What Do Inflation And Interest Rates Mean For Me?

Mario Draghi's European Central Bank (ECB) has been in the news lately as the world waits in suspense for his team's decision on whether they will cut Luigi some slack interest rates yet again. The ECB has been lowering rates for the past five years in an effort to stimulate the economy, but to little success. With the Euro's inflation rate falling to -0.2%, it seems the time has come for another round of stimulus.

But wait, why does the economy need stimulus because of its inflation rate? If inflation is defined as the general sustained increase of prices, wouldn't a -0.2% cause prices to go down, meaning that now we can afford more? Isn't that good?

The answer, unfortunately, is no. Negative inflation (Deflation) typically masks a problem with the economy, one in which the government, companies, and individuals as a whole are not spending enough. Without spending, the country's Gross Domestic Product (GDP) falters, and as the economy wanes, the companies start producing and earning less. As the companies wither, they start retrenching workers, causing these workers and their families to spend less. As individuals spend less, the cycle repeats itself and the country enters a deflationary cycle. In short, prolonged deflation is really bad news.

The Effects of Lower Interest Rates
So that explains the pressure on Draghi to start stimulating the Eurozone, and quick. The question now is, if he does decide to cut interest rates, how will that affect us as individuals and investors? The answer is much clearer for the individual - the most notable factors are that bank deposits will begin/continue earning next to nothing in interest. I emphasize continue because interest rates in the Eurozone are already low as it is. Take Belgium's BNP Paribas Fortis' latest savings account interest rates as an example. Essentially, every $100,000 we save only earns us enough for 10 meals ($50). That's about 3 days worth of food for 365 days worth of savings.

While there are other impacts on individuals, let's shift the focus now to us as investors. Lowering the interest rates would effectively:

1. Drive company expansion and generate growth
Lower interest rates would make money much cheaper and more accessible to companies, improving their ability to seize opportunities that come their way. Such flexibility afforded by loosened credit could work as a catalyst for greater growth as companies engage in more projects; though bear in mind the effect of diminishing marginal returns. Only the best projects are selected when companies are cash-strapped, but increasing the flow of credit means that taking on the less attractive projects suddenly become possible as well. This could spell disaster for companies that mismanage the risk they take on with the more lacklustre projects.

2. Increase stock valuations in markets
I wrote about stock valuations and how to go about doing them in one of my previous posts, click here to read it. Essentially, valuations are based on a companies' Weighted Average Cost of Capital (WACC) and their forecasted cash flows - as the WACC decreases through a lower cost of borrowing, valuations rise. More importantly however, real world examples tell a much more compelling story. The STI ETF rose 66.04% during the same period the first Quantitative Easing was launched by the ECB (Dec 2008 - Mar 2010), and in the same vein, the German DAX index climbed 47.13%.

3. Lower the yields of bonds
As cash becomes more available, companies become less willing to pay for investor loans, and hence bonds (debt issued by companies/governments) become less attractive for the investor. Furthermore, the already-low yield is hampered further by the increasing inflation rate. Rationally, we would then move our investments toward equities (stocks) and other securities.

While searching for higher yielding investments, we should always keep our initial strategy in mind. Our investment horizon, as touched on by my previous post, is still very much at play, while our innate risk appetite can only take so much once markets begin to wobble again.

In a nutshell, lower interest rates mean more good than bad for us average investors and the onus is on us now to find the right investment. Looking forward and tying world events together, there are ripening opportunities as two major players in the global economy (the ECB and OPEC) make massive decisions within the next two weeks.

Whether we choose to invest on this knowledge or not, let us not forget that the FED only recently raised US interest rates last year, and are currently discussing the possibility of another interest rate hike. If the interest rate changes do occur, we should not be surprised by a selloff of US equities for the more favorable Eurozone ones.