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By Bernard Hickey
Bernard Hickey explains why falling inflation has been fantastic for capital values over the past 10 years, and looks at whether a new industrial revolution could make it drop further still.
A once-in-a-generation slump in inflation and interest rates over the last decade (Figure 1) has generated massive windfall gains for the owners of property, shares, and bonds.
It seems counter-intuitive. Surely a fall in inflation and interest rates suggests slowing economic growth and profits? That’s true, but it’s cheaper to borrow money and service debt too.
It also means that the long-term worth of an asset with a fixed value is higher when you finally cash it in or spend it. For example, a bond with a value of NZ$1 million now will have a lot more purchasing power in 20 years if inflation is 1 per cent over that 20 years, instead of 5 per cent.
That’s reflected in rising capital values of bonds on bond markets. The fall in inflation expectations, bond yields, and short-term interest rates has driven up the value of assets. This is partly because it’s cheaper for investors to borrow to buy assets and partly because falling yields equal higher asset values.
Investors buy houses and shares
The obvious example in New Zealand is the 54 per cent rise in house prices and the 93 per cent rise in the NZX50 (including both capital values and dividends) since 2007.
Former Finance Minister Steven Joyce pointed to this interest-rate effect on asset prices, which was in part about housing affordability.
“The biggest problem we’ve got with first-home buyers able to buy properties is we have very, very low interest rates historically, and as a result that’s directly linked to how much house prices have been bid up around the world,” Joyce said in May, before the New Zealand general election.
“It’s not just houses. It’s shares and everything else, but it’s certainly one of the dominant reasons for that. Unfortunately, it’s going to be a little bit of time yet before that changes, although there’s indications that this period of ultra-low interest rates is coming to an end. That will improve affordability over time,” he said.
Accidental capital gain
The increasing value of assets such as property has been the biggest accidental capital gain to land on any generation in half a century of investing.
New Zealanders have also benefited from rising share values. Even though economic growth and sales growth have been tepid globally, companies have been able to increase returns on equity and hand cash back to shareholders by borrowing cheaply to buy back shares and make special dividend payments.
New Zealand’s high-cash-flow, monopoly-style businesses, such as the power companies and Auckland Airport have been particularly aggressive with these special dividends.
Back in 2009 and 2010, in the wake of the financial crisis, no one expected inflation and economic growth would stay this low for this long.
Some predicted doom
Investors and politicians worried that the money created out of thin air by central banks to buy bonds would unleash a blowout in inflation. People even bought gold and set up virtual (but limited) currencies such as Bitcoin, expecting some sort of hyperinflation apocalypse.
It never came, and the jury is out on exactly why the growth and inflation hasn’t materialised. Indeed, an increasing number of structural drags on inflation are emerging, even though economic growth is increasing globally.
Ageing populations in the developed world are sucking the juice out of investment and spending. People nearing retirement want to save and invest in low-risk assets, such as bonds. That means relatively less money and a reduced appetite to invest in companies that fuel faster growth and inflation.
A new industrial revolution
Cheap and endemically available smart phones, cloud computing, and mobile data networks are also changing the inner workings of the global economy. These technologies are opening up closed domestic markets for services such as taxis, entertainment, media, retail, health, education, accommodation, and finance to global competition, at the tap of an icon.
Costs, jobs, and small local businesses are evaporating into the globalised cloud. That’s great for consumers and the new stateless, global behemoths such as Google, Facebook, Amazon, Microsoft, Apple, Airbnb, Uber, and Alibaba. This dissolution into the cloud also drives prices lower, often dramatically.
All these factors are keeping inflation low. And it may yet be pushed lower still in New Zealand if a new, more dovish Reserve Bank Governor (due to be appointed next March by the new government) moves to target full employment by cutting the Official Cash Rate.
What keeps inflation low
In his final speech in August, outgoing Reserve Bank Governor Graeme Wheeler acknowledged the role of these underlying changes in explaining why he had cut interest rates.
“Structural factors are playing a dominant role in the low-inflation environment,” he said.
“These factors include: ongoing declines in the cost of information technology and capital goods; increasing global competition in the services sector (for example, in education, healthcare, construction, retailing, and distribution); the emergence of the gig economy; the technological revolution in the oil and gas industry that has dramatically lowered production costs and enabled new sources of supply; and the wage moderation that is taking place across the advanced economies.
“Wage moderation seems to be linked to several factors, such as the diminished bargaining power of labour, technological change, global outsourcing, demographics, and changes in labour-market composition.”
This fourth industrial revolution is keeping inflation and interest rates low globally. It has much further to run.
Gig Economy: In a gig economy, more companies are hiring for temporary positions and employing short-term contractors, rather than offering full-time roles.
Official Cash Rate (OCR): The OCR is a tool used to influence the price of borrowing money in New Zealand. It gives the Reserve Bank a way of shaping New Zealand’s level of economic activity and inflation.