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Interest Rates

October 19, 2011

The failure to control credit and the decision to leave financing to the markets and their manipulators is the great failure. It is the genesis of the great financial crisis, and its legacy is the huge burden of debt that now crushes prospects for an orthodox recovery. The invisibility of financing and financing structures – as we’ve noted before – is what made the orthodox forecasters blind to the biggest economic event of the generation. And the unwillingness to deal with the misallocation of credit in a ruthless and rational way is what prevents policy-makers from putting the crisis behind us and real recovery in front. Instead we limp from crisis to crisis, always choosing to burden the future with more debt, always choosing to socialize the losses of the powerful and privatize the suffering of the powerless.

(click on the chart for a larger image in a new window)

Source: Federal Reserve (click on the chart for a larger image in a new window)

Today on the Forecast, we look at interest rates. We are forecasting interest rates to continue to trend downward. But we do not put much stock in the importance of interest rates to the real economy or see monetary policy as playing a positive role in recovery.

For several reasons:

1. Credit availability is not described by how low interest rates are. Particularly in the mortgage market, where banks once so happily lent to anyone and were even willing to lend the down payment. Banks will not now finance anyone who needs financing. They resist refinancing even the best risks, in fact, so as to keep the old higher interest mortgages paying. Not too different from squeezing credit card holders. But the point is, mortgages may be at four percent, but you can’t get one if you need it.

2. Low rates delight the market players who can finance their stacks of chips cheaply. This means speculation, and it means higher prices in commodities like oil and food and basic materials. This means higher and volatile prices for consumers than would be the case in a supply-demand market. Which means decreased consumer confidence and reduced private demand.

3. It is not ultimately the supply of credit that is the problem, it is the demand for credit.

4. Real interest rates for assets may actually be high when nominal rates are low. Deflation in the prices for investment goods means a zero nominal rate is actually positive. Two bullets on this:

  • It doesn’t seem that long ago that markets were efficient, by the accounts of the fundamentalists, and incorporated new information with seamless efficiency. Outguessing the market was futile according to Eugene Fama and the Chicago School, and better to be passive. Now it seems that investors are stupid and their information is deluded when they take the two percent ten-year Treasuries. They need to be coaxed by the enlightened fund managers. Well, maybe investors are not so stupid. Housing as a surrogate for investment goods? Prices are dropping. A hundred dollars in a ten-year at two percent yields five percent versus a house that drops three percent in value….
  • Consumer price inflation is not relevant to calculating real interest rates. As we’ve said, if it were any more than commodity speculation, inflation in wages and incomes would be rising, too.

5. It is a lot easier to stall an economy with hikes in interest rates than it is to restart it by lowering rates. This is, again, because demand comes first. It is the demand for products and thus investment goods driven by the prospect of profit that causes people to invest. It is not the supply price of inputs.

You can see this on today’s chart. We’ve mapped GDP on the right axis with an inverted scale. So it should be going in the same direction as interest rates. And it does in many of the negative cases. The well-worn plot has been: The Fed sees inflation in its tea leaves, myopically searches for its only button, the big red EASY button, and punches it. The economy stalls. Our chart goes back only to 1991, but the pattern is similar since the Fed became the independent authority over monetary policy in 1951.

In our chart, the dot.com bust as well as the latest greatest recession both were triggered in part by the inability to lay off the interest rate button. Parenthetically, in both cases, rising energy prices were accomplices, and in fact, it was the real … ah … short-sightedness of the Fed in not seeing that its inflation fears were rooted in the price of oil that compounded the blunder of raising rates.

There is more in our chart. First, we see that one recovery was actually helped by lower interest rates. That was the recovery of 1992. The Budget Deal raised taxes and the Three Amigos – Greenspan, Summers and Rubin – brought rates down. Millions of homeowners refinanced, producing billions in new demand. Interest rates went back up in 1994, but GDP stayed strong – Plus Four was the norm through the 90’s.

And – yes – low oil prices. Don’t forget the Gulf War oil prices helped trigger the 1991 recession and then, not exclusively through the brilliance of Bill Clinton, oil prices came down to the $15 per barrel range throughout most of his presidency. That’s one-five. Fifteen. Dollars a barrel.

And further on. yes, in 2009 GDP bounced back up – or down in our inverted scale – as an apparent response to interest rates. But was it the rate of interest? No. It was the federal stimulus and the massive give-aways to the financial sector.

What else do you see?

Interest rates in the boom of the 1990s were substantially higher – five to eight percent for Treasury ten-years, seven to nine percent for triple A bonds and 30-year mortgages. They are now stretching toward two for ten-year notes and four for mortgages and triple A paper.

But you see the pogo stick at the Fed. Six percent effective federal funds rate PLUS in ’91. Three percent in ’92. Six percent in ’94, followed by a little bit of stability in the five to six range, before going up to six point five in 1999 to trigger the recession of 2001 and then diving from six and a half to one and three-quarters in 2001, finally settling in at one percent on into 2004 as a way of throwing gasoline on the housing bubble. Then? Bernanke to five plus in 2006 and Wile E. Coyote down to the zero of today.

And you see the bars for QE I and QE II. These quantitative easings were happy news for stock markets, but for the real economy, not so much. Yes, the intended interest rates did come down, though not really in sync with the QE’s, but no, the push on housing and other investment has not been observed.

Below is a chart from the Federal Reserve describing the QE’s in terms of the Fed’s balance sheet. You see the pig of direct loans to banks that was gulped in September ’08, subsequently passed in favor of the cow that is the mortgage backed securities. Which at one point were intended to be resold, but which now are apparently a permanent feature of the balance sheet, since the only buyer of MBS’s is the government. And while retaining the cow, the Fed added the long-term treasuries beginning in the fall of ’10, to no great effect on anything except financial markets.

And you see our forecast at the end, an extension of the trends because there is no reason for optimism on either the recovery front or the monetary policy front.

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From → Misc.

One Comment
  1. Hi. Nice blog!
    I was going to ask: is “net real GDP” something you borrowed or something you invented.
    But a google search turned up you, plus one like to John Taylor’s textbook… And the Taylor link was not a valid search result, so I think you invented it.

    I think I like it. If I take the annual change in Gross Federal Debt

    http://research.stlouisfed.org/fred2/graph/?g=3Uf

    and subtract it from (annual) GDP, does that give me your “net real GDP”? Thanks.

    I came here from Economists View of 3 December, your comment on greg’s graph.

    Oh! the opening statement of the above post is *perfect*!

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