Negative Real Rates Fuels Boom Bust Cycles And Enhances Inflation Dynamics

``Inflation is like sin; every government denounces it and every government practices it."- Frederick Leith-Ross (1887-1968) civil servant and international authority in Finance

Asset boom bust cycles under the paper money standard have principally been driven by monetary or credit inflation which are further stoked by unbridled speculation or investor irrationality.

This from George Soros, ``Boom-bust processes usually revolve around credit and always involve a bias or misconception. This is usually a failure to recognise a reflexive, circular connection between the willingness to lend and the value of the collateral. Ease of credit generates demand that pushes up the value of property, which in turn increases the amount of credit available.”

In short credit is the lifeblood for boom bust cycles. In a boom phase, ease of credit and increasing collateral values engenders a self reinforcing cycle buttressed by an expanded risk appetite. The opposite holds true in a bust phase, tighter credit and falling collateral values is by itself a self feeding mechanism backstopped by a shift to risk aversion.

Today, we have been witnessing the full boom bust cycle playout in the US real estate and mortgage markets. That is why the US government has been lowering its Fed controlled short term interest rates, it has also been widening the range of institutions requiring direct funding access from the Fed, and loosening up of the standards for collateral eligibility as basis for such funding, aside from changing policies needed to accommodate such facility. The aim is restore the ease of credit, restore risk taking confidence and provide a floor to declining collateral values.

In other words, the US has been utilizing expansionary monetary policies, aside from fiscal policies to reduce the negative impact of a bust phase.

And this boom bust cycle has not been isolated to select asset classes as inflationary policies likewise have been affecting consumer prices around the world. Why? Because, while governments can control its printing presses, it cannot control where the money printed goes.

As Dr. Frank Shostak explains, ``increases in money supply lead to a redistribution of real wealth from later recipients, or nonrecipients of money to the earlier recipients. Obviously this shift in real wealth alters individuals' demands for goods and services and in turn alters the relative prices of goods and services. Changes in money supply set in motion new dynamics that give rise to changes in demands for goods and to changes in their relative prices.

``Now, the effect of changes in the demand and supply of money and the demand and supply of goods on prices of goods is intertwined and there is no way that one can somehow isolate these effects.”

In other words, when monetary factors are constant, a price increase in a particular good means a shift in relative prices and not absolute prices. For instance, given a typical household budget; if the price of food increases, then the additional income spent on food would cause a diversion away from spending on non-food goods or services. This should translate to a downward pressure on the prices of non-food goods or services.

But obviously since the price of almost every basic goods and services are on the rise this goes to show how the absorption of the inflation dynamics have shifted from financial assets to consumer goods on a global scale.

Figure 2 shows of the real interest rates in the US have spawned the largest boom bust cycle in the US.

Figure 2: moneyandmarkets.com: Negative Real Rates in 2003-2006 and 2007 til present

We have spilled so much ink with negative interest rate. Negative interest rate is when changes to consumer price indices or consumer price inflation are growing faster than nominal rates.

To quote Mike Larson of moneyandmarkets.com, ``When real rates are negative, it's a sign that policy is easy. That can drive inflation pressures and inflation expectations higher. When real rates are positive, it means that monetary policy is restrictive. That, in turn, tends to keep a lid on inflation.”

As we previously wrote, negative real rates deal with the function of money as a store of value or the opportunity cost of holding cash. Negative real rates basically is a policy for dissavings (punishes savers as the purchasing power of a currency erodes via higher consumer prices) and encourages the public to go into debt and venture into speculative activities to preserve the store of value. It gives false signals to the marketplace, and encourages malinvestments. Thus negative real rates feeds on inflation driven asset boom bust cycles.

Figure 2 shows that in 2003 to 2006 real interest rates were kept in negative territory for about 3 years. Today, real interest rates have further plunged into a deeper negative territory since the credit crisis erupted in 2007.

Figure 3 Northern Trust: Housing and Credit Boom Fueled by Negative Real Rates

Chief Economist Paul Kasriel of Northern Trust gave a great presentation on how negative real rates have turbocharged the US housing and mortgage bubbles.

The select charts shows of the (left chart) Market value of real estate as % to after tax disposable income (circle shows of the accelerated trend of home prices during negative real rates).

This leverage build up was equally evident on US houses which had been used as an ATM substitute via a net home equity extraction (circle shows the dramatic expansion of credit during said period).

Figure 4: Northern Trust: US Current Account Deficit Exploded While Bank’s Mortgage Business Boomed

Figure 4 again courtesy of Northern Trust shows how US banks capitalized on the Mortgage boom by dramatically expanding the share of mortgage assets to total earnings (right chart) again during the same period.

Current account deficits reflected the pace of US household borrowing. Again the left chart of figure 4 demonstrates how the pace of deficits expanded rapidly as US households borrowing boomed, again under negative real rates.

The lesson that can be drawn from this is that as inflation pressures seems apparently building up around the world (China and GCC continue to amass current account surpluses) especially with the present deep negative real rates in the US.

Negative real rates are likely to fuel either a bubble in some asset classes (most likely in commodities or commodity related assets) or could be passed off or transmitted through higher consumer prices.

The Philippines is likewise under a negative real rate climate, hence, the rice crisis could be a possible manifestation of this phenomenon backed by skewed policies.

Further, as we have been saying all along, I wouldn’t exactly shut the door for a potential recovery in the Phisix, especially on commodity related issues. While it may take time, increased speculation utilizing liquid assets backed with potential stories (yes remember markets operates on biases which for stories!) should be good candidates for today’s alternative store of value.