Why Higher Interest Rates Could Fuel Inflation
News
|
Posted 21/06/2023
|
4128
With the world currently poised in a challenging economic landscape, we find ourselves diving deeper into the complex relationship between high-interest rates and high inflation. This intricacy, as presented by esteemed analyst Lyn Alden, could make an argument for maintaining a gold portfolio in the impending stagflationary conditions.
Common wisdom dictates that high-interest rates work as a deterrent to inflation. However, the reality is not that straightforward. Inflation is often a product of the growth of money supply combined with significant changes in productivity or resource abundance. High-interest rates are known to restrict bank lending and incentivise entities to hold currency, thereby slowing down the rate of money supply growth. Nonetheless, when there are large sovereign debts and deficits, high-interest rates can actually amplify deficit-driven inflation, creating a complex scenario for central banks to manage.
The current economic climate in many developed nations, including Australia, necessitates low-interest rates to prevent the exacerbation of fiscal-driven money creation. However, in an inflationary scenario where resources are constrained, low rates could lead to an overdrive in bank lending or even cause a surge in import and energy prices. This presents a precarious balance that governments and central banks must navigate.
Interestingly, when we delve into the relationship between interest rates and inflation, we find that high-interest rates, rather than always acting as an inflation deterrent, can also intensify deficit-driven inflation. This is especially evident during eras marked by large sovereign debts and deficits. In this scenario, each increase in interest rates exerts some disinflationary pressure on the private sector but also results in larger public sector deficits, pushing money into the economy. If these public sector deficits are substantial enough, high-interest rates can indeed turn out to be inflationary.
To further complicate matters, the private and public sectors react differently to interest rates. In the private sector, many homeowners and corporations possess long-term fixed debt. As more private debt matures and gets refinanced at higher rates, this will exert a disinflationary and recessionary force on the economy, especially on sectors sensitive to interest rates.
Conversely, for the public sector, about half of the federal debt is longer-term. This will continue to mature and be refinanced at higher rates, serving as an inflationary and stimulatory force on the economy. With $32 trillion in debt, sustained 4-6% interest rates could result in annual interest expenses ranging from $1.3 to $1.9 trillion as more debt matures and gets refinanced towards that level. This addition to the deficit would pour into the economy, thereby exacerbating inflation.
Consequently, we are likely to witness persistent stagflationary conditions, with two powerful forces - inflation and high-interest rates - battling against each other. At the moment, the cyclical disinflationary side is slowly gaining the upper hand, following a tightening period in 2022/2023 after the 2020/2021 period of rapid fiscal money creation.
It is within such a climate that gold may play a pivotal role in safeguarding wealth. The current economic environment underscores gold's inherent value as a hedge against inflation.
Gold has a long history of maintaining its purchasing power during inflationary periods. Over time, it has tended to increase in value in line with rises in the cost of living. As we move into an era that may witness higher rates of inflation due to the delicate dance of interest rates and fiscal policy, gold stands as a reliable safe haven for investors.
While we cannot predict with certainty the outcome of this delicate balancing act between high rates and high inflation, we can take steps to shield our portfolios from the potential impact.
REMINDER:
You can learn all about investing in gold and silver bullion in our live, interactive presentation, and have your questions answered by our experts in the Q&A session at the end. Sign up here!