In order to recognize the overwhelming changes in the investment climate since the 1950s, it is crucial to appreciate the impact of real short-term interest rates on the economy and inflation. They play a major role in the way the U.S. economy, and for that matter any economy, performs. Their level has a close relationship with the performance of the financial markets and price of hard assets. They can also be used to assess strengths and weaknesses of foreign economies, and as a result, to evaluate the attractiveness of foreign investments. This will be discussed in more detail later in this chapter.

Short-term interest rates represent the price of money when it's borrowed and repaid in a period of less than one year. In our discussion, we will use the rate on 13-week Treasury bills, which represents the interest paid by the U.S. government when it borrows money over 13 weeks. The reason for using this rate is that it moves quickly when market conditions change. It also has the property of moving ahead of Federal Reserve announcements. We will devote a whole chapter on how the Federal Reserve performs the function of managing short-term interest rates. For the time being, let's accept the fact that the Fed has a major role in impacting the trend and the level of short-term interest rates, and in particular the rate of 13-week Treasury bills.

The difference between the level of short-term interest rates and inflation is called real short-term interest rates. Inflation is measured as the change over 12 months in the consumer price index or in the core consumer price index (over the long-term, these numbers are the same). These data are readily available from the Bureau of Labor Statistics. The Fed, since it can manage the level of short-term interest rates, also impacts the level of real short-term interest rates. The level of real short-term interest rates has an impact on the level of real long-term interest rates, that is the price of money when investors and business borrow over the long term. The evidence shows that the 1970s, a period of low real short-term interest rates, was also accompanied by low real long-term interest rates, well below the average of the last century. On the other hand, the 1950s and the years following 1982 were periods when real short-term and real long-term interest rates were well above their long-term average.

Real short-term interest rates oscillated around the value of 1.4 throughout most of the last century. The historical evidence strongly shows that the 1.4 value is an important number to follow when developing long-term investment strategies. The history of the last century since 1955 shows that as long as real short-term interest rates stayed close to 1.4 or higher, inflation remained under control.

Real short-term interest rates were close to this value from the early 1950s to 1967, and inflation oscillated between zero and 3% most of the time. However, real short-term interest rates began to decline quite sharply after 1968 and fell from 1.4 to as low as –7. That meant that interest rates were kept below the level of inflation through most of the 1970s. For this reason, in that decade people used to say that it pays to borrow - that inflation was going to bail you out. The cost of money was lower than inflation.

In 1980-81 real interest rates rose dramatically and moved well above the level of 1.4, hovering close to 5 in the 1980s. In other words, short-term interest rates were kept five percentage points above the level of inflation. The outcome was very expensive money and this was a major determinant for inflation to decline from roughly 15% to 2-2-1/2%. Since the early 1980s, real short-term interest rates have been above the important 1.4 level, except for a short experience in 1992-93, when the price of money was kept artificially low to re-liquefy the banking system because of a severe real estate crisis.

But after 1994 real short-term interest rates moved up again above 1.4 and inflation moved close to 2-3%. The main lesson of the last century has been that in the 1970s inflation moved dramatically higher from close to 3% to 15%, as real short-term interest rates were kept by the Fed well below the 1.4 level. The other times prior to 1968 and following 1982, when real short-term interest rates were close to or above 1.4, inflation hovered close to 2-3%.

Real long-term interest rates behaved very much like real short-term interest rates during most of this century. Real long-term interest rates, computed as the yield on ten-year bonds less inflation, hovered around the 2.75 level through most of the last century. Since 1955, as it happened for short-term interest rates, one can distinguish three main periods when real long-term interest rates behaved like real short-term interest rates.

From 1955 to 1966-67, real bond yields were very close to 2.75 as the yield on 10-year bonds stayed close to 4%. From 1965 to 1982 real bond yields declined sharply below the 2.75 level to drop as low as –4. During this time, when yields on long-term bonds were below the level of inflation, inflation soared. The outcome, which will be discussed in more detail in later chapters, is that bond yields jumped from 5% to 15% during the 1970s.

However, beginning in 1982, as it has happened for real short-term interest rates, real bond yields soared to well above the 2.75 level, moving close to seven percentage points above the level of inflation. Since 1982 the level of real bond yields was constantly above the 2.75 level as bond yields declined from 15% to close to 6 - 7%.

There are various theories on how real short-term and real long-term interest rates relate to the level of inflation and the level of productivity. What we want to show, however, is their strong relationship with inflation trends in the last century. What is important to recognize is that in this century there have been three important periods:
• Prior to 1967
• From 1967 to 1982
• Following 1982

The experience of the 1970s shows that sharply rising inflation and sharply rising bond yields were accompanied by very low real interest rates. The other two periods were similar in many respects. But their main feature was low or declining inflation and high real long-term and short-term interest rates. The experience of foreign countries confirms this relationship. Countries with low real interest rates are usually countries that have much higher inflation than the countries with high real interest rates.

Real long-term interest rates are also related to the growth of the economy and growth in productivity of the country. Trends in long-term interest rates and their role in your portfolio will be discussed in a later chapter.

When we speak about real short-term interest rates, we assume the Fed has an important role in determining their level. From our perspective, the issue is not why real interest rates are high or low. Our objective is to relate their level to economic and inflationary conditions.

Why do real interest rates have such an impact on the economy? The answer is quite simple. The level of real short-term interest rates determines whether the price of money is cheap or expensive. When the price of money is high relative to inflation, money is expensive. And this makes consumers, business, and investors more cautious about the use of their funds. On the other hand, when real short-term interest rates are low, money is inexpensive and it is easy to borrow and spend.

Why are low real interest rates inflationary? Let’s consider an example. When real interest rates are low, as in the 1970s, the price of money is close or below the level of inflation. Since the price of real estate grows roughly as inflation, consumers and investors borrowed heavily to buy real estate. There was little to lose. The price increase in the asset was enough to repay the borrowed money. There was no risk. More and more people thought that this was an easy way to protect their capital. As a result, the real estate sector boomed and prices rose sharply with it. In more general terms, low real short-term interest rates stimulated inflation through excess demand for goods due to inexpensive money.

Real interest rates also impact business and their decisions to invest and the type of investments they choose. For instance, high real long-term interest rates force business to invest in projects with a high rate of return. However, investments with a high rate of return require large financial commitments and have a high technological content. Let’s assume that a manufacturing company has the need for more manufacturing capacity and they plan to have a plant expansion. The project has to pay for itself to be implemented. That is, the savings that a project will provide or the return of the project, has to be greater than the cost of the money that is needed to implement that particular project. Let’s assume that long-term interest rates are 8% and inflation is 7%. The project can be implemented only if its return is greater than 8%, which is the cost of borrowing the money. But since inflation is 7%, that means that the company can increase prices by 7% a year; offsetting 7% of the cost of the money. As a result, the project only has to return at least 1% to make it viable. Clearly, a project with only 1% improvement is not difficult to achieve. Any small adjustment to existing machinery can provide a 1% return, thus making the project profitable.

However, let’s assume now that long-term interest rates are 8% but inflation is 2%. The project can be implemented only if its return is greater than 8%, which is the cost of money. The company can increase prices a rate of 2% a year, which only takes care of 2% of the cost of borrowing. The overall project, therefore, has to return at least 6% to make it profitable after inflation. Clearly, the effort of this kind of project has to be much more involved than the previous one, because now the project has to return at least 6%. In order to achieve this goal, the company has to allocate specialists to study productivity improvements of at least 6%, and they are likely to be achieved only if there is heavy usage of computers, programming efforts, and other technical innovations.

The point of these two simple examples is to show that the level of real interest rates has an impact on the type of projects that can be implemented. The higher the real cost of money, the higher the level of sophistication of the project, because the project has to provide a higher return. The high productivity of the project is a major reason why inflation during times of high real interest rates is kept under control.

We have discussed an example of one company, but high real interest rates affect all the companies in the country. When all the companies are trying to achieve the same goal, that is, to implement projects with a high rate of return because of the high real cost of money, the whole country becomes more productive. This is the reason why as inflation declines, the productivity of the country increases. The reason is that declining inflation does not allow business to raise prices at will, thus squeezing margins. On the other hand, high real interest rates force corporations to implement high rate of return, high productivity projects. The outcome is that the whole country has a productivity boom as experienced by the U.S. after the 1980s.

The opposite happens when real short-term interest rates are low and real long-term interest rates are also low. Business does not have to invest in high rate of return projects because the money is cheap and any project is easy to justify from a financial viewpoint. This leads necessarily to low productivity and higher inflation. As discussed above, low real interest rates do not stimulate innovation because any slight improvement in efficiencies will make the project viable. Since low real interest rates are accompanied by rising inflation, the company finds it easier to improve margins by raising prices rather than going through involved technological projects. Again, what the 1970s have shown in the United States and Europe is that high levels of inflation are associated with ever decreasing levels of productivity, growth, and low real interest rates.

High real short-term interest rates, in the U.S. or any country in the world is a sign the Federal Reserve and a particular central bank are committed to keeping money expensive. This situation forces consumers and investors to use money more carefully thus keeping inflation under control and forcing productivity to rise.

Productivity rises when inflation declines is because business cannot raise prices. As a result, the only way to improve margins and profitability is to improve productivity. This is the reason why technology stocks boom in periods of very low inflation. In fact, the technology boom that we had since the 1980s did not occur in the 1970s because in the 1970s there was no need for technology because margins were improved by raising prices. There is no doubt that as inflation declines, business pricing power decreases, and as a result, it cannot raise prices to improve margins. The only way to increase margins is by improving productivity to absorb and cut costs. It’s no coincidence that as inflation declined in the 1980s and 1990s, productivity growth soared in the United States, both in the overall economic level and in the manufacturing level. One can also say that low inflation is good not only for overall corporate America, but especially for the technology sector because of the strong reliance on technology to improve productivity and improve profitability.

Low real short-term interest rates suggest money is cheap, and therefore, consumers and business do not have the self-discipline to spend it carefully and thus create inflation and a low productivity environment. Let's see now how these concepts may help in explaining the huge changes in the economy and asset prices we experienced since 1955.

(From Chapter 5 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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