30 Oct 2015 Please Federal Reserve: Raise Our Interest Rates
The financial news is dominated by speculation of when the Fed will increase interest rates. It matters because the Fed is the only economic policy maker with any potential or apparent willingness to stimulate our economy. The Administration continues to pile on regulations and complicate the tax structure, while the Congress, through its brokenness, allows sequestration to continue cutting more deeply into the areas of government spending (defense and social) that are actually stimulative to economic growth.
We have had near zero interest rates in this country for more than half a decade and our economy continues to grow uncharacteristically slowly. Cheap money simply has not been sufficient to overcome the structural policy hurdles of our government and the implied risks that the global slowdown might drag down or economy with it. In short, cheap, easy money has made investors lazy and savers poorer.
The stock market is up 175% from its low registered near the end of the Great Recession in March of 2009. Housing has largely recovered, yet many cannot afford to buy because wages have not kept pace with the rising cost of homes. Unemployment is near 5%, or what economists call full employment, but the number of Americans participating in the workforce has reached all-time lows and food stamps and other government support programs have skyrocketed.
Perhaps the worst of the lazy investors are the banks. US banks currently have over $2.5 trillion in excess reserves they park at the Fed, which is money they could/should be lending, yet they seem perfectly happy to take the risk-free .25% offered by the Federal Reserve to hold their deposits. There is talk among Fed members of dropping the Fed Funds Rate to zero to force banks to find return elsewhere – like lending. If that doesn’t work, The Fed might even take the Fed Funds rate below zero, which would in effect charge banks privilege of holding their reserves at the Fed. It is being done in other countries, but has never been done here.
There are numerous reasons for the Fed to keep rates low. The stubbornly slow rate of economic growth at home, the slowing global economy, falling commodity prices, and the like. But the biggest reason the Central Bank does not spell out is deflation. Deflation describes an economic cycle in which prices fall broadly and over a sustained period of time. The most often cited example of deflation is that of Japan, which is still struggling to climb out of a deflationary spiral that began 25 years ago.
You may have also hear the term disinflation. Disinflation occurs when prices fall, but the overall trend of inflation remains positive. These periods are generally not harmful to an economy. In fact they can be self-correcting and provide a healthy jolt when the consumer is financially healthy and engaged. Everybody likes a bargain and the idea that low prices are temporary motivates buyers to act before the bargains disappear.
But deflation is an altogether different animal. In a deflationary cycle, inflation becomes negative. Prices fall broadly and convincingly enough to encourage consumers to delay buying expensive discretionary items ranging from digital devices, to appliances, to cars and houses. Ours is an economy driven by consumption, 70% of it in fact. Imagine what happens when virtually all consumption beyond life-sustaining spending is paused while consumers hold out for lower prices next year or longer? The companies that make the devices, appliances, cars and houses will be forced to cut back on their spending, investing and hiring. A viscous cycle of contraction begins and the economy slows into recession or worse.
Low rates have made it possible for corporations and households to reduce their debt burden, but we remain a nation of debtors and low rates make it easier to hold debt. In an inflationary environment, debt is actually eroded in real value. Think about it this way: A dollar borrowed five years ago at interest only, is actually worth only 90 cents in today’s dollars if inflation was 2% a year. Inflation works like negative interest, degrading your spending power, but in this case degrading the spending power of the lender. The borrower benefits because the terms are fixed.
In a deflationary cycle, negative inflation (or falling prices) acts like positive interest. The dollar you borrowed five years ago is actually worth $1.10 to the lender now and your repayment in today’s dollars is higher by the rate of decline in prices or the negative inflation rate. Debt in a deflationary cycle leads to defaults and bankruptcies, compounding the problems of recession or depression.
But many argue that the threat of deflation in this economy is minuscule and overstated by the Fed. They say raising rates, at least for a time, could have a stimulative effect on the economy. Rising rates might stimulate investors to move on projects more quickly and aggressively before money becomes too expensive. Potential home buyers are pushed off the fence to act before rates rise. Rising rates make it more appealing for banks to lend, which would be stimulative to the economy. And finally, it is estimated that only a 1% increase in short-term interest rates would boost personal interest income (CD’s Money Markets, etc.) by $60 billion.
It’s time for the Fed to get out of the way and to stop enabling lazy investing. The economy will find ways to grow despite regulations, taxes and economic uncertainty, and even higher interest rates. Replacing the threat of increases with the actual increases will remove a large part of the economic uncertainty holding us back and allow American business and households to get off the financial couch and get back to real earnings.