Higher Interest Rates And Inflation Could Be Around The Corner

There is one individual whose words about the economy carry a lot of weight. That person is Warren Buffett who has created and estimate fortune of $37 billion managing Berkshire Hathaway Company. He is the world's second-richest man, according to the "Forbes Richlist 2009".

At the onset of the global financial crisis Buffet commended the government's actions on rescuing the economy from a collapse beyond the level of the Great Depression over 75 years ago.

Federal spending soared to avert a total collapse to the tune of a $787 billion economic stimulus package enacted in February of 2009, plus a $700 billion bailout of the financial industry, and takeovers of mortgage financiers Fannie Mae and Freddie Mac.  An example of the spending is the government setting aside $3 billion for the 'cash for clunkers program.  This program paid owners up to $4,500 to trade in gas guzzlers for new and more efficient automobiles.

The public purse also faces lower tax receipts and higher social security costs as unemployment rises to what is now 16.5% to 16.8% depending on the index used.

The stimulus packages implemented by the government helped us avert a much worse financial crisis but the cost of cleaning up the economy are really starting to come to light.

Warrant Buffett said in a NY Times interview last year,

Enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself.

Buffett, in the New York Times article, cited 20th Century economist John Maynard Keynes.  Keynes 'borrow and spend' theories were used to manage the Great Depression by President Roosevelt.  The same theories are in play today. Keynes also noted the problem of unbridled use of his plan when he stated:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens…. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

Buffett's concerns now center on America's $1.8 trillion budget deficit, which represents 13% of the size of the total economy.  According to Buffett the previous peacetime record occurred in the 1920's and was 6% of the total economy. America is paying $500 million per day in interest alone!

A big fear is that political leaders facing midterm election pressure will be tempted to continue spending and using quantitative easing, a form of printing money, that would create inflation and help to eliminate the debt.

Buffett said that the use of spending and quantitative easing is like global warming, and warns of the side-effect of 'dollar emissions' from the 'Greenback effect'.

Buffett wrote,

Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes.

Buffett further stated, “Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt.”

Printing money has a cost. It creates inflation and with it higher interest rates. According to one economist affiliated with a influential think tank, LIBOR could spiral "rapidly" as the Bank of England will need to control run away inflation.

Andrew Lilico, of the Policy Exchange think-tank, said, “To keep inflation (as measured by the Retail Prices Index) down to only 10% for one year, the economy will have to be able to tolerate interest rates of perhaps 8%.”  Unfortunately, the situation taking place in the U.K. is no different that what we are facing in America.

All of the strategies in use or being considered by the, U.S. Treasury, the Federal Reserve Board of Governors, Comptroller of Currency, etc., to stabilize or rescue financial institutions will require us to create more money.  In the absence of proportionally-higher real output from our workforce, we face more money chasing the same amount of goods. With unemployment at 16.5%, it is very difficult to increase workforce output. This is a classic example for inflation as well as the expectation of inflation.  Both of which lead to an increase of interest rates.

In a nut shell, what is an interest rate? Interest rates are the sum of real-economic growth and inflation. Very-high interest rates are mostly a product of inflation. In August 1981, the 18.79% 3-month Libor was associated with negative real growth and in the neighborhood of 20% inflation. Consumption is reduced proportionally by inflation, e.g., 20% inflation reduces consumption by 1/5 per year.

Worse yet, at some point in as inflation takes off, there will come two psychological tipping points:

· Foreign countries like China will not want to hold US dollar-denominated (noncash) assets. They will start selling their debt instruments (think Treasuries), and thus debt-instrument prices will fall, which means interest rates will rise; and

· foreigners will not want to use US dollars as a medium of exchange and the US economy will therefore suffer  "Seigniorage Shrinkage".

Seigniorage is economic term which defines the profit a government makes on the money it creates, i.e., the value of the things it buys with money that it prints (most is created electronically) minus the cost of creating the money.

Up until now, foreigners have produced real things, which we consumed and paid for partly with electronic dollars. Currently it costs the US nothing to create money since it is all done electronically with no real associated costs. Until now this type of foreign purchase can be thought of as a gift from them to us, since we have used their products and sent no domestic products in return. We have only sent them electronic money. China has supported this relationship in order to maintain its own economy.  My Grandfather once told me, “If you are going to borrow then borrow as much as you can. When you owe the bank a little they own you but when you owe the bank a lot, you own them.” Well, we owe China more than we can pay back and if we fail they fail with us so who owns who?

However, if China were to switch all transactions to the Yuan and the rest of the world were to follow and use a currency other than the Dollar then they would be buying our output by returning our electronic money. Having more of our money flow back to the US than we can consume will reverse the relationship we currently have with countries like China. So the standard of living that we have enjoyed in the past with respect to Seigniorage will be reversed. The economics of all this seem cumbersome but the effects on Americans are easy to understand.

The effects of much higher interest rates on the order of 16 times what they are now will have catastrophic effects. Let’s list the obvious one:

· Decreased Purchasing Power: each unit of currency buys fewer goods and services.

· The Value of Assets will be Reduced:Increased interest rates will deflate the value of many assets, since their future value will be discounted in a market with higher rates. If you sell an asset you will have to take less and your net worth will be drastically reduced.

· Higher Borrowing Costs: Interest payments on credit cards and loans are more expensive. Therefore this discourages people from borrowing and saving. People who already have loans will have less disposable income because they spend more on interest payments. So there will be a decrease in other possible areas of consumption.

· Higher interest rates increase the value of the Dollar: (due to hot money flows. Investors are more likely to save in US Banks since our rates are higher than other countries) A stronger Dollar makes US exports less competitive – reducing exports and increasing imports. This has the effect of reducing Aggregate demand in the economy.

· Rising interest rates affect both consumers and firms. The economy would likely experience decreases in investment and consumption.

· Government debt interest payments increase. Higher interest rates increase the cost of government interest payments. In turn, this creates increased taxes in the future.

· Reduced Confidence. Interest rates play an intricate part in consumer and business confidence. A rise in interest rates discourages investment; it makes firms and consumers less willing to take out risky investments and purchases.

Affected assets include those which provide services or cash in the future, like real estate, life insurance, health insurance, equity stocks, and most long-term bonds. For many investors and some consumers (those purchasing long-term services like owning rental real estate is like buying a stream of rental services), much higher interest rates will greatly reduce their wealth. Higher interest rates will discount future cash streams for many assets.

This effect is exacerbated by the reduced effective demand for such assets caused by more-expensive and less-available lending. It is moderated a little by people fleeing financial assets for tangible assets.

Aside from the negative effects noted above, consumer consumption (including charitable contributions) which is the object of many people's wealth will also be affected by higher interest rates.

So what are we to do? If higher interest rates and inflation are coming then what can you do to prepare yourself now and even profit in the future?

Investors and consumers can now access the fixed-income market, to hedge the above-mentioned dangers, very inexpensively. This low cost is due to several factors that have depressed the price of fixed-income volatility compared to historic levels.  If there is a substantial increase in rates then it will, in a sense, be too late as such protections will be way to expensive.  So the time to act is now.

With that said, there are only a few financial service firms equipped to offer these types of services. I am aware of only a few real-estate businesses that have approached financial-service firms for such interest-rate insurance.

These financial firms quoted and charged excessive fees. To buy such protection efficiently requires access to more mathematical-finance expertise and relationships with fixed-income trading desks, than most such firms can readily provide. What can you do to protect yourself from the negative effects of higher interest rate and inflation?

Our cleint's frustration over the lack of availability to these programs led me to form Aegis Risk Management Group, LLC (See AegisRMG.com).  At Aegis Risk Managment Group we have assembled the expertise to assess your exposure to higher interest rates, quantify the risk of loss in real dollars and cents, that allow us to implement an efficient interest investment that will protect you when inflation comes and interest rates rise.  This is with tax efficiency and with coordination of the interest protection within the Aegis Council plan for your wealth creation and preservation goals. Contact Kingsley Charles at kc@aegiccompanies.com for more information.

More information on Thomas Agresti can be found here:http://aegiscompanies.com

Thomas (T.J.) Agresti, J.D., LL.M, CEO Founder and Chairman of the Board, Aegis Holdings, Denver, Colorado

Thomas Agresti (JD LLM) from Denver, Colorado began a successful career as a tax attorney after finishing an extensive and well-planned education that included the University of Maryland, Seton Hall University School of Law, University of Parma School of Law in Italy, and University of Denver School of Law. He is currently registered with the Bar of Colorado.

While in law school, T.J. primarily focused on taxation and transactional law. He also went to Italy to understand the intricacies of international law and finance, again with a focus on taxation and transactions.  After Italy, T.J. took his skills to the ultimate level receiving a Masters in Taxation from the University of Denver School of Law.  Because of his rare professional and education experience, he quickly became a highly sought after attorney. He chose to work with a large multinational public accounting firm allowing him to gain significant tax and transactional law experience in a short time frame.

As a specialist in taxation for a "Big Six international accounting firm, T.J. specialized in domestic and international strategic tax planning.  Simply put, he reduced his clients tax burdens. His responsibilities also included financial and estate planning; income, gift, and estate tax reduction; compliance for individuals, trusts, and estates, partnerships, corporations, and tax-exempt entities. After leaving public accounting he practiced tax law with a boutique law firm before forming his own firm.  He has worked around the world with a variety of clients.  He has practical experience planning and implementing multi-national transactions, sophisticated wealth transfer planning, sophisticated life insurance structures, captive insurance, private equity and structured debt instruments.