Interest in interest rates
The major news story on markets this week was the US Federal Reserve (central bank) indicating the possibility of an interest rate increase in June. An increase would be dependent on economic data released in advance of their next meeting, and on other developments and their associated impact (e.g. the Brexit vote).
Recent US economic data have been quite buoyant (for example, employment and consumer spending), but not consistently so.
In response, the market had an "ah ha" moment, changing the assumption that rates would not be increased until later in the year (as evidenced by the rapid yield increase of US Treasuries subsequent to the release). It is now apparent that the US Federal Reserve wants to get on with progressively normalising rates - but in a manner that the US economy can tolerate.
This development provides two main thoughts:
1. What is the current inflationary environment?
In one word - benign. Well, in the developing world it is mostly benign. However, there are certain countries where inflation is anything but benign - e.g. Venezuela also in the news this week.
Fears about the inflationary impact of the GFC-driven quantitative easing programs implemented by the US, Japan and European have not come to fruition. Additionally, the current low oil price is one notable factor keeping inflation tamed - both directly and indirectly (as the oil price is a cost input into so many products).
The following graph depicts the long-term inflation movements in Australia. (The data is raw inflation, without removing volatile items. Even though this data set can be a bit more volatile than the underlying numbers would be, it does provide a correct trend representation over time.)
2. Is inflation targeting by central banks old school?
The 1990's saw the central banks of many countries adopt inflation targeting as the driver, or one of the main drivers (usually with an employment measure), of interest rates. Australia adopted an inflation target of 2-3% in 1993.
High inflation creates economic uncertainty and instability, it impacts on economic activity and growth, and can, in extreme cases, be devastating for both financial and political stability (as we are currently seeing in Venezuela).
Conversely, low inflation is also bad, and risky. It is usually associated with low or no economic growth, with low or no wages growth, and with higher unemployment rates. Debt (at a personal, corporate and/ or government level) becomes harder to pay off, or even unsustainable. Furthermore, low inflation runs the risk of turning into deflation - prices actually falling - which is an enormously bad thing for any economy, and hard to escape. Japan is a case-in-point.
Before Australia and many other countries adopted inflation targeting in the early 1990's, there had been a period of quite extreme inflation. As such, inflation management was front and centre of economic thought at the time.
A question arises as to whether, in the current low-inflation world, where other factors are at play in relation to economic stability and growth, inflation targeting remains singularly relevant. Of particular note to externally oriented countries such as Australia is the exchange rate. It plays a crucial role in balancing Australia's economy and facilitating necessary adjustments.
Employment is another factor that some countries already consider in their formal interest rate policy. Additionally, some commentators contend that economic growth (short/long? term), and credit availability should be formally considered when setting interest rates. The latter pertains to, for instance, whether the RBA should have had the charter to consider the extreme level of private sector debt built up pre- and post-GFC, and potential future economic impact of this being unwound.
Returning the focus to the US, the Federal Reserve is, we assess, recognising that economic stability is an important factor in relation to interest rate setting. Such low interest rates, as it currently has, actually undermines economic stability by:
- mis-allocating investment risk e.g. creating asset price bubbles; and
- not providing monetary fire power if conditions do deteriorate.
Hence the move to normalise rates is positive.
What does it mean for your investments?
We don't think Australia's recent interest cut, which followed the recent below-target inflation data, will change anything significantly; other than to add more leverage/ debt (excepting areas into which APRA is cracking down). It will may, though, create downward pressure on the AUD.
However, in the context of your investments, it really doesn't matter.
We target companies that can grow their revenue and profit irrespective of interest rate settings and the general economy. Company specific factors can be the driver of growth, or the sector / industry it operates in (which might not be correlated to the overall economy). Retirement exposed companies, accommodation (INA and AOG), annuity providers (CGF) and medical care (PRY), are specific examples. We seek investments that are able to growth their earnings and profit, irrespective of the RBA's interest rate setting.