Ignacio de la Torre. Professor. IE Business School
18 May 2016
There are currently a series of financial aberrations in existence, such as the fact that there are ten billions’ worth of bonds at negative rates or that the Spanish treasury is financing itself at rates lower than in the United States, which point to a rise in interest rates in the near future.
In the Gospel of Saint Luke, Jesús encourages his disciples to spread the world about lending money without interest: “Ask nothing in return”, a maxim previously proposed by Aristotle, and that was the basis of the Christian Church’s ban on usury until the middle of the 13th century. Even today, Islam prohibits charging interest on loans.
Perhaps as a result of the 2008 crisis, over recent years the West seems to have gravitated toward the Gospel, with close-to zero interest rates in Japan, the United States and Europe. In my opinion, this idyllic situation is coming to an end, with enormous consequences for all.
A worrying phenomenon can be seen in the United States: inflation is rising as a result of the progressive increase in salaries, which is hardly surprising in a country with virtually no unemployment. Underlying inflation has already surpassed the 2% objective set by the Fed, and salaries are already growing by 2.4%, which foreshadows further price rises, given that labor costs make up two thirds of all outgoings for a business. If they have to pay their workers more, companies will try to protect their margins by hiking the price of their products and services.
This situation will continue, given that there are more than five million empty job positions in the country, the largest number in its history, and like any other market, greater demand than supply means higher prices, in this case salaries. The Fed has no choice but to act: it will raise interest rates sooner and more sharply than the rate at which future money is discounted. As the data for the second quarter show economic improvements (year-on-year growth in the second quarter could triple that of the first quarter), the balance of forces in the committee that decides on US interest rates (the FOMC) will change, which will lead to higher rates than previously expected.
The eurozone economy has grown twice the expected rate in the first quarter: 0.6% against 0.35%). This means we have already recovered pre-crisis production levels and the European economy is now growing more than that of the United States. Credit is flowing, and that’s not all: the total credit stock has been on the rise for the last few months, both in homes and in businesses, which can only be explained by improved financial supply and demand. At the same time, the most sensitive element in explaining monetary growth (M1), is growing at a healthy 10% (twice as fast as that of the United States).
As a result, underlying inflation, which hit a low of around 0.3%, has shown a progressive increase of between 0.8% and 1% (it’s higher in Germany and Spain), and will continue to rise as unemployment falls and wages rise. What’s more, the banks will not manage to make the profits they need to cover their capital costs, which will prevent them from raising their own new funds, something that for some inexplicable reason, is pushing the ECB to capitalize European banking.
As a result, the economy improves, there is more credit, unemployment falls, and underlying prices rise. Does this make sense when interest rates are zero and some €80 billion is being created each month? I would say not: five years ago, under the same circumstances, the ECB raised interest rates. In my opinion, this incoherence, which is increasingly manifesting itself in Germany, will spread in the autumn (especially when oil no longer affects the consumer price index negatively), and the debate about whether the ECB should change its monetary policy will prompt a storm in the bond markets, which will lead to higher interest rates.
At the same time, the situation in Japan reveals the limits of monetary policy. Despite having more than tripled its balance in a huge exercise of quantitative easing, the Japanese economy has barely grown. Quantitative easing doesn't work when an economy loses one million workers a year. The decision taken at the most recent meeting of the ECB to increase quantitative easing surprised the markets, which should give us pause for thought. On the one hand, the emerging bloc should lower interest rates in the face of an economic storm. That said, central banks in countries like Colombia, Brazil, Nigeria, Egypt, South Africa and Peru are raising interest rates because the collapse of their currencies has encouraged inflation. Finally, China, seems to be showing signs of a change in monetary policy by limiting the massive injections of money that can create so much damage in the medium term.
We should not forget that we don't just live in times of zero interest rates, but in a world in which the main central banks have embarked on a historic process of printing new money. The Fed, the Bank of Japan and the Bank of England have tripled their balance, while the ECB has doubled it, and the Swiss central banks has increased it sixfold. The result is all kinds of financial aberrations such as ten billion Spanish negative yield bonds, or Ireland issuing 100-year bonds at 2%, or the Spanish treasury financing itself at rates lower than in the United States.
This is a huge financial bubble that is deflating rapidly as interest rates rise. The repercussions will be enormous. When interest rates go up, share prices fall, something that will affect the markets, financial and otherwise. On the other hand, people who want to transfer their mortgage to a fixed rate should do so before the summer, and those with mortgages of more than five years at a variable rate should reconsider. Finally, the emerging countries and commodity prices will suffer greatly when interest rates do begin to rise.
History exists from the moment it is written down. We have documents detailing loans starting from Babylon, more than 2,000 years before Christ. There are others from throughout the ancient world, and on up to modern times. If you chart interest rates over the last 5,000 years you will see that today we have the lowest interest rates of all time.
For better or worse, interest rates will rise sooner than many people think, distancing us from the Gospel and bringing us closer to the teachings of history… what goes around comes around.