Why Wall Street Loves Low Interest Rates and Inflation

By Vedran Vuk, Senior Analyst

Wall Street and Main Street often have extremely divergent views on inflation. Talk to the average Joe about inflation and he’s very concerned, even when inflation is low. Listen to a Wall-Street guru, and they’re almost certain to downplay inflation. Why is there such a difference of views?

What most people don’t understand is that inflation is all about timing. Prices don’t rise simultaneously across the economy. Consider this analogy. Imagine that there’s a printing press giving away a wheelbarrow of cash to whomever wants it. Naturally, printing a pile of money will lead to inflation; however, all the money doesn’t enter the economy at the same time. The first guy to get his wheelbarrow of cash is pretty well off. He can go to the market and purchase items for normal prices. As more and more people show up with their wheelbarrows of cash, prices will rise. Hence, the last guy in line for his wheelbarrow of cash is not in the same position as the first person was. By the time the printing press gets to the last person, that wheelbarrow of cash won’t be worth very much – but to the first person, it can be a fortune.

In real life, the person earning a regular salary is way at the back of the line, while the banks, big corporations, and folks on Wall Street are toward the front of the line. Naturally, those toward the front of the line have no problem with this state of affairs.

Let’s look at two ways this works. First, suppose the Fed lowers interest rates, which pulls down borrowing rates across the board. Ultimately, low rates will lead to higher inflation, which is bad for you and me. But if you’re a big corporation like General Motors and you’re looking to finance building a new plant, it sounds great. General Motors can borrow the money at a cheaper rate today, and it can use the borrowed money to build a plant before inflation filters through the economy. Essentially, it can get in the front of the line with its wheelbarrow.

The second way Wall Street benefits is through the adjustment of interest rates to inflation. If the market is expecting higher inflation, bond rates must rise to compensate investors for the expected inflation. So if inflation is expected to be 5% next year, bond rates will adjust higher for the anticipated inflation.

Bond traders and banks – earning their profits through interest rates – immediately adjust for inflation. Unfortunately, our paychecks don’t adjust anywhere close to immediately. Our wheelbarrows are way down the line. If inflation is expected to be 5% next year, how much will your paycheck change today? For the vast majority of us, the answer is 0%. Our employer is not going to change our wages simply because Wall Street analysts have anticipated higher inflation the following year.

For the average Joe, it’s going to take a long time for the paycheck to catch up to inflation – if it ever does. First, prices and your employer’s revenues have to rise before things filter down to your paycheck. The average worker only gets a higher paycheck after inflation has already kicked in. Banks dealing in interest rates get their adjustments before inflation ever kicks in. Is there any wonder now why Wall Street isn’t particularly concerned about inflation and low interest rates?

But are the banks always the winners, while we’re always the losers? No, not necessarily. Sometimes we can jump to front of the line as well… or at least, the banks can let us cut in. If the Federal Reserve just lowered rates and you managed to borrow money to purchase a sizable home, then you’re in the same position as General Motors in the previous example. You’re getting some money prior to everyone else. That’s pretty much what happened with people purchasing homes at the beginning of the last decade. It’s hard to argue that those early buyers didn’t benefit from the Fed’s policy – many of them are still above water on their homes.

So, while we think about inflation as something affecting all prices, we have to remember that price changes don’t happen all at once. A few people are at the front of the line for new cash, while the vast majority of us are toward the end. Where you’re standing in that line more often than not forms your opinion on the process… but you may not recognize where you were in the line until several months have passed.

 

ORIGINAL ARTICLE HERE