It Starts With Inflation: How Inflation, Interest Rates, Markets, and Economic Growth Relate to Each Other and What That Means for What's Ahead

In this post a) I will very briefly explain how I believe the economic machine that determines inflation, interest rates, market prices, and economic growth rates works, and b) work with you to apply current circumstances to that machine to come up with our expectations for the future.  

How It Works

Over the long term, living standards rise because of people inventing ways to get more value out of a day's work. We call this productivity. The ups and downs around that uptrend are mostly due to money and credit cycles that drive interest rates, other markets, economic growth, and inflation. All things being equal, when money and credit growth are strong, demand and economic growth are strong, unemployment declines, and all that produces higher inflation. When the opposite is true, the opposite happens. Most everyone agrees—most importantly the central bankers who determine the amount of money and credit available in reserve currency countries—that having the highest rate of economic growth and lowest unemployment rate possible is good as long as it doesn't produce undesirable inflation. What rate of inflation is undesirable? It's a rate that creates undesirable effects on productivity; most people agree and central banks agree that it's about two percent for reasons that I won't now digress into. So, most everyone and most central banks want strong growth and low unemployment on the one hand, and the desired inflation rate on the other. Since strong growth and low unemployment raise inflation, the central banks deal with the inflation-growth trade-off which leads them to pick the greater problem and change monetary policy to minimize it at the expense of the other. In other words, when inflation is high (above 2 percent), they tighten monetary policy and weaken the economy to bring it down. The higher the rate is above their target, the more they tighten.

With inflation well above what people and central banks want (e.g. today’s CPI report showed a monthly change in the core CPI of 0.6 percent, which equates to an annualized rate of 7.4 percent) and the unemployment rate low (3.7 percent), it's obvious that inflation is the targeted problem, so it’s obvious that the central banks should tighten monetary policy. Everything will flow from that. Tell me what the inflation rate will be down the road without the central bank pushing interest rates and money and credit growth rates around and I can pretty much tell you what will happen. 

So the process starts with inflation. Then it goes to interest rates, then to other markets, and then to the economy. 

It starts with inflation. Since the price of anything is equal to the amount of money and credit spent on it divided by the quantity of it sold, the change in prices i.e., inflation is equal to the change in the amount of money and credit spent on goods and services divided by the change in the quantities of goods and services sold. This is primarily determined by the amount of money and credit and the level of interest rates that the central bank makes available, though it will also be influenced by the supplies of goods and services available e.g., supply disruptions. 

Then it goes to interest rates. Central banks determine the amount of money and credit that is available to be spent. They do that by setting interest rates and buying and selling debt assets with money they print e.g., quantitative easing and quantitative tightening. Interest rates relative to inflation rates i.e., real interest rates have a big effect.

Then it goes to other markets.  Interest rates rising relative to inflation causes prices of equities, equity-like markets, and most income-producing assets to go down because of a) the negative effects it has on incomes, b) the need for asset prices to go down to provide competitive returns i.e., “the present value effect”, and c) the fact that there is less money and credit available to buy those investment assets. Also, because investors know that these things happening will slow growth in earnings, that will also be reflected in the prices of investment assets, which affects the economy. 

Then it goes to the economy.  When central banks create low interest rates relative to inflation rates and when they make plenty of credit available, they encourage a) borrowing and spending and b) the selling of debt assets e.g., bonds by investors and the buying of inflation-hedge assets, which accelerates economic growth and raises inflation (especially when there is little ability for the quantity of goods and services to be increased). And, of course, the reverse is true i.e., when they make high interest rates relative to inflation and make the supply of money and credit tight, they have the reverse effect. 

Where these things settle will be around the levels that are most tolerable, all things considered i.e., if one thing is intolerable e.g., too high inflation, too weak economic growth, etc. it will be targeted by central bankers to be changed, policies will be changed, and other things will change to bring that about. So, the process of figuring out what will happen is an iterative process, like solving a simultaneous equation optimizing for a few things that matter most. 

Applying This to What's Now Happening

Now, let's look at what that means for inflation, interest rates, the markets, and the economy. By plugging in our estimates of the determinants, we can estimate the outcomes. 

As explained, it starts with what the inflation rate will be. Pick your number based on what you can see ahead. Right now, the markets are discounting inflation over the next 10 years of 2.6 percent in the US. My guesstimate is that it will be around 4.5 percent to 5 percent long term, barring shocks (e.g., worsening economic wars in Europe and Asia, or more droughts and floods) and significantly higher with shocks. In the near term, I expect inflation will fall slightly as past shocks resolve for some items (e.g., energy) and then will trend back up towards 4.5 percent to 5 percent over the medium term. I won't take you through how I arrived at that estimate (which I'm very uncertain about) because that would take too long. What's your guesstimate? Write it down.

Next, we need to guesstimate what interest rates will be relative to inflation. Right now, the markets are discounting 1.0 percent for the next 10 years. That's a relatively low real yield compared to what it has been over the long-term and a modestly high real rate given the recent past. What is your guesstimate? My guesstimate, based on the amount of debt assets and liabilities outstanding, what the debt service costs would be for debtors, and what the real returns would mean for creditors, is for a real interest rate of between zero and one percent because that would be relatively high, but tolerable, for debtors and relatively low, but tolerable, for creditors. 

Put the inflation estimate and the real rate estimate together and you will have your projected bond yield. If you want to estimate the short rate, decide what you think the yield curve will look like. What's your guesstimate? Mine is that the yield curve will be relatively flat until there is an unacceptable negative effect on the economy. Given my guesstimates about inflation and real yields, I come up with between 4.5 and 6 percent in both long and short rates. However, because I think that the higher end of this range would be intolerably bad for debtors, markets, and the economy, I'm guesstimating that the Fed will be easier than that (though 4.5 percent is probably too easy).

While interest rates and credit availability will be influenced by what I just mentioned, simultaneously there is the supply and demand effect on interest rates that results from how much borrowing and how much lending there is. For example, the US government is going to have to sell a lot of debt to fund the deficit (4-5 percent of GDP this year) and the Federal Reserve is also going to sell (and let roll off) a lot (~4 percent of GDP). So the question is where the demand to buy this big supply (8-9 percent of GDP) will come from, or how much will interest rates have to rise to reduce private sector credit demand to balance the supply and demand. What do you think? I think it looks like interest rates will have to rise a lot (toward the higher end of the 4.5 to 6 percent range) and a significant fall in private credit that will curtail spending. This will bring private sector credit growth down, which will bring private sector spending and, hence, the economy down with it. 

Now, we can estimate what that rise in rates will mean for market prices and economic growth. The rise in interest rates will have two types of negative effects on asset prices: 1) the present value discount rate and 2) the decline in incomes produced by assets because of the weaker economy. We have to look at both. What are your estimates for these? I estimate that a rise in rates from where they are to about 4.5 percent will produce about a 20 percent negative impact on equity prices (on average, though greater for longer duration assets and less for shorter duration ones) based on the present value discount effect and about a 10 percent negative impact from declining incomes.

Now we can estimate what the fall in markets will mean for the economy i.e., the "wealth effect." When people lose money, they become cautious, and lenders are more cautious in lending to them, so they spend less. My guesstimate that a significant economic contraction will be required, but it will take a while to happen because cash levels and wealth levels are now relatively high, so they can be used to support spending until they are drawn down. We are now seeing that happen. For example, while we are seeing a significant weakening in the interest rate and debt dependent sectors like housing, we are still seeing relatively strong consumption spending and employment.

The upshot is that it looks likely to me that the inflation rate will stay significantly above what people and the Fed want it to be (while the year-over-year inflation rate will fall), that interest rates will go up, that other markets will go down, and that the economy will be weaker than expected, and that is without consideration given to the worsening trends in internal and external conflicts and their effects.