Inflation creeping in

The inflation reading in Poland for July 2021 hit 5.0% year-on-year; the highest since May 2011 and the second-highest in the last two decades. Probably I would not gripe much about it, had the monetary policy been conducted in a proper manner. Sadly, it is not. Despite the rising price level and rapid recovery in the economy, benchmark interest rate in Poland stays at 0.10% (which in fact means the real interest rate is almost -5%, perhaps the lowest in the civilised world).

Interest rates in Poland were slashed to a record-low (by historical standards) level of 1.50% in March 2015, when Poland struggled a deflation. Then such move, with real interest rate of nearly 3%, was justified. Despite economic expansion, the central bank kept its rate level until March 2020, when it responded to the pandemic-related economic standstill by a rate cut of 50 basis points. In the next weeks the current level of 0.10% was reached. I will refrain from commenting on the legitimacy of such move in a situation of an unprecedented supply shock. I believe tools different than the cost of money should have been used to help businesses and customers out.

Customarily, I am referring you to my essay on harms inflicted by too loose monetary policy. Times have changed, economic principles have not, albeit some are intent on setting new paradigms.

Astonishingly many people realise why the Polish central bank does not react to the price growth which exceeds the statutory goal of monetary policy (i.e. inflation target of 2.50% +/- 1 p.p.). They do it to help the government finance its debt cheaply and pay negative interest on a large portion thereof. Not only the debt service spending is lower thanks to lack of monetary tightening. Higher prices mean higher tax inflows, predominantly from VAT. Inflation which spirals out of control always at least temporarily translates into negative real interest rates which facilitate transfer of wealth from creditors to debtors, including the biggest debtors in the world, i.e. governments.

Those particularly worse off are savers who now either accept a depletion of their savings kept in bank accounts by 5% yearly in real terms, or search for havens which might shield their money from inflation. Unlike me and my parents, not everyone noticed the opportunity of inflation-indexed 4Y government bonds in 2019 (which has turned out to be an excellent nearly risk-free investment making me give up on my resolution made a decade earlier). Folks with substantial savings have rushed to buy properties, as they believe tangible assets should store value. I am putting it down to Poles’ inability to invest in any other asset class than properties. Had flats purchased for investment reasons been put on the market for rent, this would have been quite okay, since thosee dwellings would meet someone’s housing needs. Horrifyingly, a growing number of flats stay vacant, as the purpose of their purchase was purely speculative, i.e. to benefit from value appreciation, despite bearing upkeep costs.

Moving back to the core topic of the post, i.e. to inflation, we should understand what drives prices up and why there is little chance the price growth decelerates.

1. Far too much hollow money has been printed during lockdowns. If goods or services are not produced, but economic actors receive a pecuniary compensation for being idle from a government, the link between a payment and goods or services offered in return is broken. A first-year student in economics would recognise it!

2. Recovery programmes run by governments to stimulate economies – they raise prices of specific goods and services, i.e. construction materials and services if a programme is aimed at such sector.

3. Broken supply chains, which have not been fully restored since early 2020. This problem affects several industries and strikes several markets off balances. These days the shortage of brand-new cars or bicycles is driven by shortage of components, without which vehicles cannot be manufactured.

4. Deferred demand – after several sectors were shut for months and as the general uncertainty seems over, customers rush to catch up on spending and business want to make up for losses incurred during lockdowns.

5. Lack of incentive to save. As people see their money evaporating on real terms from bank deposits, they are more eager to spend it, i.e. consume rather than invest.

6. Climate change and environment protection. This is the foremost reason. The time is coming to bring the price of several planet-destructive goods real and make them reflect the harm caused to the planet. For such reasons cars will have to be less affordable, prices of electricity generated from burning coal are bound to go up. Same needs to happen about rubbish collection charges, plane tickets, packaging, clothes and other goods humans thoughtlessly use in excess.

Having written that, I am happy I bought and furnished my dwelling in 2018, do not need to purchase a car, nor a bike and price growth of several goods does not affect me.

Why can we lose - because it's too loose ;-)

The interest rate environment in Poland (current benchmark rate of 1.50% unchanged since March 2015) is unprecedented for two reasons – firstly monetary policy has never been that stable and predictable; secondly, it has never been that loose. Guidance of monetary policy council members and statements of central bank’s governor is uniform – interest rates are going to stay intact for around two years. The monetary decision makers in their utterances point up they would sooner consider further loosening than jacking up interest rates; horribly.

Over eight years ago I wrote an essay in which I asserted why low interest rates are detrimental to the economy in the longer run. In that respect, my views have not evolved much over nearly a decade and I still fear the current near-zero real interest rates would do more harm than good to the booming economy of Poland. I do believe there are three reasons, why monetary tightening should be initiated right now, instead of waiting for dreadful stories to unfold.

Firstly, the wage pressure. Nominal wages in recent months were outpacing inflation markedly, reflecting not only rising efficiencies in production processes, but primarily labour force shortages in several industries. The salaries are rising predominantly among low-paid employees (partly side effect of 500+ allowance) whose supply is shrinking and employers are forced to compete for them. In that labour market niche pay rises reach 20% annually.

Effects?

1. Those people whose financial well-being has improved recently (good for them) would rather spend their additional income to have their needs met which generates additional demand on the market and might push up prices of basic goods.

2. Rising payrolls should drive prices of goods and services sold (otherwise profits of businesses decline or imported substitutes replace domestic goods.

Both effects contribute to increase in the price level, i.e. to future inflation.

Secondly, the situation on the property market, which is not in a bubble only thanks to record-high supply of new dwellings and several constraints on mortgage lending (which is pricey and subject to LTV restrictions and more stringent creditworthiness assessment).

The current bank deposits bring one-third of the income of property rental yield, so whoever is not afraid of risks and liquidity constraints associated with letting a flat does not keep their extra money on little-earning bank accounts and chooses to buy a flat for sale.

This also has several implications:

1.       Outflow of money from the banking system; whoever wants to invest in properties should realise unlike with a lending spree, here flow of new money might be cut short, as number of people with six-digit savings in Poland is finite.

2.       Increased supply of properties to be rented which might balance or not demand from tenants. In the final phase (especially after an interest-rate hike) the relative attractiveness of property rental might decrease and might trigger a sell-off from less experienced investors. This might as well go the other way round, as many people might be deprived of a chance to buy a property.

3.       Property developers have been increasing output of dwelling since 2014, so far with only marginal price increases. With current demand, surpassing supply and with increasing prices of construction materials and labour charges, property prices are set to rise inevitably with might not be put up with by buyers. margins in the industry will go down. Property developers as the group seem safe, however bankruptcies among general contractors and subcotractors loom large.

While until now the property market was generally heading in a good direction (increased supply of new dwelling, stable prices, higher availability defined as number of sqm can an average salary would buy), now the threat of imbalances has grown.

Worth noting other countries have already set off to increase interest rates, to somewhat dampen the economic boom and in many countries to stem double-digit growth in property prices which in longer run is dangerous to the economy and impoverishes the society.

I can moan, I can complain, while my grumbling will change nothing. I may only hope negative implications which I foresee do not materialise and the Polish economy does not suffer a shock.

Polish economy proves its resilience

A long expected move has just been made. After nineteen months of standing at 3.50% benchmark interest rate of Polish Central Bank was raised by 25 basis points. The decision taken by Monetary Policy Council was anticipated by financial markets.

Thus Poland joined the group of countries where monetary tightening has got under way. The prudent step confirms Polish economy is back on the growth track and in the middle term inflation poses a bigger threat to macroeconomic stability than low pace of GDP growth. Quite probably this year we will witness three interest rate hikes, each by 25 basis points, so at the end of the year the benchmark rate will reach 4.50%. This series of gentle increases will not hamper economic growth, but will ensure price stability (conducive and indispensable to sustain long-term growth) and will head off the risk of overheating the economy. In the long term I expect Polish central bank to focus mainly on inflation data; pace of economic growth will recede into background.

Markets have already discounted the hike. FRA quotations had indicated one hike in 2010, so according to the markets, the decision was belated. Valuations of bond funds and money market funds, both sensitive to interest rate movements (correlation is negative) were down in the recent weeks (bond funds), or levelled off (money market funds). What was felt by participants of "safe" investment funds will soon affect borrowers who have taken out variable-rate loans (that applies to mortgage loans denominated in PLN as well). Mortgage borrowers whose debts are denominated in foreign currencies can expect, holding everything else unchanged, slightly lower installments, as rising rates should cause zloty to appreciate. Interests paid by the banks for time deposits and saving accounts will pick up, but here you ought to expect a considerable lag - banks are not hard up for cash and will not pay over the odds for your savings.

Today WIG20, the main index of Warsaw Stock Exchange hit its many months' high and climbed to levels last seen in summer 2008 (and subsequently plummeted). In the short term I expect stock prices to go up, in the mid-term a correction by round about 10% would be quite natural, my target for the end of the year is 3,200 points (WIG 20). I will look back on these forecasts at the end of the year, to check how accurate they were.

In the meantime I took a glance at comment threads following the news items informing about the hike. Commentators either fulminate against prime minister Tusk and the ruling Platforma Obywatelska (as if they were responsible for the move) or blame conspiracy of foreing banks, all in league to fleece poor Poles... Thoughtless comments, which by the way are indispensable part of the Internet (educated people have little time to comment), remind me that Poles' grasp of mechanics of economics still needs to be worked on...

The evil of keeping the interest rates low

Just as it has been done for the past year…

Easy come, easy go. Our approach to many things depends on the price we had, have, or will have to pay for them. Human life is (considered) priceless, but the respect to material goods is highly correlated with their value. If we buy a brand new car, we polish it every weekend and park it very carefully so that we don’t scratch it. If you are an owner of a new car, this scratch probably breaks your heart, buy if what you possess is a clapped-out banger, you usually don’t care. This does not apply to everyone, may the author of this blog serve as an example.

The respect for items is in my theory conditioned on the replacement costs, including transaction costs, in more simple words, the crucial criteria are price and availability or effort that has to be made to procure a certain good.

The natural economy is the thing of the past. In the contemporary world, money is used to value goods, fix prices and serves as a legal tender. But in the light of my theory, can you figure out, what the respect for money is contingent on? The most common perception, often instilled in children during the upbringing process is that the more people respect money, the harder they had to work to earn it. In terms of life this can be seen as golden rule, especially when we see the guys (called “politicians”), whose livelihood is spending someone else’s money. In economics, things tangle up a bit, but the phenomenon of ‘price approach’ remains applicable.

Can money have its price? How is this price fixed? In the market economy, price is usually driven by the market forces, so when the supply and demand meet, a certain amount (quantity) of a certain good is sold at a certain price. But hang on! Two questions slip into our reasoning. Firstly, how can the money be valued, is a 100 zł note worth more or less than 100 zł, or maybe as much as the paper it is printed on? And secondly, how do supply and demand on money can look?

The first questions is followed by two answers. The first is based on the existence of exchange rates – money as a currency of one country can be valued in another currency, but that’s not what I’m going to deal with today. In the second and final answer, we assume the money is a specific good, which can be neither sold nor bought, but can be lent and borrowed. Hence, the price of money is the interest rate.

And the “supply and demand” matter. Every student who has completed the basic course of macroeconomics should know the supply of money is controlled by the central bank, which runs monetary policy, either directly, by setting money supply, or indirectly, by setting interest rates. A demand on money is in turn generated by private persons, legal entities and governments and is basically conditioned on its price. So when the cost of money is brought down, demand on it automatically rises. So I’m responsible only for the demand… I cannot just print money at home, go to the shops and use the notes as a legal tender – this is a crime. Central banks, as the current practises of Federal Reserve or Bank of England show, can print as much money as they want and it is not a crime – how funny!

Look at the history: low interest rates in Japan fuelled stock bubble, which later on caused a financial meltdown and the decade of stagnation. Why had it happened? People ahd borrowed money cheaply and invested it in shares, as long as their valuations were on the rise they borrowed even more, hoping the trend would continue. But the moment when the growth potential reached its limits has come, and those people and businesses that had their money in stocks were left with little capital and debts they had to pay off. So instead of spending money on consumption, they had to return it to their creditors, who also had lost as a result of numerous write-offs.

At the beginning of twenty-first century, Alan Greenspan as a Fed governor hit upon a mould-breaking idea that every American should afford to buy a house (as Mr Greenspan declares on pages 229 and 230 in his book “Age of Turbulence”, I quote the original edition), no matter how poor they were (the second part of the sentence is where the author calls a spade a spade). To that end (and some others actually), Fed shaved federal funds rate to only one per cent and kept it down for a few years, until 2006. Availability of cheap subprime mortgages combined with low interest rates, high gains on property and stock markets and new inventions of financial engineering whetted the appetite for risk and blew up sizeable bubbles. When they burst it was too late. In his book, released in 2007, Mr Greenspan admits he had seen the bubble rising, however he claims an average family could move to a posh house and improve their standard of living thanks to his policy. Many of those families found their houses foreclosed, when the rising inflation made Fed jack up the interest rates and adjustable-rate mortgage repayments became they burdens many households could not carry.

A year ago, in an unprecedented move, Fed once again slashed the interest rates almost to zero. The action was intended to ease the pain of financial markets and to boost customers’ confidence. The latter was somehow propped up, but rather by expansionary fiscal policy, not by better access to consumer loans. American customers after they had been taught a hard-knock lesson are still reluctant to spend and borrow. The distressed markets, in particular banks gave a warm welcome to the liquidity injection the were granted. In a short term this move prevented a knock-on effect and ultimate collapse of financial system. After a few months it turned out that big investment banks used the cheap cash for aggressive speculation on stock, gold, crude oil, or copper markets. At the end of the year their balance sheets grow robust and bankers once again grant themselves generous bonuses. The real economy, though in recovery, still does not keep up with the markets.

Interest rates are going to remain low, so the ecstasy on financial markets will continue. Then the inflation will drive the rates higher and the next bubble will be punctured. Why is it so likely to happen? It is in the interest of US government to see the higher inflation which would decrease the real amount of its debt…

Hey, how about Poland? Unlike United States and most of EU countries Poland has not been troubled by deflation and therefore had to keep its interest rates higher in nominal terms. But in real terms our benchmark rate fluctuates around zero (the rate is currently 3,50%, whereas inflation in the recent months has been between 3% and 4%, but beware, this calculation, though commonly used is flawed, because the interest rate refers to the future period and inflation to the past).

Whenever somebody speaks about the factors that have contributed to positive economic growth in Poland, they accentuate two of them: consumer confidence and depreciation of złoty. I cannot deny their role, but hardly anyone mentions the monetary policy run during the boom. Unlike the Baltic States, Poland has not fallen into the indebtness trap. The burden of debts has not clamp down on our development, which, a bit stifled in the years of boom, now turns out to be sustainable. We owe our success not to government of Law Justice, nor to the current cabinet of Donald Tusk, but to the restrictions on denominated loans and other, imposed by our financial supervisory body and to higher than postulated by some “illiterate economists” interest rates, which tightened the credit criteria and prevented the growth of domestic subprime loan market.

To sum up, I see four main reasons, why the interest rates should be kept relatively high.

1) The influence of consumer stances. When the loans are more available (more people can afford them when they have pay not much more than they had borrowed), consumers tend to spend more and more recklessly and find it harder to estimate, what they can afford. Meanwhile their propensity to save declines, because depositors are given lower interest rates in the banks.

2) Flawed investment projects. When the interest rate is low, more business venture become viable, because for a lower interest rate on the borrowed capital, the net present value of the project is more likely to be above zero. Those enterprises turn out to be very vulnerable to any external factors that can hamper their business.

3) Inflation. Dariusz Filar, currently the member of the Monetary Policy Council has put forward a rule that the benchmark rate should be set around two percentage points above the inflation rate. In the present circumstances it should be raised to 5,25% and nobody would agree on it, but in the long term I see it as a sound principle of money value protection. Once the inflation spirals out of control it is hard to pull it down, the effects of the therapy are severe and those who lose the most are usually the poorest.

4) Risk management. When a year ago I paid almost all my savings into a 12M deposit I was bid a decent interest rate of 8,5 per cent and it did not occur to me to seek any other investments when I was given a fixed-income deposit with honest interest. But if I had been given the interest rate of 1,25 per cent on the same deposit, would I have been so eager to leave my money in the safe haven? Probably not, because the secure profits would be tiny and I would be more keen to invest that money in a risky securities. That it what has happened this year – being faced with low interest rates big market players took the chance and earned ten times more than the author of this blog!