Inflation 101: How not to become Zimbabwe

25 Sep 2022

Interest rates. It’s very seldom in world history that the entire world’s economic discussion is focused on just one very big issue. Interest rates are complicated and dull on the surface, but fantastically important, so here goes…

I’m not an economist, or even particularly an economic writer, so, please, think of this as a modest contribution from an observer outside of the industry. Given that the global focus is so intense, here is a quick primer on interest rates and a summation of where we are so far. Trust me when I say this is all very dramatic and significant.

The first thing to note is that the changes to the numbers are extremely small, so to outsiders, the instinctive reaction may be: why all the fuss? The number changes are so small that economists have elevated the hundredths to a category of their own, called basis points. These are hundredths of a single percentage point. All very fuss-worthy.

On Wednesday, 21 September, the Reserve Bank governor of the world’s largest economy, Federal Reserve chair Jerome Powell, announced a 75 basis point (0.75%) rise in the Federal Funds rate. This is the overnight interest rate at which banks lend money to each other.

That doesn’t sound very important, but interest rates across the spectrum are influenced by this rate so it matters — a lot. Homeowners will know this very acutely since every interest rate hike is followed by a letter from the bank saying you now have to pay them more.

More importantly, there is something else at work here: when the Fed, or any other reserve bank, decreases interest rates, it is effectively reducing the price of money. And when interest rates are increased, the opposite occurs. Given the amount of money in circulation, it makes sense that although these increments are small, the entire financial system and everything in it is being recalibrated.

Interest rate decisions are most directly pertinent to the bond market. Occasionally, when I have given lectures in financial journalism to prospective journalists, I start the conversation with the topic of what markets exist and how big they are. The market everybody knows is the stock market because it is very dynamic and often includes recognisable brands and companies and people. They are fun.

But, actually, the markets that matter most are arguably the currency markets and the bond markets. The currency markets because they are a function of global trade, and the bond markets because they are huge, and the consequences of failure can be devastating.

The total debt outstanding in the US bond markets is about $46-trillion. The total value of all the companies on US stock markets is less than that: about $40-trillion. Market capitalisation, however, really reflects the current value of anticipated future revenue. What is owed on the bond market is the actual, concrete value of the IOU.

Visit Daily Maverick's home page for more news, analysis and investigations

In some ways, comparing the value of listed companies on the stock market with the value of bonds on the bond market is like comparing hoped-for income with more or less assured income.

It doesn’t always work this way, but generally bond investments are more secure and therefore less variable and volatile than equity investments. They are actual. Stock market investments are conceptual.

South Africa’s markets are comparable but a little different. The total debt outstanding in South African debt markets is about R3.8-trillion, and about three-quarters of that is owed by the government. The current market value of the stocks on the JSE is about R15-trillion.

Hence, superficially, the bond market is much smaller by comparison. Of course you have to remember that considerable income generated by the companies on the JSE lies outside South Africa, which tends to boost the value of local companies. And the US bond market includes huge loans to companies, municipalities and the government; the span of the market is wider.

When Powell announced his 75 basis point increase, it truly did reverberate around the world. In September alone, 12 countries increased their interest rates, including Europe, Canada, Australia, Sweden, Switzerland, the UK and, of course, South Africa — all by unusually large increases.

It’s worth noting, too, what a big change this is. In the seven years since 2009, US interest rates didn’t move a jot; they have moved four times this year.

We all know why this is happening: inflation. Central banks are trying to balance supply and demand, by using this blunt club called interest rates to bash down demand. It’s a barbarous tool, but it’s more or less the only one in their arsenals.

History has taught us this is the way, because they don’t want inflation to feed on itself. This involves taking anticipatory action, and if you don’t do this, you lose credibility as an economic manager and you become Zimbabwe. And 90% of your population returns to subsistence farming as the only remaining, desperate way to survive, and many of the rest flee to neighbouring countries. There are few more important jobs in the world.

Obviously, central bank governors want to try to ease the economy on to a gently descending flight path that marginally reduces demand, saves jobs and the economy, and we go on to fight the next battle. This is the “soft landing” scenario so many people talk about.

But something fundamental changed this week. In his announcement, Powell said something that may go down as his most noteworthy comment. Inflation has to come down, he said. “I wish there was a painless way to do that. There isn’t.”

The soft landing scenario is now gone. Up to this point, US investors have been hoping for something called “immaculate disinflation”; a reduction in inflation without a reduction of jobs. The 75 basis point increase was anticipated. But the forward projection that interest rates would reach 4.6% in a year’s time, sharply up from the previous 3.8% increase, was not.

He was not sugar-coating the pill, or telling us we’ll be able to fly around the turbulence. Unemployment in the US is projected to reach 4.4%, up from 3.5%. Once again, there is a tyranny of small numbers. That projection could mean about 1.5 million people in the US will lose their jobs.

South Africa, again, is different — but not that different. There have been six interest rate increases over the past year. Precise estimates of how this will affect jobs are not available in South Africa, but, generally, this is obviously not good.

It’s worth remembering that overall interest rates are not high by historical standards. In South Africa, we are now only back up more or less to the point we were before the Covid crisis began. Yet, the plate tectonics that is the global economic system shifted in the past week, and the outlook is darkening. DM/BM

*To receive Tim Cohen’s After the Bell newsletter with news you need to know by close of business, sign up here.

Categories:

Tags:

DM is much better if you are signed in...

Africa