The Prevailing Wisdom
Never have so many “experts” been so sure of an uncertain outcome than those who currently believe, in mid-January 2024, that the dragon of inflation has been slain across the developed world and that cuts in interest rates will follow precipitously. Some even believe that we shall soon be eased back into the warm, cosy world of near-zero rates where the price of money is almost nothing.
The major lenders in the UK are so sure of the inevitability of imminent rate cuts that they have been slashing the cost of mortgages – which is obviously great news for the many mortgage-holders who will need to re-fix their mortgage deals this year. (And some of whom might even end up voting Tory, after all). This is on the back of a significant decline in bond yields over the last month or so. In the UK, this was exemplified by the fact that the yield on the 10-year gilt fell from 4.2 percent in early December to just under 3.8 in the first week of January. This was driven by the better-than-expected UK inflation number of 3.9 percent released before Christmas.
In a research note released on Wednesday morning (10 January), Deutsche Bank predicted that UK inflation would average 2.5 percent in 2024, down from a previous forecast of 2.7 percent. The bank reckoned that inflation would drop “a little below 2 percent in April and May” before hovering around 2-2.5 percent for the remainder of the year. That level would still be above the Bank of England’s official inflation target rate of two percent.
The markets were mired in pessimism as recently as the end of last October: but before Christmas they were in a state of near-euphoria further to the emollient words uttered by central bankers. That may have passed as the global equity markets have begun 2024 seemingly in a state of upright sobriety.
But what if the priestly caste of central bankers have surreptitiously abandoned their official target inflation rates because they know that they will not be met – even as the dullard tribe of finance ministers bang on about the need for price stability? Indeed, do they quietly know something that we don’t?
What If The Consensus Is Wrong?
The overwhelming evidence is that the era of near-zero interest rates which lasted across the West for more than a decade after the financial crisis of 2008-09 (Lehman Brothers and all that) is well and truly over. We are reverting to a more historically “normal” interest rate paradigm – and that is a good thing too, as I have argued here in the past since optimal investment allocation decisions can be only be made when real interest rates are positive.
If you look at the long-term graphic of the Bank of England base rate since the bank’s foundation in 1694 – so, 330 years – you will see that the period 2009-21 was a complete historical aberration. While interest rates have spiked historically during inflationary shocks, for much of the modern period the level of rates has fluctuated in the 4-6 percent range. That is what we are now going back to: “normality” has been restored. Even if, paradoxically, the priestly caste is not happy with that.
As central banks in Washington, London and Frankfurt shrink their balance sheets so they lose their sense of centrality to economic management. There is already a policy shift back from monetary policy to fiscal policy – away from the unelected elite functionaries to the elected (and unfortunately often clueless) politicians. The problem is that, as national debt piles accumulate further, the politicians too have very little room in which to manoeuvre.
I suppose the really fundamental economic transformation that we shall encounter in 2024 is that we shall pass from a long period of negative real interest rates to one of a (healthier) regime of positive real interest rates. Long-term, that will have positive consequences: over the past decade or more it has become tortuous to determine optimal investment decisions in an era of near-zero interest rates. Just look at the UK’s HS2 project which has been demonstrated as economically unviable since interest rates reverted to normal levels.
Harvard’s Professor Kenneth Rogoff argues that, even if inflation declines this year, it will probably remain higher over the next decade than in the decade after the financial crisis. He cites the increasing cost of government debt; the need for European countries to increase their defence spending (on which more here soon); and the unquantified cost of the transition to net zero (more here soon on that too). Meanwhile, China is challenged by the collapse of its real estate market and is likely to import less going forward – indeed the reduction in oil output by the OPEC states has already been counterbalanced by the fall in demand from China.
An Alternative View
I was struck by a recent piece from the veteran economist, Anatole Kaletsky. He has been around for quite a while – I used to read his musings in The Times when I was a young banker in the 1980s. Now he forms one half of the go-to advisor to global asset managers, Gavekal Research (the other half being the French economist Charles Gave).
Kaletsky argues that “the world economy and markets have moved permanently into a new era of higher forever long-term interest rates” – and that the Fed (and presumably the BoE and the ECB to) understands this perfectly well. He perceives that central banks think they have essentially won the war against inflation and that they will now focus on their other principal target, namely the maintenance of “maximum employment”. There is always a trade-off between the two. This amounts to abandoning the official two percent inflation target for “price stability”.
Inflation will remain above the two percent official target – in fact it will more likely remain stuck in the 3-4 percent range for some time, Kaletsky thinks, which is not “price stability. The central banks’ two percent target will come to be a floor rather than a ceiling. Demographic and geopolitical trends are driving the end of “secular stagnation” – the era in which global underinvestment and excess savings forced down rates. Kaletsky, who is essentially a Keynesian economist, believes implicitly that the “natural” interest rate is that which maintains savings and investment in equilibrium. That equation did not obtain during the era of near-zero rates. Furthermore, as fears of an imminent recession lessen, so the yield curve will regain its normally positive slope and yields on longer maturity bonds will rise accordingly. In short, real interest rates will remain higher going forward than in the first decade of this century before the crash.
If this analysis is correct, it follows that bond yields have been bid down to unrealistic levels – and, as ever, there will be a correction. Investors’ notions of what is a “normal” level of interest rates have been skewed by the aberration of a decade of near-zero rates. As interest rate expectations change with the “new normal”, so the spread between short-dated and long-term bonds will be restored and the yield curve will steepen. Kaletsky points out that the premium over Fed funds offered by the 10-year Treasury bond has averaged from one to one point five percent over every business cycle since the 1950s. Even if the futures markets are correct in predicting that the Fed funds rate will fall to 3.8 percent by the end of 2024, that would imply that the 10-year Treasury might be yielding 4.8-5.3 percent – which is well above the yield prevailing yesterday of abound 4.0 percent.
The chances of a recession in the USA during 2024 appear to be falling with improving employment and income data during November and December. A “soft landing” looks quite realistic. Kaletsky reckons that investors have been taking out long positions in the bond markets as a hedge against recession risk. As that risk recedes and the likelihood of persistent inflation increases, so many of these positions will be unwound. Instead, asset mangers will want to allocate to commodities, energy, gold and cyclically sensitive assets such as emerging market equities.
How Did We Get Here?
As I have suggested in these pages before, the original aim in slashing rates to almost nothing in late 2008 and in 2009 was to save the banking system from systemic collapse by creating sufficient liquidity and to keep the inter-bank markets functioning. For several years thereafter, with banks deleveraging like crazy, the contraction of the money supply was greater than the initial programmes of money-printing by means of quantitative easing (QE). Thus, for a decade or so, very loose monetary policy did not precipitate inflation.
Then came the pandemic. Lockdowns across the world – particularly in China – caused disruption in supply chains. This led to shortages while shipping costs soared. That was simultaneous demand side push and supply side pull inflation though the central bankers, you will recall, insisted that this was “transitory”. Next, a war erupted in Europe and Europeans had to pay through the nose for gas that had previously been piped in abundant quantities from Russia. Governments which had paid people to stay at home during the pandemic now paid their gas bills to forestall hardship. The finances of nearly all European countries, which had been slowly deteriorating anyway, only worsened.
What seems most remiss is that in a country like the UK, the government made little attempt to seize the opportunity offered by near-zero interest rates to invest in infrastructure – especially nuclear energy which has steep up-front costs but which, once a plant is built, has a 30-year or more economic life with a continuous cheap energy. (OK, there was HS2 – which was misconceived from the start). Instead, the narrative of the Cameron government was all around “austerity”. And then that government was blown apart by Brexit and the UK was engulfed in five years of internecine wrangling about how to disentangle itself from Brussels – when it should have been focussing on its dismal productivity gap.
But, most of all, the lockdowns were financed by government borrowing which was paid for by magic money printed by the Bank of England. Remember the classical economists’ definition of inflation: “too much money chasing too few goods”. The scene was set. The real architects of the inflationary tsunami which crashed at the end of 2001 were the central banks themselves.
Tsunamis have ripple effects long after they have done their worst. As with Brownian motion, erratic particles continue to reverberate. And – right on cue for Anatole Kaletsky and this contrarian writer – the US inflation number was released yesterday (11 January). It showed an uptick to 3.35 percent from 3.14 percent last month. The re-routing of shipping round the Cape to avoid the Red Sea where, as we know this morning, geopolitical risk is rising exponentially, is already stimulating food price inflation in Europe and North America.
Asset managers everywhere: you have been warned.
The extraordinary public outcry and the ensuing political fallout further to ITV’s drama series Mr Bates versus the Post Office speaks volumes. It was watched by nine million people over Christmas prime time. No amount of social media chatter nor mainstream media reportage (which has been ongoing for nearly 14 years) could match the human interest story exhibited in a brilliant and carefully researched TV drama. (Toby Jones is one of our national treasures – a deeply ordinary-looking bloke with a massive screen presence. He inhabits the characters he plays). But it took the Gogglebox brigade to bring about closure to this sorry story – not the clickers. There is a lesson in there somewhere.
So, hopefully, the hundreds of Post Office managers whose lives were destroyed by that very British duo of incompetence and arrogance will now get justice. Although, I am concerned that the act of parliament proposed is quasi-unconstitutional in so far as it legitimises the ability of the legislature to overturn the decisions of the judiciary by law. That is not an ideal place to be.
But most of all I am aggrieved about the stinking “honours system” to which the British people are still subject. Third rate time servers get gongs – especially if they cross the palms of party treasurers with silver. This is unhealthy. If HM the King wants to recognise citizens who are loyal, patriotic and outstanding that is one thing – he is after all (as I was taught when I did my British Constitution A-Level back in the 70s), the “fount of all honour”. But for a woke committee to dish out medals to people whom they recognise as their own is distatsteful.
If Labour or the Lib Dems pledged to banish this feudal throw-back I might change my vote. Except that they are both led by Sirs – so they can’t.