July 26, 2016

Higher Interest Rate Necessary

Last week I asked whether or not the Federal Reserve should raise interest rates. I did not answer the question, suggesting instead that the reasons for higher interest rates put forward in media - namely that our economy is doing better than expected - are actually not accurate. I pointed to weak growth in GDP and consumption, to a stagnant job market and to clearly weakening business investments. I especially pointed to the sharp decline in business investments in structures and equipment. Both of these variable indicate that our businesses have excess capacity, indicating production is at a peak for this business cycle.

I still maintain, though, that the Federal Reserve should raise interest rates. There are, primarily, four reasons for this. 

1. Galloping deficits.

With the exception of a short period during the late 1990s the United States government has run deficits for almost 50 years in a row. We almost reached the trillion-and-a-half dollar deficit mark at the depth of the Great Recession when revenue declined by 16.6 percent in one year (2009). 

During the recovery, 2011-2015, federal revenue grew by a remarkable 8.5 percent per year. The deficit fell by almost $1 trillion, down to $438 billion in 2015. In other words, about two thirds of the deficit was gone. 

The revenue growth in 2011-2015 happens to be the strongest five-year average in almost 30 years. The last five-year streak with stronger growth was 1984-1988 at 8.7 percent. During the years 1996-2000, when President Clinton and Congressman Kasich together balanced the budget four years in a row, federal revenue averaged 8.4 percent growth per year.  

The Office of Management and Budget (OMB) predicts that federal revenue is going to continue to grow at handsome rates over the next few years, averaging six percent per year through 2020. At this rate it should be a cinch for Congress to balance its budget, yet the OMB predicts $500+ billion deficits through 2021. Longer forecasts suggest a return to trillion-dollar deficits a couple of years later - without even considering the destructive effects that another recession would have. 

Because of the sustained deficits it is important that the Federal Reserve ceases to provide funding for the Treasury at the current rate. By reducing the monetization of deficits the Fed would raise the cost to Congress for running deficits; as the cost goes up Congress will come to a point where it is fiscally and politically less costly for them to resort to spending reforms instead of continued deficits. 

The Federal Reserve should have a self interest in reduced deficits. If we continue down the growing-deficit track there will come a point where we are no longer a first-rate global investment opportunity. At that point our interest rates will rise considerably, without us having any control over them. This means de facto that the global financial system at some point will restrain the Federal Reserve's monetary independence. At that point neither the Fed nor Congress will have any real choice in terms of monetary and fiscal policies.

2. Credit rating combined with signs of recession

The macroeconomic indications of a pending recession, which I wrote about the other day, are reason enough to raise interest rates. This may seem counter-intuitive: normally we would want to go into a recession with lower interest rates in order to mitigate the loss in economic activity. Low interest rates keep consumer credit cheap and reduce the costs of business investments. 

While correct in theory, this argument assumes that a country does not have any credit problems. We do: for the first time in the history of the United States we are going to go into a recession with less than perfect credit. The credit rating serves, in effect, as a "cushion" for an economy, providing a period of time during which government finances can deteriorate without causing alarm among global investors. All other things equal (such as monetary policy) less-than-perfect credit rating means that interest rates will start rising sooner in the recession. 

As became evident in Europe during the early years of the Great Recession, it does not take more than two or three credit downgrades during a recession to send interest rates skyrocketing. This means that if we, during the next recession, suffer one or two more credit downgrades, our "cushion" will prove to be rather thin. To buy us more time going into the next recession before credit downgrades provoke fiscal panic and Euro-style austerity, the Fed should therefore make sure our rates are higher than today.

There is one important caveat here, namely the global trend toward negative interest rates. Even countries with imperfect, even bad credit can borrow money at almost no cost at all today. This trend indicates that markets no longer let interest rates reflect credit ratings; more than anything else, the rate of interest that a treasury has to pay for its government's borrowing reflects global access to liquidity. So long as liquidity remains abundantly available (due to central banks monetizing deficits around the industrialized world) it seems as though the developed world's treasuries do not have to worry about what credit rating institutes have to say about them. 

Add to this the so called Basel III requirements on financial institutions forcing them to buy treasury bonds at certain rates and to disregard credit ratings, and it would seem as though we now live in a world where governments no longer have to be fiscally responsible. They can go on and borrow money impervious to erstwhile laws of risk management. 

The problem with this outlook is that it comes too close for comfort to the old Soviet-style way of flooding the economy with liquidity. In a manner of speaking, when we combine bond-purchasing dictates to financial institutions with deficit-monetization policies by central banks we have de facto introduced central economic planning for the federal budget. This is not the place to discuss the detriments of central planning; suffice it to note that it failed miserably in the Soviet empire, and will do so as well anywhere else it is applied. 

It would be wise of the Federal Reserve to go back to sound central banking, raise interest rates and let the market determine the price of the federal government's credit worthiness. 

3. Ride on the global "confidence wave"

In the modern globalized financial system, some old textbook rules have been thrown out the window. One of them is that long-term and short-term interest rates point in the same direction. It used to be that a higher interest rate today would raise rates over an extended period of time, with a premium on top for risk and uncertainty. 

Today the relationship is to some degree the opposite: a rise in short-term interest rates is followed by a drop in long-term rates. The short-term increase appreciates the currency and works as a proactive measure toward future market contingencies rather than a reactive measure responding to events that have already happened. 

This means that if the Federal Reserve raised the rate "now" (meaning this side of Christmas) they would lower the cost of the deficit for the federal government over time. A fiscally prudent Congress could then use that extra room to permanently reduce its deficit and be on more solid fiscal footing in the next recession. 

The argument against this outlook would be, again, the global trend into negative-rate territory. Why not ride that wave and cut the costs of the deficit here and now?

Unfortunately, such a proposal would not only have to ignore the central-planning argument made above, but also somehow assume that the tour into the realm of negative interest rates will go on for the foreseeable future. However, to keep that tour going our central banks would have to protect us and the rest of the world against another mass-liquidity induced inflation era.

So far, no central bank in the developed world has been able to provoke monetary inflation by monetizing government deficits. The reason for this is not that the connection from lax money supply to inflation has ceased to exist. Instead, sluggish growth and weak transmission mechanisms between the monetary and real sectors of the economy have kept prices from running amok.

Eventually, though, central banks pumping liquidity into the economy through government budgets will be responsible for considerably higher rates of inflation than we see now. The new component here is that deficit monetization feeds into the private sector by means of modern, sophisticated entitlement programs; it remains to be seen how strong this transmission of free cash can become before the private sector responds with higher inflation; unfortunately, it looks like central banks are willing to try this experiment live before the economics profession has had time to evaluate their policies in a proper research setting. 

All this points to the Federal Reserve ceasing its lax monetary policies and returning to more responsible monetary policy. We simply cannot afford to toy around with the bonfire of inflation. 

4. Excess liquidity destroys middle-class wealth

Cheap credit makes it virtually impossible for the middle class to build equity. They get little to no return on low-risk investments - the type recommended for families with limited margins - and credit is abundantly available. They can mortgage their house up to the chimney, buy cars with no money down, even take out credit cards at relatively low cost. 

Middle-class equity is essential to our national wealth. It builds financial stability in the broader segments of the population, thereby reducing swings in the business cycle. It also helps them sustain through hard times and unexpected major expenses, holding back government entitlement spending. Furthermore, they can save for their children's education, sending the next generation into adulthood in better shape financially. 

All in all, there are plenty of reasons for the Federal Reserve to start a moderate climb in interest rates. If done prudently, it will be of abundant benefit to our economy. Even if the Fed does it for the wrong reason - erroneously believing that our economy is gaining strength again - our economy will come out stronger. 

Let us hope the Federal Reserve Board sees things the same way and takes action somewhere between now and Thanksgiving.

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