QUESTION:
Hi Marty,
The reason central banks like to have inflation, is because they get to reduce the effective value of their respective national debts over time. I do not know why there is a link between inflation and interest rates, which is assumed in BB’s remarks. Is there any basis for that ?
Regards
D
ANSWER: The link between interest rates and inflation is fundamental. If the inflation rate is 20%, you would never lend money at 10% for that would effectively be the same as a negative interest rate. The level of interest rates must be ABOVE the inflation rate to make it profitable to lend.
This has been my argument all along; no particular interest rate level will cause the markets to decline or boom. The 2% inflation rate has been seen as necessary to keep money flowing. The missing ingredient here is CONFIDENCE. Simple correlation studies show that the economy and stock market have never peaked twice with the same level of interest rates, and they have never bottomed with the same level on the downside.
We have now crossed the one-year anniversary of the ECB introduction of negative interest rates. What happened? Still no inflation. Their next trick is to go even more negative, but to accomplish that they must eliminate physical money. In Italy, I still saw retail stores selling gold bullion coins. In Spain, there were none, but Spain had the closure of the Bank of Madrid with many people unable to get their cash out for nearly two months.
Governments are raising taxes, aggressively confiscating assets and cash, and increasing tax enforcement. That is deflationary and wears down the CONFIDENCE about the future. They wonder why people are starting to hoard money out of banks. Without CONFIDENCE, the people will not borrow at 1% if they cannot see how they will make 1%. Even Keynes said there were times you had to lower taxation to stimulate the economy. Announce that everyone who starts a business and hires people will enjoy tax-free status for 5 years. Watch how many people run out and find a business to create, hiring people to accomplish that goal. Oh sorry, that would be anti-socialism.
The central banks do not worry about the national debts because that is not their department. Even the ECB has no control over the debts of member states, but they are in charge of trying to manage the economy as they see it, and that is something they are not qualified to accomplish with only one side of the coin.
