Could higher rates work against lower inflation? And what would that mean for bonds?

Higher interest rates will eventually work, but they’re not working just now, argues Pendal’s OLIVER GE. That could mean bonds become even better value next year

• Inelastic demand and supply mean rates work differently
• In likely scenario, bonds a good place to invest
• Find out about Pendal fixed interest capabilities

WHAT if higher interest rates worked against cutting inflation?

Or at least had little effect on demand — making rate hikes ineffective in the fight against inflation?

“I want to talk about the idea that in an environment where demand is still reasonably strong, interest rate hikes effectively do nothing,” says Oliver Ge, an assistant portfolio manager with Pendal’s income and fixed interest team.

“Rather than cooling things down, they might be pushing them back up,” Oliver says.

The idea comes down to the notion of elasticity of demand – a measure of the change in the demand for a product in relation to the change in its price.

Elastic demand means there’s a big change in quantity demanded when there’s a change in price.

Inelastic demand is the opposite – little change in demand no matter what the change in price.

“When households are in decent shape, as they are today – when you have wages growth at decade highs and unemployment at near record lows, and savings are still plentiful – you end up with an environment where people are much less sensitive to price changes,” Ge says.

Covid lowered our price sensitivity

“During lockdowns, people were happy to pay for a whole range of goods like laptops, gardening tools, toilet paper,” notes Ge. “Consumer demand collectively channelled its momentum into household items.

“Suppliers jacked up prices but there was still plenty of demand.

“While we have moved on from Covid, we haven’t moved on from this sort of low-price sensitivity environment.

“The money has only moved on from chasing goods to instead chasing services.

“The bottom line is that the elasticity of demand is very, very low. It’s basically inelastic.”

Services are labour intensive – hospitals, hotels, cafes, restaurants, airlines employ hundreds of thousands of people, Ge says.

“Even though we’ve added a million people to the workforce since 2020, businesses are still experiencing labour shortages.

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“It’s a Covid hangover. People want to go out. They don’t want to be the people serving everyone else.”

“As a central banker you see inflation rising and your natural instinct is to raise rates. But the usual transmission mechanism is broken,” he says.

Transmission breakdown

Previously lifting interest rates would trigger tighter lending and refinancing, and companies would cut back on costs, including staff, says Ge. That would lead to higher unemployment and that would dampen inflation.

“But today, businesses aren’t really cutting back on staff. They’ve struggled to find and retain the right people, and thus don’t’ now want to lose them,” Oliver explains.

“Instead what they’ve chosen to do is compromise in other areas – say reduce the quality of ingredients if they are a restaurant.

“Or they are just passing the cost through to the consumer. And people are happy, at present, to pay the higher prices. Until they’re not.”

This process demonstrates an inelasticity of supply, as well as demand.

“So you have this relationship where higher rates are hurting businesses and to cope, they’re lifting prices, which consumers are paying.

“There’s a breakdown in the transmission of monetary policy to the employment market. In a very counterintuitive way, hikes are making things worse, not better.”

What it means for fixed interest investors

Higher interest rates will eventually work, but they’re not working just now, argues Ge.

“It will be the straw that breaks the camel’s back. It’s hard to see the stresses today but when it comes, it will come suddenly.

“I think there will be a fairly aggressive breaking point around the middle of next year. The Reserve Bank could realise too late, and then desperately try to reverse the rate rises.

“At which point bonds could become very good value. They are already good value, but that’s when the have the potential to become even better value.”

About Oliver Ge and Pendal’s Income and Fixed Interest boutique

Oliver Ge is an assistant portfolio manager with Pendal’s Income and Fixed Interest (IFI) team.

Oliver works on developing and running key quantitative investment models, and acting as trading support for the team. Oliver received his Bachelor of Commerce (Finance) from the University of Sydney and is also a CFA Charterholder.

Pendal’s IFI boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.

The invests across income, composite, pure alpha, global and Australian government strategies.

Find out more about Pendal’s fixed interest strategies here

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