Wednesday, March 5, 2008

Real Interest Rates Are Now Negative

From the man who wrote some of my economics textbooks, Greg Mankiw.

From his Blog:
Click on the graph to enlarge and see better an unusual phenomenon: inflation-adjusted interest rates below zero.Nothing in economic theory precludes negative real interest rates, or even suggests they should be anomalous. Nominal interest rates cannot be negative, because people would just hold cash instead of bonds, but real interest rates can be negative. If real interest rates were very negative, investors could start investing in inventories of goods, but this arbitrage is not easy. Storing goods is costly, and many things in the CPI basket, such as services, are not storable at all.In standard models of asset pricing, negative real interest rates are most likely to arise if growth expectations are particularly low or if uncertainty is particularly high. Low growth expectations encourage households to save, which drives down equilibrium rates of return. High uncertainty drives up risk premiums, which in turn drives down the return on safe assets, perhaps below zero. Both forces seem to be working now.

My thoughts:

What Mankiw is demonstrating can be seen in the huge run up in commodities (especially gold and oil) that we have seen in the last year or so. It also explains why the interest rate on my ING account (4.5% when I started a year ago) has now dipped below the “official” inflation rate. Thus I am being penalized for saving money, so I might as well spend it before it becomes useless or invest it in a riskier asset. (Which is exactly what I did when I purchased those Bank of America shares).

Usually in times of a falling dollar (also known as inflation), which is what has been going on for the last 2-3 years, real assets, such as gold and real estate, become particularly attractive, since, being real assets they cannot be touched by inflation.

However, real estate is usually purchased with borrowed money, and in periods of high inflation, you will also see higher interest rates, as investors respond to the real interest rate (adjusted for inflation) and not the nominal interest rate (the one quoted in the paper) in a process known to economists as the Fischer Effect. Perceptions of risk also influence banks and their likelihood of lending money. In an earlier post, I pointed out that the perception of risk is particularly bad right now.

Thus, banks will seek higher rates of return to counteract the effects of inflation (and to also factor in the probability of default), and less money will be lent to pursue entrepreneurial ventures (buying, selling and building buildings). Less money being lent to purchase buildings ( a decrease in the supply of loan able funds) has the effect of reducing the number of potential buyers, (since the price of borrowing money has gone up, only those companies or firms that can expect the higher rates of return needed to counteract the higher interest rates will be funded), which has the effect of lowering sales prices (since sellers are competing against fewer buyers).

Lower real estate prices (a real asset) can be expected (because of the run up in the cost of borrowing) at the same time that inflation is creeping upwards (real assets should increase in value) leads to two contradictory forces: real estate prices should be rising and falling.

The Feds actions are intended to get banks to issue more loans (since the cost of the banks borrowing money from the Fed has been reduced) and it looks like a different mechanism will be needed to get the end result.

If you have seen me in the last year or so, I have been vehemently opposed to the Fed cutting interest rates, as I see inflation as a greater evil than that of economic contraction. A negative real interest rate is the consequence of such cuts a.k.a expansionary monetary policy.

The upcoming expansionary fiscal policy (the “stimulus-package”) should further compound our folly and fuel inflation, inching me that much closer to moving all of my assets out of American dollars.

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