309: Investments to Fight Financial Repression

Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 309. It’s titled, “Investments to Fight Financial Repression.”

All-Time-Low Interest Rates

A couple of weeks ago on August 4th, the US 10-year treasury bond hit an all-time low yield of 0.52%. It’s a little higher than that now, about 0.64%. Yet, if we look at an equal-weighted composite of 10-year government bonds that includes Canada, the Eurozone, Japan, Switzerland, the UK, and the US, the composite interest rate is 0.3%. If we include corporate bonds and mortgage-backed securities, the global aggregate bond yield is 0.8%, an all-time low. 

Now those are nominal yields that supposedly take into account the potential inflation, but those rates are lower than what inflation has been over the past few years. Treasury inflation-protected securities have a negative yield, that’s the real yield. The 10-year TIP is yielding -1%. Global central banks have set their interest rates at an all-time low. A composite of central banks, the average short-term policy rate is 1.35%. That’s down from 2.4% in July 2019. Most developed countries have set their policy rate at 0. 

Financial Repression

As investors, if we are not able to generate a return that is greater than inflation, then our investments lose purchasing power over time. If central banks are implementing policies to keep interest rates low. Policies that benefit debtors, borrowers, because they can borrow cheaply at the expense of savers that aren’t able to earn even the rate of inflation on their savings, that is what is known as financial repression.

It’s policies by central banks that hold down borrowing costs. These can be traditional, monetary policy tools, such as setting the short-term policy rate. Or it can be unconventional monetary policy, such as quantitative easing where central banks purchase government bonds or other bonds in order to put downward pressure on interest rates because they’re constantly buying bonds. It could be yield-curve control, stating that they will buy as many bonds as possible to keep longer-term rates low. 

Forward Guidance

It could be what the Federal Reserve indicates that they might do, more explicit forward guidance. In their June Federal Open Market Committee meeting, the minutes said that “it will be important in the coming months for the FOMC to provide greater clarity regarding the likely path of the federal funds rate and asset purchases.” And that “a number of the participants were in favor of forward guidance tied to inflation outcomes that could possibly entail a modest, temporary overshooting of the 2% target.” 

What does that mean? The Federal Reserve has a target for inflation of 2%. They set their short-term policy rate, which is known as the federal funds rate, at a level that they believe that unemployment will stay low, but not too low that it starts to put pressure on wages and potentially inflation. And at a level that’s low enough that households and businesses want to borrow to buy things, to invest in capital projects to help the economy grow. But they’re saying that they’ll keep the policy rate low even if inflation exceeds the 2% target for a time so that the average inflation rate is about 2%. 

The most recent inflation rate in the US was 0.6%. If we exclude food and energy, the inflation rate was 1.2%. That was through the end of June 2020. The average inflation rate for the 37 countries that make up the OECD, year-over-year inflation was 1.1%. If we exclude food and energy it was 1.6%. Average world inflation from 2010–2019 was about 3.3%. 1.5% for developed markets, 4.3% for emerging markets. 

Now we’ve discussed whether inflation is measured wrong, most recently in an episode last October titled “Is Inflation Measured Wrong?” But generally, inflation has been low and interest rates had been low and getting lower. Central banks have set their policy rate low. Interest rates are based on what investors expect future short-term rates will be, what inflation will be, and an additional term premium which represents compensation that investors want in case inflation comes in higher than expects, in case central banks raise interest rates higher and faster than expected. Interest rates are interesting in that the level is set by market participants but clearly influenced by central banks. 

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