Are we heading into higher interest rates and higher inflation?
Posted on 09 January 2012 with 3 comments from readers
If you live in a US dollar-pegged region like the Gulf States then interest rates have been relatively low for savers and moderate for borrowers. There have not been the ultra-low mortgage rates or the almost zero interest for savers.
Inflation has also been relatively low. Food costs have stayed static over the past year at least. The nastiest spike has been in energy prices both for autos and air-conditioning – a little ironic for an energy-rich region.
Gulf behind the curve
Because Gulf interest rates have not fallen like most dollar areas we should feel less of the impact of rising interest rates. This surely has to happen.
In Europe we can see that the ultra-low official interest rate of the ECB has not prevented interest rates on Italian, Spanish, Portuguese, Irish and of course Greek debt soaring through the roof.
Yet there is a false sense of security about US bonds where the Fed still seems to rule over interest rates. Indeed, there is currently a flight to this perceived safety which is having the effect of keeping interest rates down.
What could cause this blessing to reverse? And let us not be in any doubt this is all that is supporting the US recovery and stopping another slump.
Basically the same laws of economics that apply in Italy also do apply to the United States. Too much borrowing and you will always reach a tipping point when lenders force up the cost of borrowing, and that means a sudden escalation of rates.
Inflation is surely the thing to watch. For higher inflation means that US bond holders are actually losing money day after day at the moment. How long do you stay in a losing asset class? Perhaps only for as long as it seems to be losing less than everything else.
Can we not imagine a reversal in which the money printing backfires and the banks begin to push that money into the economy and price levels start to move up rapidly. Then the US bond market will go the way of Italy and interest rates will spike upwards.
Asset price shock
That will not be good for asset prices. Those now supported by the Fed’s super-low interest rates will take a thrashing. Inflation of general prices would deflate investment asset prices.
Perhaps then in the Arabian Gulf countries it is no bad thing that interest rates have stayed relatively high in comparison with the US model. That should act as a buffer to rising US interest rates.
But for those with investments in US equities, real estate and of course bonds this is going to be a very painful cold shower. Going into cash for the short-term never made more sense.
Inflation is already moving up and interest rates cannot lag behind for long.
3 Comments posted by readers:
Hi Readers
Hopefully someone with the know will be able to help me out, when I studied Economics at University (it was only 1 module and was macro ecos); we were told that inflation and interest rates are inversely proportional. So with increased inflation there will be a decrease in interest.
If we have inflation knocking on the door, surely this means that interests rates are threatening to stay lower? Thus if I borrow to buy a house I will be paying less every year per dollar I borrow? This seems pretty inviting to me. I understand that interest rates affect lenders and borrowers differently, if I buy government bonds and I get low interest rates then I lose. But surely I cant lose on buying bonds (Lending to gov) and on buying a house (borrowing from banks)
If we have a period of deflation, which is still likely, interest rates will soar and every dollar I borrow will cost me more per annum plus my house may devalue. Thus I am paying more for a house that is worth less. But every dollar I lend will earn me more interest – is this right?
PS please excuse me if i get the def of borrowing and lending wrong, that one always gets me.
Ed Note: Just plain wrong – interest rates always go up with inflation (eventually).
The private Federal Reserve Bank, which has become the de facto government of the USA, has publicly stated several times that they intend to keep USA interest rates LOW for ‘an extended period’.
I think that the USA will remain the safe haven until the Europeans solve their debt and euro crisis. I have seen some pretty knowledgeable people say that it will take years to accomplish that task. A few even say that it will take a decade.
@ Ignorant Fool
Interest rates always go up with inflation. During the 1970’s they were both in double digits in the USA. The Federal Reserve can manipulate interest rates for some time by injecting or withdrawing money from the banking system. You don’t want to experience deflation, unless you have a LOT of cash and no debt. Deflation can cause a downward economic spiral which can last for decades. Prices fall, but wages soon fall too. In an economy with high levels of debt, like many today, the amount of dollars you own stays the same, but the amount of money you earn falls. You can’t pay your debts, and bankruptcies spread, unemployment spreads and the economy keeps shrinking. It becomes a self reinforcing downward spiral, like during the Great Depression. Only the huge government spending for World War II stopped it. That is why the Federal Reserve and ECB is doing QE money creation, to prevent deflation from taking hold.
Inflation favors people who owe money. Your house payment stays the same, (unless you have a variable rate mortgage) buy your wages go up. My father bought a 3 bedroom brick house in 1958. His last monthly payment in 1988 was the same as his first, about $140. That is how inflation helps the borrower.
the UK offers an insight. Inflation rocketed to nearly 5% and interest rates from the central bank were held at 0.5%. have been so now for nearly 3 years.
Inversely with inflation coming down there, I dont see 0.5% getting lany ower though!
Just hope there are more imaginative saving rate options. There is no incentive to save with banks here. Appallingly low rates.