We were all taught in basic economics: when central banks decrease interest rates they decrease the scarcity of money, and thus this in effect increases inflation.
As a result of low interest rates, corporations and individuals are able to borrow money easily and thus increase the amount of money in circulation. The borrowed money in turns goes back into the economy as corporations spend the money and create demand for end products.
The second way inflation rises is as follows: as the central bank lowers interest rates the value of the country’s currency decreases versus countries that have higher rates. This has two positive outcomes on raising inflation. First, the country’s exports become more competitive overseas as this should allow domestic exporters to bring back more profits in their own currency. Secondly the devalued currency pushes up the prices of imports, thus raising prices of goods consumed.
The first two consequences of low interest rates are meant to stimulate the economy by increasing demand and profits. This forces companies to employee more people to meet the end demand, which should put pressure on wages to increase as it becomes harder to fill employment vacancies.
The third consequence, higher import prices, also puts pressure on wages as employees need larger salaries to afford the higher cost of living.
And yet, what we see in actuality is that the global policies of maintaining virtually zero or negative interest rates over last 8 years has caused the low inflation we see in the world today.
How is this possible? Very simply put: corporations suffice to have earnings growth based on converting profits back to their domestic currency. As a result domestic producers are unable to raise prices and increase their earnings.
Since end demand has been weak following the financial crisis, exporters from countries with weak currencies have been able to maintain relatively stable prices for their goods while showing earnings growth when profits are converted back to their domestic currency. This in turn has left corporations from the importing country no choice, but to use low interest rates to lever up their balance sheets by issuing debt. Instead of using the low interest rate debt to increase R&D or capital expenditure, companies are using the newly issued debt to buy back stock and decrease outstanding shares. This allows corporations to keep prices and market share steady, while increasing earnings with the added benefit of rising stock prices and happy shareholders.
For example, the Japanese Yen has devalued in comparison to the USD from 80 to 120. This 50% devaluation over the course of several years allowed for Japanese companies whose main market is the USA to keep prices relatively stable and still convert profits back to yen with a 50% increase in profits over the course of several years. This forces their US competitors to keep prices steady in order to not lose market share. The US corporations are forced to find growth elsewhere and since there is limited demand and limited price pressure, they financially engineer and destroy their balance sheet by buying back stock.
Stock buybacks in turn hurts US demand domestically because companies are not using debt for hiring, capital expenditure and R&D. Since they are not using the debt productively the velocity of money is not moving through the economy and not causing the desired effect of higher inflation.
Unfortunately the long-term effects of corporations financially engineering profits are grave. Of course, in the near term these policies seem productive as they allow corporations to compete with foreign companies, not eliminate jobs, and experience rising stock prices.
However, as the years pass by, one of two outcomes will occur:
1) The central banks will eventually get inflation to edge higher forcing interest rates higher, or
2) Alternatively, the current business cycle will enter a recession.
In both these scenarios corporations will have too much debt on their balance sheets, and with higher interest rates, they will have problems issuing more debt as their current debt will be seen as too expensive to refinance when it comes due.
In the second scenario, in the past, strong companies with strong balance sheets have been able to weather recessions by having access to cash, or access to the debt market. In the coming recession there will be a much higher percentage of companies entering the recession with little cash on hands and bad balance sheets because they have spent most of the borrowed money on repurchasing shares.