The interest rate that really matters for investors

In the US last month, inflation hit a five-year high.

Consumer prices rose by 2.5% on January 2016. That’s up from a 2.1% rate the previous month. And “core” inflation – the bit the Federal Reserve pretends to care about – hit 2.3%.

That’s above the Fed’s target of 2%. And it’s a lot higher than interest rates are right now.

So what does it mean for monetary policy? And, more importantly, for your investments?

The Fed will stay behind the curve – here’s why

How will the Federal Reserve react to rising inflation in the US? It’ll probably raise interest rates.

But the key point to understand is that the central bank will raise interest rates so slowly as to make sure that inflation stays well ahead of the game. So expect inflation to rise more rapidly than rates do.

My assumption has always been that the Federal Reserve is going to stay behind the curve. Why does that matter? Because for asset prices, what’s important is “real” interest rates.

Put simply, the “real” interest rate is the amount of interest you earn in “real” terms – ie, after inflation. So if interest rates are higher than inflation, then you have a positive real interest rate. If inflation is higher than interest rates, you have a negative real rate.

In other words, if inflation is at negative 1% (ie, you have deflation), then it’s possible for monetary policy to still be suffocatingly tight even at 0%. Because you still have a positive “real” interest rate.

Here’s a practical example. If the cost of living is falling every year, then you will not be penalised for holding your money in a 0% bank account. In fact, the value of your money will still be growing every year, because by the end of the year, £100 will buy you more than it did the year before. The “real” interest rate is still positive.

On the other hand, if the cost of living is rising at 5% a year, then your savings will be losing value unless you can find a bank account that pays at least that much interest (and that’s not even considering other costs such as tax). If your bank account pays 3% for example, then the “real” interest rate is quite strongly negative.

If central bankers want us to spend and invest – and that’s exactly what they’ve been trying to encourage since the financial crisis – then they target a negative real interest rate. In short, they force you to go out and either spend your money or take risks with it, before its value is entirely eroded away.

(This, incidentally, is why central banks are keen on the idea of banning cash. If interest rates are at 0%, and deflation hits 3%, then cash under the mattress becomes a valuable asset. Even under your bed, its value is increasing year by year. If all cash is electronic, that can be stopped. You can impose a negative interest rate on electronic cash, because there’s nowhere else for it to go.)

When real interest rates are high, it pays to sit on your cash, or cash-like assets – “risk-free” government bonds, for example. Because, basically, you can get a decent income for taking very little risk.

If your bank account pays 5% at a time when inflation is at 1%, then other assets such as equities, have to be offering very healthy potential returns to persuade you to take the risk of investing your money in them.

However, when real interest rates are low, or negative, you need to put your money to work. If inflation is at 5% and your bank account pays 1%, your cash is being eaten away by the minute. So you have to find some way of preserving or growing your wealth, usually by investing in risk assets.

Gold’s price fluctuations are heavily influenced by “real” interest rates. If “real” rates are high, then gold becomes less attractive. Why invest in an asset that pays no income if you can get a much better return on a ten-year US government bond?

But if “real” rates are negative, then gold becomes much more appealing. Suddenly the fact that it pays no income doesn’t matter. Instead the characteristic of gold that appeals is the fact that it maintains its long-term purchasing power and carries no credit risk.

(If you’re interested in reading more on this by the way, giant bond fund manager Pimco has a good piece on the relationship between gold and “real” rates.)

Real interest rates could go increasingly negative in years to come

So, what’s my point?

Unless and until inflation becomes a bigger threat to economic stability (in the eyes of central banks) than a lapse back into deflation, you can expect central banks to maintain negative interest rates.

You can also expect them to raise rates at a pace that doesn’t scare the horses. If there’s one thing that central bankers have likely learned by now, the way to do that is by raising rates incredibly slowly. And it helps to soften the markets up by talking a big game and then doing a lot less.

In the longer run (possibly a lot longer, but equally, possibly a lot quicker than anyone expects), inflation will take off and we’ll end up with a scenario in which central banks are actually under pressure to get ahead of inflation.

But that’s not where we are yet. Instead we’re at the stage where “real” interest rates might even become increasingly negative, as inflation starts to rise more rapidly than rates do, but not at a pace that terrifies the markets.

So, stick with your equity investments. Hang on to gold. And be wary of bonds.