The hawk is really a dove

The Federal Reserve moved interest rates up 0.25% last week. The US stockmarket jumped. Market commentators are mystified by the paradox. But it’s not hard to explain. Or to invest accordingly.

Today you’ll discover when a hawk is really a dove. That’s central bank speak for interest rate increases secretly stimulating the economy instead of slowing it down. The inflation hawks might look like they’re clamping down, but the stimulus doves are as busy as ever. Only now they’re in disguise.

Normally an increase in interest rates is bad for stockmarkets because it’s designed to slow the economy and keep inflation in check. Stocks don’t like either of those.

So why did markets absolutely love the Fed’s decision?

The answer is simple. The Fed may be increasing nominal interest rates. But it’s not increasing the real interest rate – the one that counts.

The same thing is set to happen here in the UK soon, as one Bank of England (BoE) member of the Monetary Policy Committee pointed out by mistake in the Financial Times. But why does it matter?

Well, the last time hawkish-looking policy was actually dovish, it gave us the housing bubble and bust. Central bankers claimed to have reeled in the speculative excess by raising interest rates in the mid 2000s, but it was a lie. They didn’t raise the real rate until it was far too late.

If you want to understand what’s in for the property and stockmarket in this cycle, you can’t be fooled into thinking interest rate increases are necessarily going to slow down inflation and the creation of another bubble.

What is the real interest rate?

There’s a big difference between the interest rate and the real interest rate. The difference is inflation. It’s best explained as an example.

Say the central bank interest rate, the nominal rate, is at 3%. Inflation is running at the central bank’s target of 2%. Then the real interest rate is only 1%.

That’s because your debt is being inflated away at a rate of 2% a year – you owe less and less as time goes by. But your nominal interest rate – the rate you’re paying, is 3%. The 1% difference between the two is the genuine cost – the real interest rate.

But what if inflation doubles to 4% in our example? Then the rate at which your debt is being inflated away is higher than the cost of borrowing. The real interest rate is -1%. Suddenly you’re paid to borrow money from the central bank.

That’s the bizarre world we actually live in. In the UK, the nominal rate is 0.25%. Inflation was at 1.8% in January. So the real rate is -1.55%. It’s also negative in Europe.

The difference between the nominal and real interest rate is one of the few useful economic concepts you learn at school. Not that they dare to explain the useful implications. But here you can discover them…

When interest rate increases are actually stimulus

In a world where inflation is rising faster than interest rates are being increased, central banks are not actually reigning in the economy. They’re still stimulating it. Even when they do increase interest rates, the real interest rate can be falling. Or so low it’s negative.

This disguises dovish monetary policy as hawkish. It allows central bankers to claim they’re being responsible when they’re not. And it explains how economic booms get out of hand. It’s part of what happened in the 1970s and early 2000s.

But don’t take it from me. Kirstin Forbes from the BoE’s Monetary Policy Committee penned an article in The Telegraph explaining why she recently voted for an increase in interest rates. She was out voted in the end, but makes a darn good case:

Headline inflation is picking up sharply. Although it is close to 2pc today, the MPC’s February forecast predicts it will reach 2.7pc within a yearAt Wednesday’s meeting, I voted to increase Bank Rate by 25 basis points. This still implies a substantial degree of support for the economy.

It’s that last sentence which is so interesting. Inflation is expected to hit 2.7%, but the BoE doesn’t want to increase the interest rate, even to a point where that increase still “implies a substantial degree of support for the economy.”

Just how far above the inflation target do we have to get before the BoE makes a move? Will it move so slowly it’ll still be stimulating the economy despite increases in the rate? Will it let another boom and inflation get out of hand?

As the inflation rate gets higher and higher, bigger and bigger increases are required to bring the real interest rate to bear on the economy. The further behind the curve it gets, the more radical it’ll have to be in the future.

Tomorrow we’ll look into what this means for borrowers in the UK. Could we even stomach an increase in rates? Especially one that tries to catch up to inflation which got out of hand. There’s a boom in pensioner mortgages which is a worry too.

But what can we make of all this as investors?

Learning from last time

Charlie Morris over at The Fleet Street Letter has put together a Treasure Map for you to follow. I can’t reveal it here, for obvious reasons. But the idea is to have an investment class during each different type of economic scenario your home country faces.

If I’m right above, and with the inflation alert issued last week, we’re about to change where on the Treasure Map you want to look for treasure. A different type of investment is going to start prospering while the winners of the past few years lag. And some investments will be in trouble in the new environment.

You need to be in the right quadrant. Get your hands on Charlie’s Treasure Map here.

Until next time,

Nick Hubble

Category: Central Banks

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