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The Fed Is About To Spur Growth - By Raising Rates

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This article is more than 9 years old.

The pressure is building at the Fed to get out of the low rate business. The economy is looking “too good,” and more Fed Board members are getting testy. These Fed hawks are eyeing the doves again, and this time it looks like they will come out on top. The argument appears to have shifted from whether to when.

So, is this is end of the good times? No, because higher short-term rates are not simply a payer expense and a drain on the economy. Those rates are on both sides of the ledger, with the higher interest payments producing higher interest income for the payees, and that’s good news. Moreover, market-based rates are an integral ingredient for a well-functioning capitalist economy. Here’s the explanation…

Note: While this may read like Fed-bashing, that is not my intention. This analysis is based on my long-term view and analysis of Federal Reserve policy. When thinking about the efficacy of Fed policy, it’s important to remember that occasionally (make that, rarely) the Fed needs to step in as “lender of last resort” when the U.S. market-based financial system breaks down, as it did in 2008.

What about that added 1977 Congressional mandate of promoting economic growth and protecting against high unemployment? The subsequent economic malaise accompanied by runaway inflation (when "stagflation" was coined) proved its failure, requiring Volker to take drastic action that appeared a detriment to economic growth and employment, yet restored the U.S.'s  financial health. For that reason, it’s proper to criticize the Bernanke-Yellen Fed for using the second mandate as support for continuing dramatic Fed actions long after the financial system has healed itself.

Why market-based interest rates are so important and the Fed’s return to them carries significant benefits

Market-based interest rates (just like market-based prices) play three vital roles in the U.S. capitalist economy.

First, they help allocate resources by giving investors and borrowers a benefit and cost measure on which to base decisions. Without an accurate rate, misallocations and imbalances occur, with actions even running counter to the controlled-rate goals. (Think back to the 2009 argument that low short rates would “encourage” investors to return to risk investments, thereby helping the financial system get ship-shape. Then, think about the health regained and all those articles over the past 2-3 years decrying the over-exuberant and “erroneous” moves by investors chasing yields in all the wrong places, even driving prices up and yields down to inappropriate levels by their relentless desire to put their zero-yielding cash reserves into something.)

A recent (6/2) example of “investors are misguided” analysis that ignores the perverse conditions that exist is from The New York Times (“It’s Easy to Forget About Risk in a Stable Market”):

As a result of forgetting our most recent investing pain in 2008-9, we see things like:

  • Serious interest in penny stocks
  • Retail investors setting new trading records
  • Greece issuing bonds worth 3 billion euros with yields of just 4.95 percent — and investors buying it all
  • People saying REITs and utilities are substitutes for bonds
  • Volatility hitting almost historic lows, with the Volatility Index (VIX) dropping to 11.36 in May
  • Housing in expensive areas selling like crazy

Then, there are the advisers who are trying to convince clients to get back into stocks even though many indexes posted enormous gains in 2013.

So, what would this writer propose to savers and investors whose preferred choices yield near zero, less than inflation? Those people have been forced out of their comfort/knowledge zone and are bound to make mistakes. The real cure isn’t to harangue them into becoming more investment savvy – it is for the Fed to stop preventing them from earning a market yield from their preferred investment.

Second, short-term holdings (including savings accounts) are a key financial component for individuals and organizations, alike. Those holdings (unlike bonds and stocks) carry little or no principal risk, so the income payments can be used as a source of spendable income and/or as a steady builder of wealth. This is where the Fed’s 5-year policy has had the largest detrimental effect, both skewing investor actions and, ironically, dampening consumer spending, the key driver for the economy.

Savers and risk-averse investors who depend on income (think of the long-held conservative group of retirees, widows and orphans) have had their interest payments cut for the good of the economy. They’ve had to rely on three, undesirable options: cut budgets, spend principal, and/or put their money into risky investments for income. Here’s how interest income (which includes bond interest) has fallen, both in dollars (green, solid line) and relative to discretionary income (orange, dotted line).

Third, financial intermediaries (banks, etc.) profit less from current interest rate levels than from ongoing spreads (the determinant of profits). The Fed has also argued that the economy remains slower growing (thus needing Fed help) because bank lending is unrecovered. However, the intermediaries’ concern is not with the risk of lending. Rather, it’s with the uncertainty of future spreads (profitability), knowing that the current spread is not market-determined and will shrink as soon as the Fed changes course. Because intermediaries always face some maturity mismatch (shorter-term deposits supporting longer-term loans), the current Fed policy creates long-term profit uncertainty and, therefore, lending reluctance. Both adverse reactions will disappear once intermediaries know just what the actual market rates are.

One more benefit for banks: The reduction in time deposits will reverse. To help with maturity mismatch, banks like time deposits. That once reliable source of money has been adversely affected by the Fed’s too-low rate policy that removed the incentive for savers and investors to lock up their money. Here’s the picture…

The bottom line

The Fed has crimped the flow of interest to savers and other short-term investors for five years. Finally, the pressure has become too great to have this seemingly perpetual policy continue. Importantly, the Fed’s packing it in will be beneficial, not detrimental. Higher rates will…

  1. Encourage savings and make cash equivalents a viable investment again
  2. Boost income for savers and other short-term investors
  3. Give financial intermediaries the market rates needed to base longer-term lending activities on, while also improving maturity matching by reversing the time deposit drain