Are higher rates inflationary?

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No, higher rates are not (very) inflationary

Here’s a theory that’s been making the rounds. Interest rates are high, yet growth is strong and could even accelerate, while inflation is stubborn. So perhaps high rates, far from slowing growth and inflation, fuel them.

The idea is not, at first glance, totally crazy. Some economists, notably the modern monetary theorist Stephanie Kelton, have long defended a version. Policy interventions work through multiple channels, so different effects may go in different directions or vary over time. Perhaps we have overcome most of the disinflationary impulse (dormant mergers and acquisitions, lower rate-sensitive activity, higher financing costs, etc.) and are left with the inflationary residuals.

Three plausible causal mechanisms have been proposed:

1. Thanks to the frozen real estate market. Jack Manley of JPMorgan Asset Management told us about this yesterday. He argues that the housing sector’s recent stubborn inflation surge is caused by the lock-in effect. Homeowners, who hold cheap mortgages, are no longer willing to sell their homes. This restricts the supply of housing and, combined with unaffordable mortgage rates, increases demand in the rental market, generating housing inflation. Until the Fed unlocks housing supply with lower mortgage rates, Manley says, inflation will likely remain high.

2. Thanks to increased interest income from consumers. All those high-yield cash accounts must mean something. Hedge fund David Einhorn made an argument along these lines in Bloomberg earlier this year, pointing out that households’ $13 trillion in short-term interest-bearing assets exceeded the $5 trillion in non-profit consumer debt. mortgages. He estimates net income at $400 billion a year.

3. Thanks to the increase in corporate interest income. As with households, corporate cash now generates significant returns.

Let’s take them in order.

In the housing market, we are willing to believe that high rates could support rent inflation (even if more recent rental market measures look less bad than official data). But we are not convinced that reductions could bring down rent inflation. Demand measures in the housing sector – from housing starts and construction employment to residential investment and mortgage applications – have looked weak for almost two years. Whatever increase in the supply of existing housing would be offset by an increase in demand. It’s not clear how these losses will be offset, but given the structural shortage of supply in the housing market, we’d bet it would be inflationary.

The consumer interest income story is intuitive but ultimately unrealistic. There’s no doubt that people are now getting paid more interest (and, if they have fixed-rate mortgages, aren’t paying much more interest than they were a few years ago). Since rates started rising, the increase in monthly personal interest income is $265 billion. It’s a lot! But remember that during the same period, interest costs and inflation have also increased. The chart below uses non-mortgage consumer interest income data from the U.S. Bureau of Economic Analysis. Real net interest income (i.e. less interest charges), in green, has decreased since the start of 2022:

There is also something strange in concluding that because one can now earn 5 percent in a money market account, people feel richer. The question is: where was this money before? If it was all alone in a savings account with almost no yield, OK, maybe they’d feel richer (although if it wasn’t transferred to a money market account, they wouldn’t do not feel richer). a lot richer: average returns on savings accounts increased from 0.06 percent in 2022 to 0.46 percent today). But if the money was part of a cash/bond/fixed income allocation, the returns on that allocation would have been horrendous in recent years, thanks to the monstrous 2022. Do I feel rich because Is a part of my portfolio that has performed horribly for years earning a high return?

Finally, corporate interest income. National accounts data suggests that net funding costs for non-financial corporations have fallen by 40 percent since the rate rise began, which could suggest that rising interest income has more than offset that. Interestingly, however, this trend is less clear among S&P 500 companies, which one would expect to have larger cash reserves and more debt pegged at low rates, which would allow them to benefit more from higher rates. But over the past ten quarters, the net interest expense (that is, interest expense minus investment income) of S&P companies has remained stable and the recent trend has been upward.

This is a question we have admittedly spent little time thinking about (readers, have your say). It is possible, although far from obvious, that higher rates could have a slight inflationary effect. But this is only one factor among many. Growth seems strong for fundamental reasons: a tight labor market, productivity gains, healthy consumption balance sheets outside the low end. The hypothesis of high rates fueling inflation is neither sufficiently established nor important enough to influence us, or, in all likelihood, the Fed.

The RIP size factor?

At Alphaville, Robin Wigglesworth wrote an excellent and in-depth article on how US small cap stocks, depending on how you measure them, have not outperformed US large caps. Those of you who managed to stay awake in finance school will remember that the theoretical consensus used to be that small ones should outperform large ones over time, either because small ones are riskier and investors have to getting paid for it, either because of ingrained behavior, something or other. among investors, or both. This is the “size factor”.

Here is the incriminating table:

What happened? It’s not clear, but Wigg has three main ideas:

1. The quality of small-cap companies has declined, with lower growth, weaker profits and weaker balance sheets. Many small, solid businesses have been privatized. And lately, weaker balance sheets have been exposed to rising rates.

2. Greater transparency and liquidity mean there are fewer undiscovered gems in small-cap indices.

3. The Russell 2000 index weighting system creates frictions that weigh on performance.

All three may be true to a greater or lesser extent. Unhedged only has two small points to add. Factor performance evolves in long-term plans, as quality factor investors have discovered, to their chagrin, over the past 20 years. In particular, as factor investing mogul Cliff Asness of AQR wrote a few years ago, factors can undergo valuation changes that cause them to outperform or underperform for significant periods of time. These changes can overwhelm the performance of fundamental factors for a long time. But valuation changes don’t last forever. Looking at a 20-year chart of the price-to-earnings valuations of the S&P 500 and its small-cap sibling, the S&P 600, it seems possible that this is what happened to small stocks:

Small caps (dark blue line) once traded at a sustained premium. They lost it about five years ago and are now trading at a steep discount to large caps (light blue) and their own long-term average (pink line). Meanwhile, large caps are trading well above their own long-term average (green). This largely explains Robin’s long-term price performance chart. Should the change in valuation be reversed? No. Can the small-cap discount continue to widen indefinitely? Probably not.

(I should note that Asness does not believe in a size factor in itself. He believes smaller stocks have higher beta – volatility relative to the market – and that, rather than their size, explains why small-cap investors get paid more. In other words, there is no volatility-adjusted size factor. But if you think there is a size factor, the point above about valuation changes still applies).

The second point is closely related. While we accept the idea that small caps have become fundamentally weaker recently, this does not mean that they will forever underperform large caps, nor does it mean that there has never been size factor. This means that their valuations must adapt to the new fundamental reality. This could be what’s happening in the P/E chart above. This would not necessarily mean the death of the size factor.

A good read

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