E The Deflationary Forces From Rising Debt Loads Will Keep Interest Rates Low

There is a steady drumbeat that inflation is on its way, conjuring up reminders of the 1970s and early 1980s experience. Recent one-month spikes in consumer prices have now taken front and center rows in the debates about the path of interest rates over the next few years. Larry Summers, former US Treasury Secretary, is championing those arguing that the Fed must act soon to counter inflation whose origins lie in the extraordinary levels of government spending. Hardly a day goes by without the financial press reporting on rise in inflationary expectations and, in many instances, arguing that the central banks are behind the curve and should be bumping up interest rates sooner than later. The recovery is underway, so the argument goes, and now is the time to turn our attention to restoring rates to more “normal” levels.

Time, Time Management, Stopwatch, Industry, Economy

Image Source: Pixabay

There is another, and totally different side, to the question of whether we are in store for an acceleration in consumer prices. And that lies in the relationship between debt and inflation.  The biggest drag on future inflation will turn out to be the combination of public and private indebtedness, especially that incurred during the height of the pandemic in 2020. Arguably, governments had no choice but to transfer payments to individuals and businesses as the pandemic forced exceptionally high unemployment and output losses in so many vital sectors. The cost of all this debt will be weak growth and low-interest rates for a long time.

Source: Hoisington Review, Second Quarter, 2020

Lacy Hunt makes the argument that rising debts retard economic growth.  His position is that, persistently, since the early 1990s, the marginal revenue product of debt has been steadily declining.  Put in layman-like terms, each dollar of debt added has had a diminishing return as measured by national output. Starting in the mid-1980s, the returns on debt financing has steadily dropped well below the historical average. In a recent newsletter, David Rosenberg demonstrates that there is a 75% inverse correlation between the debt ratio and core inflation. That is, as the debt ratios to GDP pile up, the interest rate on the 10-year government bond steadily declines---- declining interest rate reflects deflationary conditions. Echoing Hunt’s theme, Rosenberg notes that “we have the law of diminishing marginal utility as it pertains to debt decades ago, and we will come out of the pandemic with debt across the household, business and government sectors at unprecedented levels.”

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