Thousands of years ago, Polynesian explorers using basic, wooden outrigger canoes embarked on long-distance voyages across the vast Pacific Ocean to travel between regional islands.
They did so long before the advent of any maritime navigational instruments, relying heavily on the night sky to guide them.
More precisely, they used two stars in particular – Polaris and Polaris Australis.
Why these stars? Both are bright, and both are polar stars. Because they’re respectively aligned to the North and South Poles, the Polynesians effectively had fixed points in the stars to help triangulate their nautical positions and navigate to different islands.
Stars and economics
The successes of the Polynesian seagoing wayfarers presents an interesting history lesson, but what does this have to do with modern day economics?
Well, the economy has a pole star too, and it can provide a fairly accurate navigational guide for investors.
The pole star in economics that Vanguard has been using for many years is the short-term interest rate central banks, such as the Reserve Bank of Australia, set to control inflation.
It shows that historical inflation levels have been relatively low when official interest rates have been kept within a relatively tight range.
However, when interest rates have been very low, inflation levels have spiked, requiring central banks to take evasive action to reduce spending by raising interest rates to much higher levels.
A good longer-term perspective on the economic pole star can been seen from the United Kingdom and the actions taken by the Bank of England over more than 200 years to bring surging inflation under control.
Pole star: Cash above trend inflation
Source: www.macrohistory.net. Data as at 27 January 2023
The chart above shows how trend inflation in the U.K. was benign from 1800 for almost 150 years, with interest rates over the same period kept above the inflation rate.
But when interest rates were dropped to below the inflation rate during World War II, and again after the Global Financial Crisis, the trend inflation rate rose. Successive interest rate hikes followed.
In effect, the secret “pole star” to avoiding a high inflation world is simple. That is, keeping the short-term interest rate above the trend inflation rate.
The era of ‘sound money’
Official interest rates have nearly always been set above the trend inflation range. The last decade however has seen an unusual low-rate environment that is more the exception than the rule.
“We’re entering an era where short-term interest rates are above trend inflation on average and provide positive real return: an era of ‘sound money’,” says Vanguard’s Global Chief Economist, Joe Davis.
“Investors concerned about rising interest rates would do well to remember that while this higher rate era may seem ‘new’, it’s actually a return to normal and shouldn’t necessarily be viewed as a negative.
“The last few years of near-zero rates were in part to accommodate exceptional events such as COVID-19, and while effective at the time, they’re unsustainable in the long-run.
“So, while rising rates might mean the end of ‘easy’ money for some, the return to ‘sound money’ is a clear positive for the global economy and for long-term investors.”
Sound money is good for the economy
Source: Global financial data and U.S. historical statistics as at 31 December 2022.
“Real positive interest rates not only provide a solid foundation for returns on all asset classes, but also lead to higher economic growth, higher returns for savers, forces fiscal trade-offs and ensures production efficiencies – they are the firewall protecting us from future inflationary pressures,” Davis says.
The above material has been reprinted with the permission of Vanguard Investments Australia Ltd