04/30/2008

How Low Interest Rates Cause Inflation

By Martin Gremm

The most recent value of the Consumer Price Index, a measure of inflation, was 4%. This means that a representative basket of goods cost 4% more last month than a year earlier. A 4% increase does not sound like a big issue, but it becomes a problem if it continues for long periods of time.

For example, a cup of coffee costs about $1.70 today. At a constant 4% inflation rate it will cost $2.52 in 10 years, $3.73 in 20 years, and $5.51 in 30 years. At this rate of inflation, 30 years from now, you will need about three times your present income to support the same lifestyle.

The Fed recently lowered the Fed Funds Rate to 2.25%, significantly below the current inflation rate. Interest rates below the inflation rate cause runaway inflation if they remain in place for too long. Consequently, we expect that inflation may become a bigger threat to your assets than it already is.

Let us take a look at how low interest rates fuel inflation. The example below is highly simplified to illustrate the mechanism. It is not a complete description of the real world and leaves out several important risk factors. Do not make investment decisions based on this example!

We assume that savings accounts yield 2% per year; that gold as a proxy for other goods appreciates at the inflation rate of 4%, and that entities and individuals with good credit can borrow money at 0.75% above the Fed Funds rate, i.e. 3%.

Let's say you have $1 to invest for a year. You could put it in the bank, earning $0.02 in interest, or you could buy gold (or a basket of fungible goods). After a year, $1 worth of gold would turn into $1.04 per our assumptions. Obviously it is more desirable to invest in gold than to put the money into a savings account.

Now let's say you have good credit and can borrow money at 3%; 1% below the inflation rate. If you borrow $1 and buy gold, it will grow to $1.04. You have to pay $0.03 in interest for this loan, but that still leaves you with a $0.01 net profit form this transaction. Based upon this model, there is an incentive to borrow as much as possible and buy gold.

If a sufficient number of people not only buy gold from their savings, but borrow money to buy more, this will drive up the price of gold quickly. If the price of gold, as a proxy for other goods, increases, the inflation rate increases. As the inflation rate increases, borrowing money to buy gold becomes more attractive and more people start doing it, which in turn drives up the price more quickly.

This example illustrates how below-inflation interest rates fuel inflation. The process only stops if banks become unwilling to loan more money or the interest rates increase above the inflation rate. The current excessive real estate values are due to such an inflationary period and the same is true for most commodities and art. Most likely there will be significant price corrections in these markets as well as some lasting inflation.

The Federal Reserve lowered interest rates as a short-term fix for a slowing economy. We hope they have the foresight and fortitude to raise them again before inflation becomes unmanageable or they will ignite new asset bubbles.