The developed world is much agitated by very low interest rates. So low that it is hard to imagine them declining further. This is emasculating monetary policy. These interest rates reflect a relative abundance of global savings. Hence inflation (prices rise when demand exceeds available supplies) is confidently expected to remain at very low rates. Interest rates accordingly offer compensation for expected inflation. The US bond market only offers an extra 1.56% per annum for bearing inflation risks over the next 10 years.
The US Treasury Bond Market (10-year yields – daily data)
Source: Bloomberg and Investec Wealth and Investment
Rather it is deflation — generally falling prices — that has become a threat to economic stability. When prices are expected to fall and interest rates offer no reward to lenders, cash (literally hoarded notes and coin) may be a highly desirable option. If prices are to be lower in six months than today it may make sense for firms and households to postpone spending, including on hiring labour. Hence even less spent and more saved, compounding the slow growth issue.
An economy-wide unwillingness to demand more stuff is not a normal state of economic affairs. If demand is lacking and resources — land, labour and capital — are idled for want of demand for the goods and income they could normally produce, a government and its central bank can always stimulate more spending, including its own, without any real cost to taxpayers or economic trade-offs. More demand means no output or income will be lost — rather more output will be forthcoming should demand catch up with potential supply. A win-win, as they like to say.
Most simply, spending can be encouraged by handing out money — throwing cash from the proverbial helicopter. For a government, being able to borrow for 30 years at very low interest rates is almost as inexpensive a funding method as printing money. One can confidently expect unorthodox experiments in stimulating demand should the developed economies continue to grow very slowly and interest rates and inflation remain at very low levels. Cutting taxes and funding a temporarily enlarged fiscal deficit with money or loans is another, better, option.
While the developed world struggles with low interest rates and highly subdued inflation and expectations of inflation, emerging markets present very differently. Interest rates remain persistently high, with elevated expectations of inflation (and exchange rate weakness) to come. Accordingly, interest rates, after adjusting for realised inflation, remain at high levels, as do inflation-protected interest rates.
The SA financial markets have continued to perform very much in line with other emerging financial markets.
Emerging market local currency bond yields remain elevated — above 6% per annum on average for 10-year bonds. While average bond yields have edged lower in 2019, RSA bond yields have moved higher.
RSA and EM Bond Yields (10 year)
Source: Thompson Reuters, Federal Reserve Bank of St.Louis and Investec Wealth and Investment
The market in RSA bonds is factoring in more, rather than less, inflation and a still weaker rand-dollar exchange rate.
Unlike in the developed world, the cost of capital — the required rates of real return to justify expenditure on additional plant and equipment in SA — remains highly elevated and a continued discouragement to such expenditure and to the growth outlook. Capital remains expensive for SA borrowers and growth rates remain highly subdued.
Interest rates and spreads in the SA bond market
Source: Bloomberg and Investec Wealth and Investment
More inflation expected with less inflation realised because demand has been so subdued, has been toxic medicine for the SA economy. As in the developed world, the slack in the SA economy calls for stimulation from lower interest rates. And unlike the developed there is ample scope for traditional monetary policy — that is, cutting interest rates. The inflation expected of the SA economy reflects the well understood dangers of a debt trap — and that the SA government, sometime in the future, will print money to escape its consequences.
Yet fighting these expectations, which have nothing to do with monetary policy, with austere monetary policy makes no sense. Rather it means more economic slack, less growth, a larger fiscal deficit and enhanced inflationary expectations. Eliminating slack with lower short-term interest rates would do the opposite.
• Kantor is head of the research institute at Investec Wealth & Investment. He writes in his personal capacity.
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