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INFORMATION FOR THE ENTERPRISE AND INVESTOR
September 14, 2016
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Over the last three weeks, IntelDigest has focused on The Federal Reserve and its policies … and the similar policies of central banks around the world … because these policies have had an enormous impact on the world economy.
In effect, the central banks have been fighting a futile battle against the business cycle … amounting to not much more than a Holding Action … but the outcome will most likely be extremely negative for lots of people. The Human Cost has already been too high for people who have worked hard all their lives and made sensible financial decisions, but now find themselves falling behind.
In this issue, we will summarize the effects of ultra-low and negative interest rates. In coming weeks, we will discuss asset management, allocation, and diversification; the International Monetary Fund and significant developments in currencies; free trade and protectionism; updates on “Brexit” and related developments; and a variety of topics dealing with finance, markets, government policies, and legal issues.
The primary result of central banks’ creating ultra-low interest rates has been to shift wealth … from savers and retirees to borrowers, and from middle class workers to upper-income investors. In fact, the primary beneficiaries of ultra-low interest rates are governments, which can continue to run massive deficits and continue to borrow at ultra-low rates to fund those deficits.
If only we had some sort of legislative body in this country tasked with oversight of government spending and other fiscal matters!!!
Let’s focus on The Federal Reserve. The stated mission of the “The Fed” is to manage monetary policy “… in pursuit of maximum employment, stable prices, and moderate long-term interest rates.” Over the last eight years, the primary method employed was pushing short-term rates down to levels never before seen, creating a number of serious problems in our economy.
Has this stimulated the economy?
As we wrote in the August 24 issue of IntelDigest
“Interest rates are near Zero or Negative in many places around the world. Central bankers postulated that reducing rates would encourage spending and produce inflation; instead, low and negative rates appear to induce more saving (to compensate for lost interest) and deferred spending (in anticipation of lower prices due to deflation).”
Short-term interest rates are at their lowest point in recorded history! But, lower interest rates did NOT stimulate demand. They did NOT create higher demand for goods and services. Instead, they seem to have reduced demand, as people save more and spend less.
For example, many retirees (for generations) have tried to live off the interest earned on savings and super-safe investments. That is not possible in a low-interestrate environment. In order to earn income, the retiree has to take on more risk in stocks and bonds. He or she would then compensate for the increased risk by trying to save more … to have a bigger savings cushion. This reduces spending, which reduces demand.
Similarly, low rates have a depressing effect on household incomes of consumers and savers. Their savings accounts and pensions are stagnant. Even in relatively wealthy economies, people have to contend with rising healthcare costs, increasing longevity, and uncertainty over pension funding. Households likely respond to lower income by trying to save more.
At the same time, lower interest rates seem NOT to spur corporate investment. Sure, many corporations have borrowed (at very low interest rates) Billions of Dollars to buy back their own stock in the marketplace, but have low rates spurred investment in operations? Investment decisions have financial consequences over many years, and are more influenced by attitudes about risk and calculations of future growth … not so much by interest rates set by central banks.
In fact, some very successful companies have been hoarding cash … for example, some giant tech companies, including Apple and Microsoft, have Billions stashed outside the country for tax reasons. But, even if those tax disadvantages went away, such companies would probably still keep much of that money in cash.
If they determine that they have no good places to spend or invest that money, then the ultra-low interest rates are stimulating nothing.
Has monetary policy been well managed by The Fed?
Arguably, no. In 2008 the whole financial system was on the verge of collapse. The Chairman of The Fed, Ben Bernanke, fought that collapse with a number of tools, including cutting short-term interest rates and adding liquidity. That certainly made sense, under the circumstances, but there is less justification for continuing to reduce rates, year after year after year, until they are close to Zero.
Many central bankers are devotees of John Maynard Keynes. Even Keynes acknowledged that interest rates needed to reflect reality, that they could not be set so low that they inhibited business. Could the central bankers not see that low rates would punish savers and inhibit business?
As Walter Bagehot noted, the purpose of a central bank is to provide liquidity at a price in the middle of a crisis. (Bagehot … pronounced “Badge-it” … was a 19th Century British economist and editor of The Economist). In his influential 1873 book, Lombard Street: A Description of the Money Market, he described the “lender of last resort” function of the Bank of England, a model embraced by The Fed and other central banks. He said that, when necessary, the BoE should lend freely, at a high rate of interest, with good collateral.
In today’s world, central bankers certainly follow the “lend freely” part, but have ignored the rest. Bagehot said last-resort loans should impose a “heavy fine on unreasonable timidity” and deter borrowing by institutions that did not really need to borrow. Instead, central bankers around the world simply prop up banks by lending low-interest taxpayer money, even when management has made bad decisions.
In 2008, The Fed acted in contradiction to Bagehot’s rule, spraying money in all directions, charged practically nothing for it, and accepting almost anything as collateral.
Does The Fed have a plan, going forward?
The Fed .. over the last 15 years, but particularly since the 2008 financial crisis … seems to have been overly concerned with propping up the stock market (NOT in its mandate) and avoiding the recessions which come with the normal business cycle (also, NOT in its mandate).
However, restoring short-term rates to normal and reasonable levels will inevitably slam the stock markets and bring on recession, unless The Fed raises rates gradually over 5-6 years. Is this in the plan? Who knows?
How can Insurance Companies and Pension Funds survive?
Insurers make a profit by taking your money and turning it into long-term loans. They use the money they make, along with your premiums, to cover your insurance risk in the event of need.
Pension funds generate profits from long-term loans to grow the money they need, along with your contributions, in order to pay for your retirement. They have built into their models a reasonable long-term return (from a historical perspective) on bonds and the stock market.
This model can fall apart very quickly in a very-low-interest-rate environment. The returns insurers and pension plans make on their investments no longer adequately fund the promises they have made.