This isn’t 2008. Interest Rates Are on the Rise.

The Great Financial Crisis of 2008 (GFC) brought with it immense changes in the American economic system. The greatest of these was the introduction of Quantitative Easing (QE) which led to the popular belief that there would be a massive rise in inflation post-crisis. Hence, it was confounding to many when this notion didn’t pan out. Instead, the USA struggled with a decade of inflation below its 2% target. A variety of factors contributed to this phenomenon, including the poor financial health of American households pre and post-crisis, the inadequate government response to the recession, and the unintended depression of the velocity of M2 money stock, which is a broad measure of money supply. However, opposite forces are at play in 2020, so low inflation will not be the case this time around. As a result, interest rates will rise to higher levels than seen in recent years, and the divergence between growth and value stocks that was seen throughout the 2010s will converge.

 The GFC was as much of a debt crisis as it was a banking failure. Before the recession, the 2000s were characterized by loose lending requirements causing a massive increase in household debt, with the household debt-to-national income ratio rising to over 90%. Due to this, total financial obligations as a percentage of household income hit all-time highs pre-crisis. In addition to this debt frenzy, consumers were euphoric and optimistic coming off of the 2001 recession, such that their savings rate plummeted to all-time lows. Hence, households entered the GFC with immense debt loads, financial obligations, and low cash reserves, decreasing their ability to make payments at a time of immense job losses and uncertainty. The GFC amplified these problems. The housing crisis resulted in lower household net worth. This combined with all-time high credit delinquencies and skyrocketing unemployment worsened households’ financial health as they came out of the recession, leading to a household debt-to-national income ratio of around 100%. American consumers were in no position to spend, and without spending, there can be no inflation.

The economic outlook would not have been as bleak as it was after the recession had the government taken the right steps. It leaned extensively on monetary policy and concentrated its fiscal packages on government spending, trying to offset the reduction in private spending with public spending by undertaking a variety of infrastructure projects. However, the government failed to recognize households’ dire situation, not extending any real financial relief to consumers. It also didn’t adequately help the failing business sector, resulting in the large-scale job losses we saw. In hindsight, many economists agree the US government’s fiscal stimulus was too small. As mentioned above, fiscal policy wasn’t the government’s main response tool to the crisis, rather it was monetary policy. In the implementation of this monetary policy, the Federal Reserve (Fed) introduced QE to the American economy. It bought assets off of private bank balance sheets, injecting the banking system with cash. This expansion of the money supply fueled widespread inflationary fears. However, institutions and consumers alike failed to recognize that QE only increased the monetary base (MB), a narrow measure of the money supply. It didn’t have the anticipated impact on M2, which increased at roughly the same rate as it had been since 2000. On paper, the Fed can increase MB, and to a smaller extent, M2. However, money supply in the real economy is composed of M2 less MB, which the Fed can’t influence. Its expansion is primarily dictated by fiscal policy and private banks. Hence, due to banks’ unwillingness to lend at the time combined with an inadequate fiscal stimulus, real M2 expansion did not occur. Banks used the cash injection to fix their balance sheets and held onto the rest as excess capital, increasing reserves. The money didn’t find its way to the real economy and thus, the adage of “too much money chasing too few goods” didn’t pan out.

The reduced bank lending in the economy and the dire financial situation households found themselves in after the GFC resulted in the depression of the velocity of M2 money stock. Since a large portion of the M2 expansion was on paper, sitting in bank reserves and being deployed in investments accruing a velocity of 0, it placed downward pressure on velocity. In addition, since households exited the GFC less inclined to borrow and spend, velocity was further decreased. Consequently, as we saw the money supply continue to grow at its previous pace with lower velocity this time around, the post-crisis recovery was extremely slow and inflation remained similarly low.

Since households witnessed the negative impacts of extraordinarily high debt levels, they spent the last decade paying down debt. This resulted in the household debt-to-national income ratio decreasing by 25% from its GFC highs as of January 2020. This ratio has remained under 80% throughout the pandemic as consumers have continued to pay down debt and have slowed spending, as noted by Barclays. Consumers understood the benefit of having a cash buffer post-crisis, so they spent the last decade saving more of their incomes. Resultantly, they entered the COVID-19 induced economic shutdown with a savings rate more than double that with which they entered the GFC, and it has risen throughout the pandemic. Since savings rates are near the highest they’ve ever been, and household debt is near the lowest it’s ever been, households will be primed to increase spending at a high clip to satiate their pent-up demand. They’ll have cash sitting around while also being able to take on debt to finance purchases and vacations, which is something most consumers couldn’t afford to do in 2010. This situation is already being played out. Less than half of American consumers normally go on vacation, however, roughly 82% of Americans have made travel plans for the second half of 2021. Also, when restrictions were eased in Q3 of 2020, spending rose at an unbelievable pace. Similar spending boosts will push inflation higher as the economy reopens.

Households’ ability to exit the pandemic in a strong financial position is largely due to the American government’s response to the crisis. Unlike 2008, the government didn’t just lean on monetary policy, it also enacted huge fiscal packages, directly supporting the real economy. It supported consumers by enacting a variety of policies that allowed them to continue to receive an income while reducing their financial obligations. The government also helped businesses by creating lending programs for firms of all sizes. These activities helped push credit delinquencies to all-time lows while allowing consumers and businesses to come out of the recession ready to spend. Through these programs, the government also directly increased the money supply in the real economy this time around. It has risen by a historic 24% over the course of the pandemic. Thus, as the economy reopens, too much money will in fact be chasing too few goods, placing upward pressure on inflation. 

With households and businesses in strong financial positions, M2 velocity is also expected to substantially rebound. As the vaccine rollout continues, economic uncertainty will decrease, and consumer confidence and spending will rise. This will increase velocity. The combination of substantially higher M2 and rising velocity will create immense inflationary pressures in the economy. However, it is important to note that the economy is still in an output gap, so the probability of hyperinflation remains extremely low.

These inflationary pressures are already being seen in the economy today in the form of asset price inflation in housing prices and the stock market, as well as through rising input costs for producers. As this continues to trickle into the real economy through the reopening, interest rates will see upward pressure resulting in rising valuations for value stocks, as near-term cash flows are more coveted. At the same time, this will have an adverse impact on both bonds and growth stocks as cash flows received in the distant future have lower appeal.

This isn’t 2008. Post-crisis inflationary fears during the GFC were stoked by a singular focus on the Fed’s heightened money creation. However, this view ignored how the new money was being used as well as the dire situation of the real economy. These details ended up limiting inflation and economic growth after the recession. As a result, low interest rates were seen in the economy throughout the 2010s, fueling an immense expansion in the valuation of growth stocks. On the other hand, the granular details support the expectations for high inflation this time around. Consequently, the American economy is poised to return to the era of mid-single-digit interest rates that haven’t been seen in decades, and financial markets will have to adjust to this changing climate.