March 19, 2023
by Stephen Stofka
Inflation is a cat’s cradle of mechanisms and motivations as mysterious as time, a simple and puzzling concept that controls our lives. Our minds are caged by this thing that is objectively invariant – a second is a second – but experienced so differently by each of us. It begins when we are very young and ask a parent when we can go to the beach or an amusement park. “Next week,” we are told, and our eyes glaze over. How far away is next week? Albert Einstein was the first to understand time as a distance. Stephen Hawking, one of the most fertile minds of the last century, wrestled with the beginning of cosmological time. Many of us struggle to knit two concepts together – time and money. To many of us the net present value of a future flow of moneylooks like something inside of a tangled ball of fishing line.
Several banks blew up recently because they mismanaged their exposure to time risk. Inflation is the experience that time is moving faster than our money. It’s like our money is running on a treadmill when someone starts increasing the speed of the treadmill. The Fed cannot directly affect the speed of the treadmill so it raises interest rates, the equivalent of adding weight to our money. More often than not, the Fed damages the treadmill, sending the economy into recession.
I’ll include some background on the relationship between inflation and interest rates. Irving Fisher was an influential economist in the early half of the 20th century whose ideas continue to influence economic thinking. Several of these are the Quantity Theory of Money, a way of computing a price index, and a hypothetical relationship between inflation and unemployment that later became known as the Phillips Curve. Fisher hypothesized that interest rates rise in a lockstep response to inflation – an idea known as the Fisher Effect. Fisher reasoned that lenders would demand higher interest rates if they anticipated that a dollar would buy less in the future. For the same reason, depositors would demand higher interest rates on their savings. Fisher died in 1947, just after World War 2. In the decades after his death, the data did not support a simple one-for-one relationship between interest rates and inflation.
Despite the lack of a simple relationship, the Fed has limited tools to achieve – by law – two counterbalancing targets, full employment and stable prices. For several decades, its policy objective has targeted a 2% inflation rate as a quantitative mark of stable prices. To counter inflation, the Fed initiates a Fisher Effect by being the first bank to raise the interest rate it pays to all the other banks. The reasoning is that banks will charge higher interest on their loans to cover the higher cost of their funds. That should slow loan demand. Secondly, the Fed reasons that banks will raise the interest rate they pay on deposits. A higher rate should induce people to save more and spend less, thus slowing down the treadmill.
Fisher’s Quantity Theory of Money (QTM) is built on the assumption – an “if” – that interest rates stayed constant. Since interest rates were lowered to near zero during the financial crisis in 2008, there has been little movement in interest rates. This became a natural experiment that Fisher had imagined – a world where interest rates remained constant. As the Fed pumped more money into the economy during the 2010s, the QTM predicted that prices would rise. They didn’t. Just as economists had discovered that the relationship between interest rates and prices was complicated, so too was the relationship the quantity of money and prices.
Banking is the art and discipline of managing the speed and weight of money when an individual bank has no control over either the speed or the weight. Anything that stays still for long becomes invisible or at least minimizes their risk. Cats instinctively know this as they wait still and patient in the hope that a wary bird will relax its guard. The long lack of movement in interest rates tempted those at Silicon Valley Bank to take concentrated risks based on the assumption that interest rates would continue to stay low.
Retail investors are cautioned not to load up on long-term bonds just to get a higher interest rate return. From October 2021 to October 2022 Vanguard’s long-term bond index BLV lost almost 30% in value. Professional bankers broke that cautionary rule. Former Fed Chairman Alan Greenspan admitted his mistake in judgment as the 2008 financial crisis unfolded: “I made a mistake in presuming that the self-interests of … banks … were such that they were best capable of protecting their own shareholders and their equity in the firms.” By holding interest rates low for so long, some banks lost their sense of prudent risk management. The cat pounced.
This experience should guide our own choices of investment, savings and risk management. We can be lulled into thinking that some factor in our lives will stay constant. Some factors are personal – a job, a marriage, our health and the health of our family. Some factors belong to the wider community we are a part of – the local economy, the housing market and the weather. Other factors are macro – interest rates, inflation, state and federal policies. We can do what Silicon Valley Bank did not do – diversify.
Some have likened the run on SVB to the D&D model presented in a 1983 paper. Douglas Diamond and Philip Dybvig (D&D) won the 2022 Nobel Prize for their model demonstrating the efficiency and appropriateness of government deposit insurance. Douglas Diamond was interviewed this past Tuesday on the podcast Capital Isn’t. Diamond says that the bank run on SVB was not like the ones they presented in their model. In that model the depositor base was much wider and diverse, more like a random sample than the depositors of SVB who were primarily businesses in the tech industry.
Photo by Sven Mieke on Unsplash