I receive e-mails from members occasionally and this question led to me getting a bit carried away. So I think it worth sharing how I see things for the new generation. I don’t think I simplified his advice much. LoL. Here was his question:
Thanks for all the great info you provide. I really enjoy all the commentary and analysis. My question is could you provide a basic, high school level, explanation on why raising interest in 2022 is a good thing?
I want to have this conversation with a some young men right out of highschool and I would like to see how you would explain it. I think I can do a decent enough job explaining inflation, probably using the big mac example.
But I struggle explaining why raising rates, a slowing economic growth is a good thing. Anyway just thought I’d ask for any advice.
Start off by telling them the markets are massively distorted by activist monetary policy over the last 13 years. So the starting position today is not the free markets position but the distorted one they created.
Historically, the 10-year Treasury (the main risk free yardstick) would run close to nominal GDP (real GDP + inflation). Prior to the pandemic this rate should have been 4.5% but was suppressed to under 2%. This 13 years of distortion has to be unwound to return to free market financial markets.
Tell them in the olden days when the free market set rates and they were not severely distorted by the central bank printing money out-of-thin-air to suppress interest rates…
… that free market rising interest rates signaled economic strength. The high demand for debt in a growing economy led to higher interest rates. It was declining rates that signaled economic weakness.
Probably one of the smallest factors in making business decisions are interest rates. No CEO is going to give the go-ahead just because rates are 1 or 2% less than otherwise. Long term Capital intensive business investments need to be expected to pay handsomely for the ago-ahead.
If demand is strong businesses grow their business. If demand is weak they curtail investment.
In deeply suppressed interest rate environments with weak demand and higher inflation, businesses borrow cheap to make financial speculative investments and do buybacks instead of economic investment. Buybacks are actually de-investing, not investing in the economy.
This decade of ever-increasing money printing and credit expansion with every pull back in the financial markets (not the economy) has led to excessive speculation in crazy things. These times will end one day and not in a good way.
So when I say it is good for interest rates to rise, I am for ending these times. Inflation kills the standard of living of 80% of the people while supporting the top 1%.
My complaint for the last decade or so, is that suppressing rates by 3% as they have done was taking away from savers and giving to the speculators in the form of cheap money. Pensions, life insurance, and retirees with CDs etc lost significant income they would have spent in the real economy (and no economic model accounts for this).
Pension funds that went heavy on equities early did well, but we have not experienced the full market cycle yet. Where will they end up?
Checks question again…
Real interest rates matter: real rates are nominal rates minus inflation
Real rates today are somewhere between -5% and -8% depending on your inflation measurement.
At this rate, life time savings would lose half their purchasing power in 8 years
We have been at -2% for a decade (10-year Treasury) and savings have been devalued by a third
Concept: Stock market and house market *price gains* have been pulled forward due to bubble policies.
For a high schooler, they should want a return to normalized pricing in stocks and housing over the next 5 -10 years so they can have a descent investment life.
At 3x normal prices the stock market now has a negative future return built in. My concept of pulling prices forward also means returns can be pushed back into the future. If the SP500 drops 60% in the next few years, then future returns go from -1% annualized for 10 years to 8% future returns again.
Below inflation interest rates were apart of the bubble dynamics in stocks and housing.
So normally raising rates in a slowing economy would not make sense. But inflation is more dangerous in that it destroys the value of money. Then again it makes old debt cheaper if the dollar is devalued. This is the battle today. Devaluing debt or devaluing standard of living for Americans. The ruling 1% want to devalue their debt without too much inflation…
Paul Volcker battled inflation in the 1980s by forcing rates up to 20% to create back-to-back recessions to kill inflation and save the dollar. He is hailed as the best central banker ever. But the US was a credit nation then and not a debtor. Hmm.
They will try to balance their response today. They want to bring inflation down as much as possible and a minor recession may be required. The stock market froth coming off would slow spending in the top 10% of America. I think they will let this happen in 2022.
Fixing (by investing) in global supply chains will relieve supply issues. Less stimulus checks for people will slow demand – but they are going to cut significantly in 2022 without BBB.
The media will talk about the decline in corporate earnings in 2022 over the stimulus boosted earnings of 2020 & 2021. The media will report a soft economy due to pulling back from massive govt deficits of 2020 & 2021. Let the High Schoolers know the President is not responsible for inflation, the economy or inflation as voters assume. Presidents are given credit or blamed for years of prior decisions.
Tell the high schoolers I want what is best for their future and my sons. I want the Federal Reserve to end their 13 years of extreme emergency monetary policy and allow rates to rise by stop printing money to buy Treasuries and Mortgages. This will be the beginning of returning to free markets, but it will take time.
I do not want them to do it cold Turkey. I do want deficit spending for the purpose of growing demand in the economy after the supply issues are fixed. I do not want them to print to bail out wall street and suppress interest rates.
The stock market needs to fall 60-70% relative to corporate revenue. The bond market will lose principle as rates rise. Home prices will be suppressed for the next decade if they normalize policy.
For high schoolers, gaining good skills to replace the retiring boomers will lead to good incomes once again. It does not have to be college. There is a massive shortage of skilled labor in electrical, plumbing, and the new technologies. Wages will bounce back after being suppressed for the last few decades.
I expect they will do well if our policy makers return to free market Capitalism for the Financial Economy. If not, buckle up.
PS. I kind of got carried away.