Low Interest Rates Over Long Frames Distorting Economy
Analysts and participants have been searching for clues as to whether Fed policymakers (FOMC) will begin raising interest rates when they meet next week.
And, globalization makes that decision a lot less important than in years past.
Keeping interest rates low for long time frames imposes distortions on the economy.
For example, lower earnings on Certificates of Deposit (COD) forces many seniors to take part-time jobs to supplement pensions and Social Security, this displaces younger job seekers and contributes to lower labor force participation among prime working age adults.
Holding short-term interest rates near zero makes conventional loans less profitable and encourages the large banks to focus more on trading in securities and private-equity deals, those flip assets and repay loans quickly but contribute little to growth and jobs creation.
Prolonged low mortgage rates push up land values in hot markets like Manhattan to levels not easily sustained when interest rates are normalized.
And low rates encourage corporations to take on more debt, often to boost stock prices artificially by buying back shares.
Yet, as the Fed raises rates, both the domestic economy and global markets will push back.
In Q-2 of this year, GDP grew at a robust 3.7% pace, but recent jobs data indicates a stronger USD Vs Asian currencies is slowing US manufacturing outside the auto sector, and Detroit is resorting to 0% financing to keep its cars moving off dealer lots.
Falling gasoline prices have boosted car sales and broader consumer spending, but those cannot tumble down indefinitely.
Overall, the US economy is returning to moderate economic growth, and cannot sustain quickly rising medium and longer term interest rates, especially in the Key auto and housing sectors.
The Fed’s primary policy tool is to virtually set the banks’ overnight borrowing rate, the federal-funds rate which has been 0’ish since June 2008.
However, the overall impact of Fed policy tightening depends importantly on whether increasing that rate significantly pushes up rates on mortgages, corporate and municipal bonds, and other longer term borrowing.
Throughout the credit and bond markets, longer interest rates peg off the rate on 10-yr US Treasury securities, but from June 2004 to June 2006, when Ben Bernanke increased the federal-funds rate from 1 to 5.25%, the 10-yr US Treasury rate rose just 0.6% to 5.22%.
The Fed’s efforts to raise long rates and curb bubbles in real estate and stock markets, which actually caused the financial crisis, were frustrated by foreign capital inflows.
In particular, the purchase of US Treasury securities by the People’s Bank of China (PBOC), and other Asian central banks seeking to maintain weak currencies against the USD and boost their trade surpluses with the United States.
This time, weakening economic conditions in Asia and growing doubts about Beijing’s ability to manage the world’s 2nd largest economy, have increased private demand for US securities.
Since early June, when Chinese participants began exiting stock positions on the Shanghai Exchange, the rate on the Key 10-year Treasury bond has fallen from 2.5 to 2.2%, despite repeated assertions by most Fed policymakers of their intention to begin raising US interest rates soon.
As 10-yr US Treasury rates rise with any increase in the federal funds rate, foreign investors will have even greater incentive to move cash into Treasuries, pushing those rates back down again.
Ultimately the Fed will be frustrated in its efforts to significantly push up 10-yr US Treasury, mortgage and corporate bond rates and moderate the pace of home buying and corporate borrowing.
If they are savvy and they are, non-bank firms that finance much of the new car buying they will use longer term bonds to keep auto loan rates from rising too much.
As it is now, the US Fed is hobbled by the weakness of the US economic recovery and the globalization of capital markets, meaning they are out of “bullets.”
Stay tuned…
HeffX-LTN
Paul Ebeling
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