credit cycles that drive interest rates, other markets, economic
growth, and inflation. All things being equal, when money and credit growth are strong,
demand and economic growth are strong, unemployment declines, and all that produces
higher inflation. When the opposite is true, the opposite happens. Most everyone agrees—
most importantly the central bankers who determine the amount of money and credit available
in reserve currency countries—that having the highest rate of economic growth and lowest
unemployment rate possible is good as long as it doesn't produce undesirable inflation. What
rate of inflation is undesirable? It's a rate that creates undesirable effects on productivity; most
people agree and central banks agree that it's about two percent for reasons that I won't now
digress into. So, most everyone and most central banks want strong growth and low
unemployment on the one hand, and the desired inflation rate on the other. Since strong
growth and low unemployment raise inflation, the central banks deal with the inflation-growth
trade-off which leads them to pick the greater problem and change monetary policy to
minimize it at the expense of the other. In other words, when inflation is high (above 2
percent), they tighten monetary policy and weaken the economy to bring it down. The higher
the rate is above their target, the more they tighten.

With inflation well above what people and central banks want (e.g. today’s CPI report showed
a monthly change in the core CPI of 0.6 percent, which equates to an annualized rate of 7.4
percent) and the unemployment rate low (3.7 percent), it's obvious that inflation is the
targeted problem, so it’s obvious that the central banks should tighten monetary
policy. Everything will flow from that. Tell me what the inflation rate will be down the road
without the central bank pushing interest rates and money and credit growth rates around and
I can pretty much tell you what will happen.

So the process starts with inflation. Then it goes to interest rates, then to other markets,
and then to the economy.

It starts with inflation. Since the price of anything is equal to the amount of money and
credit spent on it divided by the quantity of it sold, the change in prices i.e., inflation is equal
to the change in the amount of money and credit spent on goods and services divided by the
change in the quantities of goods and services sold. This is primarily determined by the
amount of money and credit and the level of interest rates that the central bank makes
available, though it will also be influenced by the supplies of goods and services available
e.g., supply disruptions.
Then it goes to interest rates. Central banks determine the amount of money and credit that
is available to be spent. They do that by setting interest rates and buying and selling debt
assets with money they print e.g., quantitative easing and quantitative tightening. Interest
rates relative to inflation rates i.e., real interest rates have a big effect.

Then it goes to other markets. Interest rates rising relative to inflation causes prices of
equities, equity-like markets, and most income-producing assets to go down because of a) the
negative effects it has on incomes, b) the need for asset prices to go down to provide
competitive returns i.e., “the present value effect”, and c) the fact that there is less money and
credit available to buy those investment assets. Also, because investors know that these things
happening will slow growth in earnings, that will also be reflected in the prices of investment
assets, which affects the economy.

Then it goes to the economy. When central banks create low interest rates relative to
inflation rates and when they make plenty of credit available, they encourage a) borrowing
and spending and b) the selling of debt assets e.g., bonds by investors and the buying of
inflation-hedge assets, which accelerates economic growth and raises inflation (especially
when there is little ability for the quantity of goods and services to be increased). And, of
course, the reverse is true i.e., when they make high interest rates relative to inflation and
make the supply of money and credit tight, they have the reverse effect.

Where these things settle will be around the levels that are most tolerable, all things
considered i.e., if one thing is intolerable e.g., too high inflation, too weak economic growth,
etc. it will be targeted by central bankers to be changed, policies will be changed, and other
things will change to bring that about. So, the process of figuring out what will happen is an
iterative process, like solving a simultaneous equation optimizing for a few things that matter
most.

Applying This to What's Now Happening

Now, let's look at what that means for inflation, interest rates, the markets, and the economy.
By plugging in our estimates of the determinants, we can estimate the outcomes.

As explained, it starts with what the inflation rate will be. Pick your number based on what
you can see ahead. Right now, the markets are discounting inflation over the next 10 years of
2.6 percent in the US. My guesstimate is that it will be around 4.5 percent to 5 percent long
term, barring shocks (e.g., worsening economic wars in Europe and Asia, or more droughts
and floods) and significantly higher with shocks. In the near term, I expect inflation will fall
slightly as past shocks resolve for some items (e.g., energy) and then will trend back up
towards 4.5 percent to 5 percent over the medium term. I won't take you through how I
arrived at that estimate (which I'm very uncertain about) because that would take too long.
What's your guesstimate? Write it down.

Next, we need to guesstimate what interest rates will be relative to inflation. Right now,
the markets are discounting 1.0 percent for the next 10 years. That's a relatively low real yield
compared to what it has been over the long-term and a modestly high real rate given the
recent past. What is your guesstimate? My guesstimate, based on the amount of debt assets
and liabilities outstanding, what the debt service costs would be for debtors, and what the real
returns would mean for creditors, is for a real interest rate of between zero and one percent
because that would be relatively high, but tolerable, for debtors and relatively low, but
tolerable, for creditors.

Put the inflation estimate and the real rate estimate together and you will have your
projected bond yield. If you want to estimate the short rate, decide what you think the yield
curve will look like. What's your guesstimate? Mine is that the yield curve will be relatively
flat until there is an unacceptable negative effect on the economy. Given my guesstimates
about inflation and real yields, I come up with between 4.5 and 6 percent in both long and
short rates. However, because I think that the higher end of this range would be intolerably
bad for debtors, markets, and the economy, I'm guesstimating that the Fed will be easier than
that (though 4.5 percent is probably too easy).

While interest rates and credit availability will be influenced by what I just mentioned,
simultaneously there is the supply and demand effect on interest rates that results from how
much borrowing and how much lending there is. For example, the US government is going to
have to sell a lot of debt to fund the deficit (4-5 percent of GDP this year) and the Federal
Reserve is also going to sell (and let roll off) a lot (~4 percent of GDP). So the question is
where the demand to buy this big supply (8-9 percent of GDP) will come from, or how much
will interest rates have to rise to reduce private sector credit demand to balance the supply and
demand. What do you think? I think it looks like interest rates will have to rise a lot (toward
the higher end of the 4.5 to 6 percent range) and a significant fall in private credit that will
curtail spending. This will bring private sector credit growth down, which will bring private
sector spending and, hence, the economy down with it.

Now, we can estimate what that rise in rates will mean for market prices and economic
growth. The rise in interest rates will have two types of negative effects on asset prices: 1) the
present value discount rate and 2) the decline in incomes produced by assets because of the
weaker economy. We have to look at both. What are your estimates for these? I estimate that
a rise in rates from where they are to about 4.5 percent will produce about a 20 percent
negative impact on equity prices (on average, though greater for longer duration assets and
less for shorter duration ones) based on the present value discount effect and about a 10
percent negative impact from declining incomes.

Now we can estimate what the fall in markets will mean for the economy i.e., the "wealth
effect." When people lose money, they become cautious, and lenders are more cautious in
lending to them, so they spend less. My guesstimate that a significant economic contraction
will be required, but it will take a while to happen because cash levels and wealth levels are
now relatively high, so they can be used to support spending until they are drawn down. We
are now seeing that happen. For example, while we are seeing a significant weakening in the
interest rate and debt dependent sectors like housing, we are still seeing relatively strong
consumption spending and employment.

The upshot is that it looks likely to me that the inflation rate will stay significantly above what
people and the Fed want it to be (while the year-over-year inflation rate will fall), that interest
rates will go up, that other markets will go down, and that the economy will be weaker than
expected, and that is without consideration given to the worsening trends in internal and
external conflicts and their effects.