My thoughts on low interest rates / monetary policy

Hi guys,

in order to straighten my thoughts on monetary policy and when interest rates could rise, I have tried to write down my current mental model.

I am obviously no economist. Any feedback would be highly appreciated.

Fundamental hypothesis

My fundamental hypothesis is that interest rates have not been so low, because they need to be so low (as stimulus was required post financial- / euro-crisis), but rather that they have been so low, because the central banks can afford to keep them so low (in a low inflation environment).

Both fed and ECB are required to keep inflation in check. In a time of global deflationary pressure (more on this below), the central banks are able to keep interest rates extremely low without causing inflation rates above the target rate of 2%. So, providing stimulus is like a free lunch (at the moment) and an obvious thing to do for central banks.

I believe this may change rapidly if global deflationary pressures reduce and we see real inflation again. In this logic the question of when interest rates will rise is a question of what is causing global deflationary tendencies and when this will change.

What is causing low inflation?

I am still forming a solid mental model of this, but my current mental model is that there are three main (and interconnected) components:

1) Globalization has led to a more “efficient” division of labour and 100s of millions of low cost workers joining the global value chain, leading to lower production cost for many products (especially consumer goods).

2) Digitalization and automation have made the production of many products much cheaper than this was historically possible. E.g. advanced technology is helping farmers reduce waste and produce more product with less resources.

3) Western working class wages have grown significantly slower than the economy. As working class wages are growing slowly (or shrinking) they are not creating upward price pressure.

It is hard to say what the relative weight of the individual components is (especially since they are interconnected).

My outlook on these factors

1) I believe globalization is in early maturity (to use the technology adoption life cycle) and will there fore have slowing deflationary impact going forward. We are also seeing anti-globalization / anti- free trade movements globally. Only to name the US.
Despite China and the EU growing their number of free trade efforts, I would expect this deflationary pressure to slow or even reverse. Especially in the US, I expect a significant increase in inflationary pressure as free trade agreements are not signed and de facto customs duties charged via the new tax legislation.

2) I expect technological progress to continue and that this will continue to be a very strong deflationary pressure. Although higher costs of capital (e.g. through rising interest rates) may reduce the capital inflows into tech development (namely VC funding reducing as investors would be able to produce returns in traditional industries if interest rates rise). My fundamental believe is that this development is predominantly due to growing computing power / capacity and that what we are seeing is still the early days. (e.g. the broad adoption of machine learning is likely to lead to massive new break throughs in agriculture, medical research et al over the next 20 years.)

3) From a policy perspective I expect a bigger focus on raising wages for lower income families across the EU at least (I don’t understand other markets well enough to judge). I believe this has been identified by traditional parties as a key way to try and beat the alt right movements.

So in sum we get a mixed outlook, depending on how you value the components.

My prediction

My outlook is that we may see rising interest rates in the US in 2018 and no immediate rises in the EU (wage increases will take time to materialize). Although rising interest rates in the US will probably create a delayed knock-on effect in the EU.

What do you guys think? (This is not a rhetorical question – I am looking forward to hear your thoughts).

Leave a Reply

Your email address will not be published. Required fields are marked *