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Wednesday, August 20, 2014

Interest rates, inflation and growth

I go through US data periodically for a weekly radio show on W3Z - WREL in Lexington, Virginia. Unfortunately they don't stream their locally-produced content, probably because most of what they broadcast is syndicated and they aren't licensed to do so.
I've talked in recent weeks about the low returns available on savings. Let me trace that logic in more detail. In the end, I'll tie this to the discussion going on in economics circles about secular stagnation. (Since this is a blog, here's a link to VoxEU, which has just released a free eBook with essays by 19 economists, arguing the empirical strengths, weaknesses and implications of "staganation.")
Long-term rates are generally down since December: 30-year bonds fell from 4.0% to 3.2% and 20-year bonds from 3.0% to 2.4%. Those are drops of 0.8 percentage points and 0.6 percentage points, respectively. (Meanwhile-year rates are flat at 1.6%.) That is not necessarily good news, as it means that the serious money crowd think that growth will be weak for years to come.
Let's look at the numbers over time and see what they imply. If you're an investor, you can buy a 1-year bond today and another 1-year bond a year from now. Or you can buy a 2-year-bond today. Since there are lots of players in this market trading minute-by-minute, those two returns ought to be comparable. Here are calculations of future rates consistent with today's bond prices. (There are other corrections, such as for risk, but I don't think that changes my results in a qualitative manner.)
The first column is actual rates. The second column are rates in the respective years that are consistent with the actual rates. The third column is the year, and the final column is the implied 1-year bond rate that year consistent with today's rates. As you can see below, when I do these arbitrage calculations, we don't get "normal" 3+% interest rates until 2019. (In fact, over the period Jan 1990-Dec 2007 one-year interest rates averaged 4.5%) In other words, we will have had 10 years of well-below-normal interest rates.
The total return after (say) 3 years of buying 1-year-bonds 3 years in a row should equal the return on a 3-year-bond. In algebra, we have (1+i3 yr)3 = (1+iyr 1)*(1+iyr 2)*(1+iyr 3). Excel lets you find the future rates consistent with todays rates; I used rates in 0.25 percentage point (25 basis point) increments to get close.
MaturityInterest Rate
Aug 19, 2014
YearImplied 1-year
bond rate
1 year0.11%20140.11% (actual)
2 years0.46%20150.75%
3 years0.90%20161.75%
4 years1.1% (implied)20172.00%
5 years1.59%20182.00%
20193.75%
7 years2.05%20204.00%
20213.25%
20223.25%
10 years2.40%20233.25%
In the background 3 components are operating::
  • Growth will remain low. Unfortunately, the 2019 date is consistent with my calculations of when labor markets return to normal, based on jobs growth versus population growth, corrected for baby boomer retirement, updates of which I post here from time to time.
  • We will not have inflation in the foreseeable future. None. (Remember, short-term interest rates should be approximately the growth rate plus the inflation rate.)
  • Yes, there's lots of noise from gold bugs. There are the "old dog" monetarists (those who blindly apply a single, simple-minded monetarist equation, as fitted to data from the 1950s). They play with a few billion dollars. In contrast, the real players, pension and insurance fund managers, mutual fund managers and the Saudis and Chinese have invested a few trillion dollars on the belief that there won't be inflation. I believe money talks.
  • Stock prices will remain high and returns low. Low growth means that profits won't rise much, while low interest rates mean that stocks will still look attractive relative to bonds and bank accounts.
Now slow but steady isn't bad, unless you're job-hunting. But low interest rates impose a risk, because interest rates that are near zero can't be pushed down. In other words, as we've observed these past several years, monetary policy has no power, and aggressive "quantitative easing" only a little. If we have another recession – there are lots of scenarios in which something goes wrong over the next 5 years – then we're powerless to do anything, unless we can engage in fiscal stimulus. Will Congress be prepared to act? I fear not.
But let me return to stock prices: Robert Shiller, the Nobel laureate who discussed the housing while it was developing and predicted its collapse, argues that stocks are overpriced (see here on MarketWatch). If growth will indeed remain low, however, interest rates will stay low, and stock prices high by historic norms. That would also make sense from another direction: the returns to buying stocks were unusually profitable for decades. As savers adapt to that and hold more stocks, prices should be high – but then not rise further. So either way – overprice or not – don't look to buying stocks as a reliable way to make money. And certainly don't believe anyone who tells you they can beat the market, or generate good returns. The best you can aim for are comparable returns, and those returns are low.
Finally, we have a reality check in the most recent consumer price data, released yesterday (August 19th). The headline number remains 2.0% and the rate excluding the volatile components of food and energy is at 1.9%. The biggest rises at the detailed level remain medical commodities at 3.0% and medical services at 2.5%. (Actually, these have fallen a bit.)
Oh, and since this is an auto blog, new car prices were up +0.3% in July, but bounce around quite a bit. Over the last 12 months there were up 0.2%, so well below average inflation. The same is true of used car prices, up 0.2% over the past year. However, they have been falling over past few months, and Tom Kontos, the Chief Economist at Adesa, one of the two big auto auction companies, thinks they'll continue to fall: the normalization of sales and leasing over the past few years is leading to a rise in the supply of off-lease vehicles and trade-ins. He doesn't see demand rising so as to offset that. That's consistent with my above analysis of the economy as a whole.