Since 1981, interest rates have been in a falling trend. Last week, we said this trend will continue, and the present blip up in rates is just a correction. We did not argue technical analysis, nor quantity of dollars, nor the general price level.
Instead, we asked a question:
…It seems obvious that if one wishes to say that a trend has changed, after enduring for well over three decades, one needs to explain why. The Question of the Day is: what has suddenly happened?
For extra credit, no scratch that, to get any credit your answer should include an explanation of why the rate has been falling for so long. Is this too much to ask? Your explanation should contain three parts:
- The cause that drove interest rates to fall for most of the time that Generation X has been alive, for most of the duration of the careers of even the oldest Baby Boomers
- Why the old cause is now inoperable
- Identify a new cause, and show why it will drive the new trend for rising rates
We discussed a graph from the BIS, showing that as of 2015, 10.5% of corporations did not earn enough gross profit to pay the interest expense on their debt. Even at the lower interest rates of 2015, it is a sharply rising trend (from 5% in 2007). Who knows how much it would have risen even if rates had remained unchanged? And how much did it rise with the little blip up in interest rates we have had so far?
To answer part 1, we identified the cause of the trend. The cause is when interest > productivity (return on capital in this context), and each drop in interest drives down productivity. It's a ratchet.
We promised to answer questions 2 and 3 this week, as a hypothetical. We do not believe that the old cause is inoperable, or that a new driver exists for higher rates. So our topic this week is: what would break the old cause and create a new one?
Let's start with the old cause of falling rates.
Interest > marginal productivity
There are two ways to alter this relationship. Interest could fall below productivity. We mention this for completeness, but we are not going to look it this further because we are trying to explain rising rates not a further fall.
The other way is, of course, that productivity can rise. This means that deeply-indebted firms (we are looking at the margin, not the few tech giants without much debt) will find a way to increase their return on capital. They can't just borrow more to buy more plant or build a nicer restaurant. They must either raise prices or cut costs. And we are not going to look at cost-cutting, because again this is an exploration of a generally-rising price trend.
We do not mean rising costs due to tax, regulatory, litigation, environmental, zoning, permitting, licensure, compliance, audit, and other non-monetary government policies. These factors can all force prices up. But notice that they push profit margins down. For example, the price of gasoline rises due to a new road tax. It rises further due to environmental regulation that forces the refiner add ethanol. While most people call this “inflation”, it has nothing to do with the rising cycle.
By rising prices, we mean that all businesses, from makers of commodities to low-value-add goods, all the way up to high-value complex products, have pricing power. They can raise prices almost arbitrarily, and competitors will match. And the people will pay. Businesses know that if the consumer does not pay their price this week, they can hold their goods, and the price next week will be even higher.
If prices were to begin rising like this, it would be a godsend to struggling businesses. Their margins would expand (and expand and expand). Interest would quickly be under marginal productivity. This is not happening today, and it won't happen any time soon.
Marginal Time Preference
Let's address the cause of the rising cycle, when prices and interest rates are going up. It happened from 1947 through 1981. It is not only that interest < productivity. Interest is also under marginal time preference. This is the key.
The central bank pushes interest rates down (initially) below time preference. The protest-response to this sets in motion a ratchet in the upward direction. People begin hoarding finished goods (Keith's parents in the late 1970's used to stock up on canned tuna fish). And enterprises borrow to increase stocks of raw materials (commodities), plus buffers of inventory at every step in the production process.
With relentlessly rising consumer prices, time preference keeps rising ahead of prices. The central bank's initial violation is not so easily cured. The interest rate would have to rise—without prices also rising. But the interest rate and prices are linked. Not by inflation expectations and nominal vs real rates, and certainly not by the mythological creature known as the Bond Vigilante Unicorn. They are linked because individual savers are buying more and more goods to hoard. Their demand for goods is rising (and as we shall see below, supply is constrained or declining).
