CHAPTER - LOW INFLATION TRAP

This is  just one page of this website. 

A comment from a reader made in the days before people realised that Sub-Prime was not the biggest problem we have to deal with. 

Dear Edward, 
This is by far the most interesting piece that I have read so far. Indeed, the house price problem is one that governments and central banks have to grapple with, particularly the EMU countries where the financial structures are so different leading to some of the major problems in those economies. I did want to structure my PhD thesis along these lines,...

This page has now been edited as at December 5th/6th 2014. 

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This text has three parts:

  1. How the trap develops
  2. Why it is called the LOW INFATION TRAP and not the low interest rate trap
  3. A WAY TO ESCAPE FROM THE TRAP - Return to normality

1. HOW THE TRAP DEVELOPS

It could be said that this would not have happened if the Fed had not lowered interest rates as far or for as long as they did. But readers will see that the trap exists anyway - it is just not as severe in more normal times. But it is still nasty. It is all about financial instability which is built into the world's economies. It just gets worse at low rates of interest.  And if the school of thought that says we should manage money supply and keep it almost constant or rising slowly prevails, these instabilities will still be a problem. The value of money will still change and all of the instabilities linked to that will remain unless we remove them. Let me explain.

When nominal interest rates get too low, property prices swell, forcing people to borrow more if they want a house to call home. And this is not a slow process - the cost of buying a home using mortgage finance moves much too fast for a financially stable economy.

Fig 1 - Sensitivity of Loan Size and of Annual Repayment cost to interest rate changes.
Source ECD Ingram Spreadsheets for 25 year Level Payments (LP) Mortgage Model

The above table was compiled for rising interest rates, but if readers start at 7% interest and note the loan size on offer for a given income would be 46,616 (in any currency) then this increases steadily as interest rates fall, ending at 100,000 when zero interest is reached.

As people struggle to compete for a home, the more they can borrow as interest rates fall, the more they will borrow. The more that lenders can lend (according to this formula) the more they will lend. The effect on property prices will be somewhat proportionate to what people can borrow..

In a recession after the bubble has burst, as interest rates started to rise, and property prices have crashed, governments and central banks try to stimulate demand by lowering interest rates further.


But when recovery sets in, nominal interest rates start to rise. This makes the annual / monthly cost of repaying a mortgage increase dramatically – far more than the accompanying increase in average earnings, and thus much more than the percentage increase in demand related to rising incomes / earnings. This is financial instability and it is created by the way these contracts are written and the repayment levels are calculated.

Now have another look at Fig1. 

The table shows how fast repayment costs will rise as interest rates start to climb. It is unaffordable if they rise very far. And...

...when the repayment level rises this fast for such a big sector of the economy, it is diverting spending into faster mortgage repayments and slowing spending elsewhere. 

When spending patterns alter like this, an economy generally slows. Existing jobs become vulnerable in some sectors and the sectors which benefit take time to move forward.

This increased cost of the monthly repayments on mortgages also undermines property prices and the wealth that is stored there, reviving bad memories and slowing consumer spending. And it is causing a needless crisis for both  the lenders and the borrowers.

There is also the debt overhang - too many people have borrowed too much and as interest rates rise this scares them - as it should. It can take years to pay down that much debt and restore confidence in spending, or in borrowing to spend. There is such a thing as a credit cycle - people sometimes borrow more and when they have borrowed enough they start to pay down their debts. The more unstable borrowing costs are, the longer it can take for confidence in borrowing to be restored. Even if people borrow using fixed interest rates the effects on new borrowing and on property prices as interest rates recover remains a problem for the economy.

FIXED INTEREST BONDS
This worrisome scenario is further re-enforced by the effect on the value of fixed interest rate bonds. These are used as assets for all kinds of things including pension funds and reserves for banks and insurance companies and other businesses, managed funds, and people. The Financial Times published a study on this recently and another source calculated that a 1% rise in US interest rates can knock off more asset value than was lost in 2008. Here is a related post from the Cobden centre with my comment below.

Any recovery from slow growth feeds through to a raise in interest rates and a discouraging scenario that begs for a return to the prior condition of slower economic growth which is again followed by lower interest rates.

With the advent of QE (printing trillions of dollars by the Federal; Reserve Bank, and The Bank of England among others), there is nervousness about inflation taking off. It is not so much because these Reserve Banks have created all that money, it is more because, if interest rates remain low for long enough, borrowing may take off and the only way that Central Banks normally address such problems is by raising interest rates. [There are other ways which are not generally talked about: raising taxes and selling bonds].

The alternative of inaction is a high rate of inflation and a crash of the economy as interest rates are then forced to rise, taking down the value of all of the major assets in the economy.

Has no one thought that rising inflation should raise all those values not crash them down? 

That will happen eventually but why not now? Why later? Does that not tell us that there is something wrong with the pricing of these assets? There certainly is something wrong...

...Whether interest rates rise because of faster economic growth or because of higher inflation it makes no difference. The tabulation in Fig 1 shows that the sensitivity of our finances and our assets to rising interest rates is too much. Yes that is what is wrong - it is the whole loan repayment scheduling (and fixed interest bond valuation) that makes no sense. But that is what we have.

HOW MUCH TOO MUCH?

In Adam Smith’s Wealth of Nations, unlike what we are allowing to happen now, indeed forcing to happen with the debt repayment structures that we are using for all forms of debt, the increases in mortgage costs and bond servicing costs should be much more proportionate to the increased spending and increased incomes as the economy recovers. But what we have from mortgages is a disproportionate rise in costs. What we have from bonds is falling values when there should be rising values. What we have from property is falling values when there should be rising values. These responses create a negative feedback loop -  a trap which tries to prevent interest rates from rising.

In this case the feedback is the damage that any rise in the interest rate causes resulting in a wish to return to a lower rate of interest once more.  This is directly caused by the unstable behaviour of the monthly mortgage payments, and the unstable capital value behaviour of fixed interest bonds. 

The unsafe behaviour of fixed interest rate bonds whose value also rises and falls disproportionately fast as well, reduces the strength of balance sheets and pensions funds and savings. All of this makes people and institutions, including the banks and other lenders, suddenly insecure.


Fig 2 at right. Several nations have raised interest rates and suddenly reduced them again. This proves nothing but it is what we could forecast based upon the above.

Raising the interest rate by 1% in an environment where long dated bonds are offering a yield of say 2% may (in simplistic terms) halve the current capital value by doubling the yield. That is if the maturity date is very far in the future. For shorter term maturities those figures reduce but the inverse sensitivity of property and bond values to rising interest rates cannot be argued with. These values move in a contrary direction.

There is nothing like a 1% raise in National Average Earnings (NAE). leading to a 1% rise in interest rates leading to a 1% p.a. rise in debt servicing costs in response. Rising demand from rising incomes should increase all costs, values, and prices by a similar amount and definitely in the same direction. That is for sure.

What we should be doing is to use bond contracts which repay the value borrowed, not the money borrowed. 

What we should have is mortgage repayment costs and schedules which raise the cost of repayments slowly as National Average Earnings, NAE, are rising.and as interest rates consequently have to rise. The cost of the repayments can rise less slowly than NAE making it easier to repay as time passes but the cost can still rise faster or fall more slowly as the economy recovers and as NAE rises faster. This is how the ILS mortgage model works.

If Adam Smith was still alive, he would probably be thinking that he wasted his time writing about pricing. He would wonder why we use a mortgage model which behaves so differently, one in which costs rise and fall at an incredible rate. He would wonder why we use a fixed interest rate bond whose value goes down when it should go up.

These disruptive pricing and costing forces act against any economic recovery.  They make no sense but that is how things are.


2. WHY I CALLED IT THE LOW INFLATION TRAP

You may have noticed that nations that had a higher level of inflation were not hit by the same crisis in 2007/8.

When inflation rates get very low it brings interest rates down to the lowest levels.

And that is what inflated asset prices in the developed economies to this extra-ordinary extent during the early years of this century. The effect on mortgage sizes is much higher when interest rates are low. And the time taken for people's incomes to rise to catch up with any rise in mortgage repayment costs lengthens very fast at low rates of interest.

Fig 3 - Using the data in Fig 1, here is the maths of that:


The chart above shows that when interest rates rise from a low level the cost of repayments increase is much greater than when they rise from a higher level. Developed economies are the most vulnerable. 

It might be said that economies with higher rates of inflation and interest would need to raise interest rates more than those with lower rates of inflation and interest. But when it comes to one nation raising interest rates the effect on the interest rates of other nations is more or less proportionate. A 2% interest rate raise in the USA will not cause a 4% interest rate raise in another nation in response to that.

The higher interest rate starting level associated with economies that have a higher rate of increasing incomes / inflation offers them more protection. The interest rate sensitivity is less.

This link to low inflation countries being the hardest hit is not completely obvious until we look at Fig 4

Fig 4 - When inflation is low and incomes are barely rising, a jump in the cost of mortgage repayments may take many years to be equalled by pay rises.

As you move further to the right on this chart, incomes are rising faster.

Recovery times can be much faster - so fast as to avoid a major crisis.



For example, a 10% raise in the monthly / annual cost of repayments when incomes are rising at 10% p.a. takes just one typical annual pay increase to catch up.

But a 10% rise in the cost of payments due to a similar increase in interest rates for a low inflation nation where incomes are rising at 4% p.a. could take 2.5 years to catch up.

The difference is enough to explain why the developing economies were not seriously damaged.

In the case of the USA and the UK, the rate of interest for housing finance, instead of being around 7% (the predicted figure that it should be - see the page before this one on this website), it had fallen to nearer 3.5%.

The Fed had noticed that inflation was rising or was likely to rise and they raised interest rates in response to that. Because incomes were stating to rise faster than usual, I projected that interest rates will probably have to reach 8% or more to prevent inflation from gathering pace. That is what the Fed was discovering just before the crash. The assumption was that the housing sector would not crash - not my assumption, the Fed's assumption.

And it did not crash - at first. Rates started to rise in June 2004 and continued to rise in 0.25% increments until things started to fall apart in about August 2007.

Why the delay? Because their adjustable rate mortgages took three years to respond. That is about the same three years that they spent raising rates...

They increased their interest rate by 4.25% "with a little further to go" the Chairman said, thus taking rates towards 8% for housing finance.

This next chart shows how the cost of borrowing responds to that kind of increase. This chart is for 25 year loans.

It is worse for 30 year loans as used in the USA.

Fig 5 - Response to a 4.5% interest rate hike when starting from 3.5% interest.



A 50% plus in mortgage costs is way too much.

Earlier, the kind of response of house prices to that extended period of low rates of interest can be seen on this chart.

Fig 6 - The Shiller Index of USA house prices

Clearly the low rates of interest after 1999 had a significant effect on house prices. Mortgages enlarged as they became cheaper in monthly payments as per the tables above.

We can also see the jitters in the aftermath with interest rates still around their original low level of 3.5% for mortgages. In theory house prices should still be at a peak. In fact house prices are not as high but people have learned. And there is probably an over-supply of houses relative to the demand from people in a position to borrow (not as many now). People are jittery because they know what happens if prices are that high after interest rates do rise. You can see the jitters at the right hand sde of the chart.

WHAT ABOUT BONDS?

Here is a graph of how the value of fixed interest bonds change starting at the peak interest and inflation rates in 1980:

Fig 7 - Showing extreme volatility in the market value of USA Fixed Interest Bonds - (Treasuries) 1980 - 2005.


My apologies for the mess below the X-axis. They changed the way that Excel does charts and I never found out how to sort this out. Any offers? I have the data. My contact details are on the Home page along with an outline of Macro-economic Design.

This is what Fig 7 tells us: The value of an investment in USA Bonds from 1980 till 2005, (near the interest rate low point) is shown by the blue line. The value is adjusted for rising incomes. 

The trend line tells us the cost to USA tax-payers of servicing that debt. A GDP of debt in the 1980s would have been costing around 9% of GDP p.a. in interest. Say around 9% on income tax. Fortunately they were borrowing closer to half that. But it was expensive.

The cost fell to almost nothing by 2005 when inflation and interest rates were both low. The return to savers also fell to near zero.

Now imagine that interest and inflation rates reverse during the next economic recovery back to normality. Follow the reverse path...move your eyes from right to left and turn the graph upside down because Bond Values will be falling. It may not be an accurate forecast, but it gives the idea of unprecedented instability in the bond market that may come as interest rates move upwards. 

So with property values, bond values, and borrowing costs all leaping around in the wrong direction (falling instead of rising as they ought to do, and with the kind of uncertainty in values that this last graph and the property price graph shows can take place, seeing interest rates rise poses certain problems....

This kind of threat is the LOW INFLATION TRAP.

So we have a low inflation trap.

BUT THERE IS A SOLUTION.

3. RETURN TO NORMALITY

The solution is to put an end to this interest rate sensitivity in bonds and mortgage costs and then to use this to change the nature of the problem. Get costs and pricing to respond in the way that Adam Smith would have expected.

How to do this?

That is what these blogs are all about.

If we exchange fixed interest bonds for Wealth Bonds, we achieve that for government borrowing. Wealth bonds will be worth much more than fixed interest bonds because no one really knows what fixed interest bonds are worth. Wealth Bonds rise in value as incomes rise and they rise faster as incomes rise faster. That is what Adam Smith might have expected - all wealth, costs, and prices should rise if everyone has more to spend, or if not then they should be higher than they otherwise would have been.

We can change the mortgage model to the Ingram Lending and Savings (ILS) Model. These models protect both the lender and the borrower. And the costs of repayments does respond appropriately being 1% higher than it otherwise would be if National Average Earnings are 1% higher. Home prices will not crash when interest rates rise accordingly. They are likely to be 1% higher than they otherwise would be like everything else.

The contract is about how fast the wealth that has been lent is repaid. Start high and end low. That way interest rates and inflation rates do not get involved very much.

But right now property prices and mortgage sizes are inflated. We have a problem.

In order to avoid a crisis we need to keep it that way and to adjust slowly.

To keep property values high we have to keep the mortgages inflated at least until incomes rise enough to be able to cope with such large mortgages. We do not want any more sudden changes creating more shocks.

Governments can offer Wealth Bonds in exchange for Fixed Interest Bonds and thus stabilise that market and those reserve assets invested in them. Wealth Bonds are worth more than Fixed Interest Bonds because they have a known value. So they may be sold at a premium, guaranteeing the investor a known loss instead of an unknown loss. What a bargain! Well it may not feel like a whopping bargain but it is far better than riding the fixed interest bond all the way down when interest rates and/or inflation rates do rise.

Governments will need to plan a little bit about how much damage gets done by the change-over; and which people and businesses will suffer. They may want to adjust the plan a bit.

What about the inflated Equity markets? They will be more firmly based upon real prospects of long term economic growth without the usual problems. Those prices might stay inflated but with a firmer base. Owners of equities will have provided for any losses as it is in the nature of such investments and investors to do so. They are risky investments. So we need not concern ourselves as much about equities.

Macro-Economic Design also deals with currency instability and how to create money so as to avoid any repetition of these problems.

So there should be a good reason for Equity values to remain high. How high? Anyone's guess. But not falling out of the sky.

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