Sean Keane: The price of money – where to from here for interest rates?

Stimulus has propelled an increase in the price of almost every tradeable asset on the planet, with money plentiful and borrowing costs near free. Photo / Getty Images

Opinion

OPINION:

One of the great governmental successes of the past 30 years has been the virtual annihilation of Consumer Price Inflation as a source of economic instability and the consequent reduction in borrowing costs for billions of people around the world.

The re-emergence of China as an economic participant on the world stage significantly reduced global manufacturing costs, but just as significant were the decisions taken by almost every advanced nation to outsource control of its monetary policy and interest rate settings to their central banks.

Having failed to control inflation in the 1970s, governments handed off that unpleasant task to their central banks, setting them a target of maintaining low and steady inflation over the medium term.

New Zealand was the earliest adopter of the inflation targeting regime, and the result has been a long slow decline in interest rates that has brought borrowing costs down from more than 20 per cent in the mid 1980s to under 2 per cent today.

Central banks have so effectively wiped inflation concerns from the economic map that in recent years they have instead become concerned inflation has been too low.

That concern has forced them to try previously unimagined policy solutions that collectively have become known as unconventional monetary policy.

The Covid liquidity flood and the digital Midas touch

The Covid crisis was quite reasonably expected to crush global confidence, to depress consumer spending and to cause a prolonged contraction in economic growth.

Nervous central bankers became worried about deflation rather than inflation and unsurprisingly cut their cash rates aggressively and flooded their economies with liquidity.

Not convinced traditional policy measures would be enough, central bankers created, adopted and implemented new "unconventional" measures, and talked about taking official interest rates below zero.

To most observers the investment landscape has never looked so strange, and its oddness has been amplified by the unusual sight of central bank governors and finance ministers actively encouraging higher inflation in their economies.

With fears the Covid-19 crisis would depress consumer spending and cause a prolonged contraction in economic growth, central bankers were forced to take action. Photo / NZME

For more than a year now, central banks such as the Reserve Bank of New Zealand and the Reserve Bank of Australia have been loudly saying they will only hike interest rates when they can actually see sustainably higher inflation - not when their models forecast its arrival.

This is a remarkable change in stance, unlike anything we have seen in the past three decades.

The titanic rate cutting and liquidity adding efforts of the central banks have been amplified by the arrival of a fiscal tidal wave of government spending and subsidies that eclipse any previous support packages.

The resulting stimulus has overwhelmed markets and has propelled an increase in the price of almost every tradeable asset on the planet, with money plentiful and borrowing costs near free.

In fact, the digital creation of central bank reserves at such record pace has even inflated the value of digital assets themselves. Single pixels in previously unheard of "assets" known as "Non-Fungible Tokens" recently traded for more than US$1 million each.

The outlook for interest rates

As wonderful as the new digital version of Midas appears to be, many investors worry the amount of combined stimulus governments and central banks have provided is far greater than it needs to be, given most large economies appear to be bouncing back from their Covid slowdown at a much more rapid pace than expected.

Covid-19 has had the perverse effect not only of reducing supplies of imported goods, but also of imported workers for the labour market.

Despite fears of double-digit unemployment driven by the pandemic, the New Zealand unemployment rate peaked at just 5.2 per cent, and is now heading comfortably back down towards 4.5 per cent.

The labour market is tight and wage pressures are mounting precisely because employers cannot access all the staff they need.

Reserve Bank of New Zealand Governor Adrian Orr. Photo / Mark Mitchell

At the same time, imports of raw and processed goods have been severely restricted because of the lack of container shipping, driving up the price of almost everything.

There are signs of inflation almost everywhere in the supply chain and the RBNZ is awakening to them.

The discussion of the Monetary Policy Committee is no longer about adding stimulus or undertaking additional support measures.

Now it is about reining back some of the stimulus and thinking about when and how best to turn down the economic heat.

The RBNZ's relatively brief dalliance with dovish policy settings will likely come to an end in 2022 as the local economy delivers stronger than expected outcomes on both growth and inflation. The OCR will have to rise.

So what now for asset prices?

As money has become cheaper and fixed income returns have become harder to achieve, risk-taking has increased while risk assessment is seemingly declining.

This remarkable era will be remembered as one in which many people were scared to invest but equally terrified of sitting on the sidelines.

They really didn't want the risk that equity markets appeared to represent, but neither could they suffer the paltry returns that bank deposits and corporate bonds were delivering.

Interest rate reductions and quantitative easing have undoubtedly helped to stabilise economic output and employment, but asset inflation has been rampant and the benefits of economic support have been uneven.

With global policymakers so aligned in their objectives, inflation has never before received such coordinated and sustained encouragement to push higher.

It is therefore highly likely that, ultimately, inflation will move up and investors should expect interest rates to gradually rise as we return closer to normal.

The real challenge is not picking whether interest rates will rise, but to pick when they will start rising. The central bank community have made a remarkable commitment to be patient in the face of rising signs of inflation and we expect they will hold the line this year as well as for the first half of next year.

In our view, however, they will feel more market pressure to act in the second half of 2022 but the degree to which they will need to push interest rates higher will be constrained by the size of the debt mountain that has been built up in recent years.

That means the peak in interest rates will again likely be lower than in previous cycles, and investors should not expect a return to the high fixed-income coupons of pre-GFC times.

Equity markets will still end up offering more attractive long-term returns than the yields available in most fixed-income markets, and long bond yields probably won't spiral higher given that the central banks will not ignore building growth and inflation pressures.

Periods of rapid asset price changes will continue into the future, just as we have seen them in the past.

Thinking carefully about what impact changes in central bank policy settings and market interest rates will have on asset values is a necessary and important exercise.

Thinking specifically about the size and magnitude of the likely moves has never been more essential, and it will form a key part of the most successful asset allocation strategies.

• Sean Keane is a non-executive director at Jarden.