Want long-term inflation? Raise rates, now

janet_yellen_official_federal_reserve_portrait
Credit: Wikipedia

Central banks across the world have been trying to reignite inflation by injecting a massive amount of liquidity and buying financial instruments, most recently corporate bonds. In theory, a higher supply of money should devalue the currency, thus boosting both exports and domestic demand. In particular, demand translates into more investment, which is a necessary cornerstone for long-term growth. Needless to say, this classic monetary tool has been more than widely used over the last few months. But the target remains out of reach in many countries. Despite more than $1tn of debt now yielding negative interest rates, inflation barely climbed to 0.6% in the UK. The US Fed is considering raising interest rates again although inflation in the US is 2.2% and thus barely exceeds the official 2% target.

Credit: Getty Images
Credit: Getty Images

I have already highlighted in this blog the importance of confidence in driving the decision of individuals. When people are confident about the future (i.e. they can predict with relative certainty the future state of the economy and the implication for their personal wealth) they do not hesitate to invest part of their income in ‘non-vital goods and services’ such as domestic appliances, automotive etc. The same logic applies to companies – this is what we call investment. Today’s environment largely lacks visibility. Geopolitical concerns (elections in the US, France and Germany, Brexit in the UK, tensions in the Middle East) make economic decisions even harder to predict. As a consequence, despite the affordability of debt, households and companies prefer to save today in case the situation gets tougher tomorrow. The resulting drop in demand has been widely pointed out as a cause for low inflation or potentially deflation in some areas (e.g. food in the UK).

Not only are hyper-low interest rates inefficient, they are counterproductive, and central banks should raise interest rates as early as feasible. Let me explain. The excessive amount of non-invested liquidity has led individuals and companies to invest in financial assets such as bonds or funds. Venture capital funds have been particularly in demand given their risk-reward profile; they tend to be more risky than ‘plain LBO’ funds and according to theory should yield better expected returns. Unsurprisingly E&Y in its latest global venture capital trends report states that venture capital deal activity increased by 54% in 2015 to reach $148bn.

Flooded with liquidity venture capitalists are begging for start-up ideas to invest their money – given that the worst scenario for an asset manager is to show his investors that their commitments are sleeping at the bank. The number of start-ups has been logically soaring in all developed economies as a result, sometimes giving birth to incubators, the most famous certainly being Rocket Internet, and a few have been raising tens or even hundreds of millions of dollars to boost their development.

In the 2.0 economy, where marginal costs are almost non-existent and barriers to entry are low, ‘customer acquisition’ and ‘network effect’ are the new mantras. Rather than investing in expensive marketing campaigns, start-ups have decided to invest in prices, most often selling their services at a loss to ensure maximal penetration. Uber is a good example. Rides in London are on average 30% cheaper than a black cab. The company is present in more than 500 cities and has been valued at $68bn in its latest fundraising round completed last year. And yet, Uber reported $1.2bn in losses in H1 2016 – this raises a broader debate about the criteria for start-up valuation, which we will address in a later post.

Credits: bpplan.com
Credits: bpplan.com

Private investors have shown patience so far, hoping that the ‘hockey stick’ will materialise. And if it does not, investors often believe that it is simply due to a lack of scale and that further investment is required to ensure the user base is large enough to prove profitable. The stock market, conversely, has been indifferent to this thesis and very few start-ups have succeeded to make a strong enough profit to reach the IPO stage – a feature that differs from the 2000 ‘dot-com’ bubble.

Exit of VC deals: IPO vs. M&A (value in $bn). Source: E&Y.
Exit of VC deals: IPO vs. M&A (value in $bn). Source: E&Y.

My point is that for months now many aspects of our daily life have been ‘subsidised’ by increasingly risk-seeking venture capitalists and that behaviour has largely been driven by the abnormally high amounts of liquidity made available by Central Banks. Paradoxically, these start-ups have most often been bringing down prices and ultimately favouring deflation, pushing Central Banks further away from their initial objective. I am not saying that price cuts are always bad. But in this case price cuts have only come at the cost of corporate losses – simply put: value destruction.

The argument about the ‘hunt for worldwide scale’ is dubious. Although this hunt is legitimate in a limited number of cases (social networks represent the most typical examples), entering new markets brings limited benefits to most start-ups. When Uber decides to enter Santiago, it cannot rely on network effect: the taxi drivers operating in Santiago are different from the ones in Singapore and the customer base is also very distinct. Given the very lean cost base, the only synergy it can expect is the brand power – which may not justify hundreds of millions of dollars of losses. And, even if you do so, you cannot prevent an aggressive competitor to emerge with even lower prices – only the depth of the investors’ pockets will make the difference.

My recommandation to Central Bank governors is thus simple: raise interest rates and clean up the mess. We will not find growth by artificially subsidising value-destructing activities. The fear of the next crisis and the willingness to avoid recession at all costs are leaving everyone in doubt. Take the hit, start from a fresh and economically sane breeding-ground and build again from there.

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Credit: www.ericnguyen23.com

Brexit – 9 (almost) inexorable consequences

Waving United Kingdom and European Union FlagLast Thursday British people decided to take their country away from the EU. No one knows (yet) how the economic relationship between those two areas will be shaped in the future – for those interested a governmental paper outlines the existing precedents in a very clear and interesting way.

In the meantime, looking at the market reaction, the situation has been seemingly well handled so far and stakeholders believe in a smooth transition rather than an abrupt ending. The CBOE Volatility Index, better known as ‘VIX’ or ‘fear index’, has reached levels which can be considered as modest relative to the ones witnessed in 2008 and is already on a downward trend. As I am writing those words the FTSE 100 is only 3.1% down compared with the 23/06 close and the pound has weakened but not collapsed against other major currencies.

Year-high levels reached by the VIX since 2000. Sources: Yahoo Finance, author analysis.
Year-high levels reached by the VIX since 2000. Sources: Yahoo Finance, author analysis.

In the long-term, however, the usual macroeconomic mechanisms will start acting – some of them are already noticeable. I do not have a crystal ball to tell you when and to which extent those trends will manifest themselves – and the ‘2-year window’ the UK benefits from after triggering article 50 adds to that uncertainty. Other future events could also change the course of action. This list of 9 items has therefore been prepared with the information made publicly available and the convictions I have at the time I write those lines. All in all, though, the picture looks relatively grim and one could fear that the UK is now sitting on a potential economic timebomb.

Credits: http://www.mattgoodwinlaw.com/
Credits: www.mattgoodwinlaw.com
  1. A weakened pound and potentially higher trade barriers will lift inflation. Goods and services from abroad will mechanically become more expensive once their price is translated into pounds – a phenomenon economists call ‘imported inflation’. On top of that, the UK has been enjoying non-existent or low trade barriers, both within and outside the EU,  and it is unlikely that it will be able to negotiate the same terms on its own. Higher trade barriers increase the ‘total cost of purchase’ and therefore inflation.
  2. Lower confidence will weight on growth. The uncertain period we are entering is reinforcing the anxiety-provoking environment in which the developed economies have been living in over the last few months. As a consequence, individuals are likely to save more and consume less and companies are tempted to defer non-essential investments. Thinner money flows ultimately impact GDP.
  3. Interest rates will rise, all other things remaining equal. The UK’s financial strength will decline as it leaves the EU – Standard & Poor’s has already downgraded the country’s credit rating to reflect this point. A weaker credit rating and creditworthiness translates into higher interest rates to reflect a higher probability of default (‘country risk’). I insist on the fact that this is the case all other things remaining equal since we will see later that the Bank of England is likely to have the final word through the benchmark rate.
  4. Rising trade barriers will mitigate the stimulating impact of currency devaluation. Usually, a currency devaluation means that exports are cheaper and therefore more in-demand all other things remaining equal. In our case nonetheless, and as highlighted in point 1, the devaluation comes jointly with an increase in trade barriers that will make exports ‘less more competitive’ than expected. As a result, it is possible that the currency devaluation triggers inflation (as pointed out in 1) without significantly reigniting the economic engine.
  5. There will be a few winners… Companies bearing costs in pounds but selling a large share of their products abroad will benefit from the currency devaluation. The Wall Street Journal mentions Diageo – whose product lines include Scottish whiskey – and pharma behemoths such as AstraZeneca and GSK – whose staff is largely headquartered in the UK while benefiting from a very global sales footprint. Again, this assumes no significant long-term change in the UK’s custom tariffs and policy.
  6. … but there will be many losers: Conversely companies manufacturing goods or providing services with a non-sterling cost base and then selling them in the UK will be negatively affected by the situation. Airlines are a typical example : costs are very often expressed in dollars but tickets are sold in local currencies. Banks got affected since they will not be able to enjoy their ‘passporting‘ right once the UK has exited the EU.
  7. Homeowners may have difficult nights ahead: After several years of continuous (and sometimes impressive) growth, housing prices are likely to flatten or even drop. Several corporations, primarily banks, are thinking about moving part of their operations outside of the UK. This move would impact the demand for housing and thus prices. On top of that, without Central Bank intervention, interest rates are likely to rise, negatively impacting the purchasing power of prospective buyers – and raising the burden on mortgage owners. Homeowners with recent mortgages living in areas where the drop in demand will be the most significant could end up in a ‘negative equity’ situation – a theoretical case where the sale of the house would not be enough to repay the mortgage.
  8. Mark Carney, Governor of the Bank of England
    Mark Carney, Governor of the Bank of England

    The situation will create monetary… We have seen that the Brexit could lead the UK into a period of ‘stagflation’, i.e. inflation with limited economic growth. The Bank of England could use monetary policy to either fight against inflation (by increasing benchmark rates) or stimulate growth (by decreasing the same rates). Whereas in the Eurozone the ECB has a clear mandate to focus solely on inflation (I am not saying that this is an optimal solution), the BoE has both growth and inflation management within its remit and will have to make a trade-off. The Telegraph indicates that growth may prevail as the market is not expecting any interest rate rise before 2020.

chart
Source: The Telegraph
George Osborne, (future ex?) Chancellor of the Exchequer
George Osborne, (future ex?) Chancellor of the Exchequer

9. … and fiscal dilemmas. Separately, the government will also have a difficult fiscal decision to make. With tax receipts dropping due to the lower activity, shall it aim for more austerity (and the political consequences attached) or for a fiscal stimulus? In any case, the fiscal and monetary policies will have to be fully aligned to avoid being trapped in the ‘worst of both worlds’ – a situation that some countries are currently facing.

Again, this is based on the assumptions that economic actors keep behaving rationally. Market volatility in the medium-term will indeed be driven less by the outcome of the negotiations than by the way they progress.

The 3 macroeconomic equations underpinning the theory behind this post's thinking.
The 3 macroeconomic equations underpinning the theory behind this post’s thinking. Sorry, couldn’t help myself.

Watch the step – Paradigm shift ahead

Have you fastened your seat belt?
Have you fastened your seat belt?

Last week the IMF downgraded its global growth forecast for 2016 to 3.4%. Among the developed economies, only the US and the UK show encouraging signs, with forecast growth of around 2.4% for this year. Growth remains limited despite abnormally low interest rates and a debt stock only seen in a WW2 context which low inflation cannot clear. Such a sequence of bad news could trigger only one question: is the ‘crisis’ back?

Advanced economies' debt amount as share of GDP. Source: Le Figaro.
Advanced economies’ debt amount as share of GDP. Source: Le Figaro.

The commodity price drop witnessed at the beginning of the year has taken its toll on the lending and bond side. 46 corporate borrowers have already defaulted on a total of $50bn of debt so far this year. According to the Financial Times, more than 80% of investors expect the default rate on junk-rated companies to reach at least 5% by year-end. This has already caused the liquidity on the bond markets to dry up, practically barring the weakest companies from accessing fresh capital inflows. Private equity sponsors, which are well known for making highly-leveraged acquisitions, have seen the default rate for their leveraged loans go from 0.88% on 31 January to 1.46% as of 31 March. Again, this tightness happens at a time of very affordable debt, which can make us fear the time when Central Banks will sketch a move back towards positive interest rates territory. At a country level, lending from the World Bank has reached its highest level since the aftermath of the 2008 financial crisis. “It is our highest lending in a non-crisis period ever” added the World Bank’s president. If we are not in a crisis then where are we?

What is certain is that the root causes have been identified for months: “sluggish capital investment, falling industrial production and declining business confidence” which partly feed themselves from geopolitical uncertainties (Brexit currently topping the agenda) and a lack of politically supported structural reforms – on the latter, we cannot blame politicians for favouring electorate-friendly measures over high-risk initiatives one year before reelection time.

Three leaders that put their job back in play in 2016 and 2017
Three leaders who will have put their job back in play by 2017

To solve these issues, all only have one word to say: ‘GROWTH’. The IMF estimates that one additional point of growth would enable the advanced economies to bring their indebtedness ratio to pre-crisis levels. But experts strongly diverge on practical ways to get hold of this extra growth.

Although many lights are red-flashing on the world economy dashboard, I agree with IMF’s Jose Vinals and I do not believe we are heading towards a ‘sudden’ crisis of the type we faced in 2007-2008. I nonetheless think that we are entering a world where low growth and low inflation will become the new norm –

Olivier Blanchard
Olivier Blanchard

former IMF Chief Economist Olivier Blanchard writes about a ‘weak recovery‘ situation. Once decision makers and Central Banks will have realised that achieving 2% of inflation annually is not realistic in a world where innovation builds on limited capital accumulation, where disruption takes place through not only better features but also lower prices and therefore drag inflation down (take the example of Airbnb or Uber) and where 5 out of 10 America’s fastest growing jobs pay less than $25k a year, the money tap will stop running, there will undoubtedly be a few winners but many more clear losers. And the interest rise wall can be closer than we think: in the video below, US Federal Reserve Chair Janet Yellen justified the December 2015 rate increase by the fact that labour statistics were positive – still the case as the US is experiencing its longest-ever streak of private sector job growth ever – and that “the Federal Reserve was feeling reasonably confident in the fact that inflation would move up over the medium-term back to 2%” – i.e. there is no need for inflation to reach 2% for rates to go up again.

The big question is now if the paradigm shift happens, how will it do so, and which target will Central Banks will be asked to go for. A brand new uncharted territory for the economic theory to discover.

On red boxes and helicopters

George Osborne
George Osborne and his case

George Osborne, the Chancellor of the Exchequer, will present the next Government’s budget tomorrow. Although it is not official yet, this year’s Budget has already triggered a general outcry given the various alleged tax increases that have emerged in the press, including an increase in fuel duty, and has raised fears about the return of ‘austerity policies’ – which Mr. Osborne’s interview video below will not alleviate. We will have the opportunity to discuss the key measures once they have been made official. In the meantime this post presents the difficult conundrum Mr. Osborne has to confront.

Firstly, Mr. Osborne bets a large chunk of his political credibility on this budget. After hinting a fiscal surplus – a result that has rarely been achieved in the past -, boosted by promising economic prospects in sight, the Chancellor got caught by the real world and a disappointing economic recovery in the UK, whose 2015 GDP has been revised downwards by £18bn in December 2015. And yet, an apathetic economic activity translates into lower tax receipts for the government – up to £50bn over the course of the parliament. In order to partly offset this unexpected ‘black hole’, Mr. Osborne has to rely on a mix of public spending cuts and tax increases. The first lever will consist of “50p [of cuts] from every £100 the government spends” by 2020. The second lever will be further detailed tomorrow but, beyond the fuel duty increase we mentioned above, tax on insurance premiums and banks are also on the agenda. Mr. Osborne nonetheless proved his political instinct by softening the bitter pill with an announced reduction in income tax – the most visible and universal

Historical UK general government deficit as a percentage of GDP. Source: ONS.
Historical UK general government deficit as a percentage of GDP.
Source: ONS.
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Credits: www.abceconomics.com

Secondly, the looming Brexit threat adds uncertainty to the state of the UK economy at least for the year to come. In the short-term, this uncertainty translates into deferred investment decisions (‘sit and wait’) and ties the hands of the Chancellor, who has been publicly urged by David Cameron not to do anything that could complicate the referendum campaign. This phenomenon would however become marginal if the country decided to leave the EU. In that case, there is little doubt that the road to a fiscal surplus would significantly steepen.

Credits: www.moneymetals.com
Credits: www.moneymetals.com

Lastly, this political stance is challengeable from an economic perspective. Central Banks have struggled to revive inflation despite injecting thousands of billions of pounds/euros/dollars in the economy. The result has been mixed to say the least – inflation in 2015 in the UK will end up close to 0% – and has conducted some economists to bring the notion of ‘helicopter dropback in the spotlight. This measure consists in giving money directly to households in an attempt to encourage private spending. This decision would be a sensible way for the ‘fiscal stimulus’ to reach individuals, given that, as accurately diagnosed by Joseph Stiglitz, banks prefer to leave cheap money sleeping on their accounts – even if it means paying for it – and that companies have benefited from the low interest rates to buy financial assets – including their own shares – instead of investing.

Are helicopter drops the ultimate solution? They could be, provided that households are confident in the future enough to spend part of this gift rather than piling cash in the bank. By putting ‘skin in the game’ itself, the State could facilitate individual decision-making by highlighting trustworthy investments. Higher taxes – leading to lower disposable income – and lower public spending both go in the other direction.

Unfortunately, as we see today, the political agenda is too much focused on short-term deficits to account for longer-term economic benefits. This difficult (and inefficient) trade-off could have been avoided, at least partly, if governments had been bold enough to implement structural cost-cutting reforms in good times. This has not been the case, as the chart below shows. Another thing to think about for the Maastricht Treaty advocates.

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Correlation between UK GDP growth and UK budget deficit as % of GDP. Sources: ONS, World Bank.

To understand what will happen tomorrow you can watch the video below extracted from the UK Parliament website.

Update (16/03): The US banking industry body called for a rate rise yesterday, arguing that the key root cause of the current poor economic conditions was more the lack of business confidence than the availability of funding.