Financial Idiot 018 - Interest Rates & Inflation

This Blog Post was originally distributed by the Newsletter "Financial Idiot". You can find and subscribe to it here.
DISCLAIMER: I'm an idiot and this isn't financial advice! You can lose money when investing, and you should never invest money you don't own or you can't afford to lose. I'm not responsible for your decisions!

Welcome back to a new Issue of „Financial Idiot“. First, I want to apologise for the cliffhanger last week. Let’s continue where we left off. :)

As a quick recap, we discussed how the FED and ECB had raised interest rates over the last couple of months. Unexpectedly for me, but expected in general (I forgot about it basically), the ECB raised the rates right after I released my last issue (see this German Article). That means the general interest rate in Europe is now at 2 per cent per annum.

But how should that conquer inflation? Well, what both central banks are doing is reducing the overall cash that gets released into the monetary system. If the interest rates are higher, fewer companies and people can take loans and mortgages at banks. That reduces the demand in several sectors. For example, if more people can’t afford a mortgage to build a house, they won’t order one from builder companies. That reduces the workload and will lead to fewer people working or being laid off, reducing the buying power of people employed in the building sector. The spiral continues to reduce the demand for many industries, and with the need getting lower, the prices will eventually fall later.

All in all, that is nothing new, and Ray Dalio has some great videos about why that is on YouTube.

But doesn’t that mean states also have difficulty borrowing money and thus reducing investments even more? Which could exponentially create a downward spiral where we get into no investments.

We know that several states in the European Union already have a hard time getting money to keep themselves running. Greece was such a state a few years back. Nowadays, people talk about Italy and Spain. Wouldn’t they run out of money if they can’t afford the higher interest rates? Usually, that could be the case, but the ECB has a plan.

After the COVID-19 Pandemic hit, the ECB set up a program to buy government bonds for states with lower credibility. The ECB called that program the „Pandemic emergency purchase programme“ (PEPP for short, see here). It let the ECB buy bonds totalling up to 1.850 billion Euros. That means states could borrow a tremendous amount of money to keep healthcare and the country running.

Now comes the link to the current (almost post-pandemic) situation, the ECB raised the interest rates but also removed the buying limit on bonds (ref). States can continue to borrow money, but to keep the economy from breaking down, it is crucial that those states borrowing money need to make large amounts of investments. A good example of „suitable “ investments would be education, infrastructure, healthcare and everything other that gets money „to the people“.

That way, companies can still invest in themselves but, in contrast to before, only with leftover profit instead of loans. Of course, that means slower growth, but it still means growth.

The hard part for the ECB is to find the sweet spot of raising interest rates slowly enough not to stop the market too quickly and t raise them fast enough to stop people (and companies) from buying „over their limits“. Over the next couple of years, we will see if that plan succeeds and if we get the mid-term inflation to two per cent as the ECB wants it to be for the Euroregion.

Subscribe to Philipp Haidenbauer | Blog

Don’t miss out on the latest issues. Sign up now to get access to the library of members-only issues.