When it comes to understanding the complex workings of the economy, few names carry as much weight as that of Ray Dalio. As the founder of Bridgewater Associates, one of the world’s largest and most successful investment firms, Dalio has built a reputation as a master of economic forecasting and analysis. Not only does he have a track record of success in the industry, but his unique approach of “principles” and transparent communication sets him apart as a true authority on the subject. In his article, ‘It Starts With Inflation,’ Dalio takes us on a journey through the inner workings of the economic machine and how it relates to our current circumstances, giving us a clear understanding of what’s ahead.

In this article, I will highlight some of Dalio’s most important points and why this knowledge can help us make informed decisions and plan for the future.

The Economic Puzzle

In the long run, rising living standards are driven by increased productivity – the ability to get more done in a day’s work. This is the fundamental trend, but there are fluctuations caused by money and credit cycles. These cycles affect interest rates, markets, economic growth, and inflation. Generally, when money and credit growth is strong, demand and economic growth are strong, and unemployment falls. This leads to higher inflation.

On the other hand, when the opposite is true, the opposite happens. Central banks, who control the amount of money and credit in reserve currency countries, aim for the highest economic growth and lowest unemployment rate possible, as long as it doesn’t produce undesirable inflation – usually around 2%. So, they must balance economic growth and inflation using monetary policy.

When inflation is high, they tighten the policy to bring it down. The higher the inflation rate, the more they tighten. Currently, with inflation well above the desired rate and low unemployment, it’s clear that central banks will tighten policy to bring inflation down. This will have a domino effect on the economy. Inflation is the first step in this process. It is driven by the amount of money and credit in the economy and interest rates set by the central bank. These factors affect the prices of goods and services. This, in turn, leads to changes in interest rates, markets, and the overall economy.

The Interest Rate Escalating

This leads to the rise in interest rates. Central banks control the flow of money and credit by setting interest rates and buying and selling debt. These actions, such as quantitative easing and quantitative tightening, greatly impact the economy. Real interest rates, or interest rates relative to inflation, play a crucial role in determining economic stability.

Turbulence Hitting Markets

Inflation and interest rates have a domino effect on markets. As interest rates rise, relative to inflation, prices of equities, other markets, and income-producing assets decrease. This happens due to the negative impact on incomes, the need for competitive returns, and the reduced availability of money and credit. Investors also anticipate slower growth in earnings, further affecting the prices of investment assets and the economy.

Economy Reflecting Results

When central banks create low-interest rates relative to inflation and make credit readily available, it encourages borrowing, spending, and the selling of debt assets. This accelerates economic growth and raises inflation. Conversely, high-interest rates and tight credit have the opposite effect. The optimal balance is determined by what is most tolerable for central bankers, and policies are adjusted accordingly. Understanding and anticipating these interconnections is key to making informed decisions and achieving desired outcomes.

What Does This Tell Us?

By understanding how inflation, interest rates, markets, and economic growth are interconnected, we can anticipate their future developments. Currently, the markets are forecasting a 2.6% inflation rate over the next ten years in the US. Ray estimates that it will reach 4.5% to 5% in the long term, subject to external factors such as economic conflicts and natural disasters. He expects inflation to decrease temporarily in the short term before trending back up to the 4.5% to 5% range.

Next, he says that we have to estimate interest rates in relation to inflation. Currently, markets are projecting a 1.0 percent rate for the next ten years. However, this may not be entirely accurate. It’s essential to consider factors such as the amount of debt assets and liabilities, debt service costs, and real returns for creditors. Ray estimates that the real interest rate will fall between zero and one percent, striking a balance between being manageable for debtors while also being acceptable for creditors.

When combined, inflation and real rate estimates provide a projection of bond yields. Guesstimating the shape of the yield curve and considering the effects on the economy, he projects a relatively flat curve until negative effects on the economy occur. Given Ray’s estimates, yields could range between 4.5 and 6 percent, with the Fed likely to avoid the higher end to prevent negative impacts on debtors, markets, and the economy.

The Supply and Demand of Interest Rates

As mentioned above, interest rates and credit availability are influenced by factors such as government spending and central bank policies, but there is also a supply and demand effect. The question is, where will the demand come from to buy the government and Federal Reserve’s debt? Or, how much will interest rates have to rise to balance supply and demand? It looks like interest rates will have to rise significantly, leading to a fall in private-sector credit and spending, ultimately bringing the economy down.

How This Impacts Market Prices and Economic Growth

As interest rates rise, Ray says that we can anticipate the negative effects it will have on asset prices, specifically the present value discount rate and decline in income produced by assets due to a weaker economy. It is important to consider both factors when making estimates. His estimate is that a rise in rates to 4.5 percent will result in an average 20 percent decrease in equity prices, with a greater impact on longer-duration assets and less on shorter-duration ones. Additionally, we can expect a 10 percent decline in income from assets.

The Wealth Effect: How Market Losses Affect the Economy

The fall in markets can significantly impact the economy through the “wealth effect.” Losses lead to caution, both for individuals and lenders, resulting in less spending. Ray adds that a significant economic contraction is likely, but it will take time due to the presence of high cash and wealth levels. We are currently observing this with a weakening in interest rate and debt-dependent sectors such as housing, but relatively strong consumption spending and employment.

The Bottom Line

The current state of inflation suggests that it will remain above the desired level for people and the Fed. As a result, Ray says that the interest rates will increase, other markets will decrease, and the economy will be weaker than expected. This is without considering the potential impact of internal and external conflicts.

Ray Dalio’s insights on how inflation, interest rates, markets, and economic growth are interconnected and how they relate to each other are thought-provoking. Understanding these interconnections and anticipating their potential consequences is important, as they can significantly impact our economy. As we navigate the ever-changing economic landscape, it’s essential to keep in mind the inflation-growth trade-off and the role of central banks in determining monetary policy. This knowledge can help us make informed decisions and plan for the future.

Read the full article here: https://www.linkedin.com/pulse/starts-inflation-ray-dalio/