Showing posts with label interest rates. Show all posts
Showing posts with label interest rates. Show all posts

Sunday, August 19, 2012

The Setting for Ben Bernanke's Speech at Jackson Hole


Anticipation is rising for the annual late summer speech given by the Chairman of the Board of Governors of the Federal Reserve System, Ben Bernanke.  The basic economic environment surrounding this speech is what I would like to touch on in this post.

This environment along with what the Federal Reserve does…or doesn’t do…is crucial to the possible “macro” position a person could in their investments and in their business decisions.

For example, John Paulson, the hedge fund investor, has apparently started placing his bets with respect to current economic and financial conditions and with respect to what the Fed can…or can’t do.  Mr. Paulson, according to recent regulatory fillings, has been re-arranging his portfolio…increasing his position in gold and reducing other positions…in anticipation of higher future levels of inflation.

Future inflation is certainly a concern and I will discuss this a little later, but there are also other issues that need to be discussed as well.

For example, dominating discussions about the current environment is the rate at which the economy is growing.  In the second quarter of 2012, real GDP grew at a 2.2 percent year-over-year rate.  I am expecting this growth rate to remain around 2 percent for the next year or so.  This expectation is backed up by other numbers, like that for industrial production.  Economic growth has been tepid, is tepid right now, and is expected to remain tepid for the near term. 

There are numerous reasons why economic growth is likely to remain slow.  I have reported on these in many recent posts.  A short list of reasons include continued deleveraging of the private sector; under-employment of eligible labor; residential mortgages being underwater; bankruptcies and foreclosures; commercial real estate losses; health of a large portion of the banking system; the financial condition of state and municipal governments; the uncertainty that exists with respect to government policy and regulation; the European recession and sovereign debt crisis; and the slowdown in other countries like China, Brazil, and India.

I believe the American economy will continue to grow but only at or below a 2 percent year-over-year rate.  This is an environment of stagnation with unemployment and under-employment staying high and capacity utilization of industry remaining historically low. 

Given this basic scenario, interest rates will rise over the next year or so.  There are, I believe, three reasons for this. 

First, interest rates in the United States are as low as they are because of the “haven” nature of US government debt.  Large quantities of “risk averse” funds have flown into American security markets escaping the mess in Europe.  As a consequence, the yield on 10-year US Treasury securities closed at 1.82 percent on August 17.

If one subtracts an “expected rate” of inflation from this figure, let’s use 2.00 percent (which is about what the inflation rate is in the United States using the year-over-year rate of increase in the GDP implicit price deflator).  Then an estimate for the “real” rate of interest is a negative 18 basis points.  This is not too far off the yield on the 10-year TIPS bond, which was a negative 45 basis points on August 17.

And, what “should” this real rate of interest be?  I have always argued that “the” real rate of interest should be somewhere around the level of the “expected” real rate of growth of the economy.  Thus, from the 1960s through the end of the century a 3.0 percent rate worked out to be a good working estimate of the real rate.  If we use my current “expected” rate of growth of the economy, 2.0 percent, then the “real” rate of interest in the United States should be in the 1.50 percent to 2.00 percent range. 

Therefore, as the “risk averse” money leaves United States shores, the yield on TIPS should rise fairly steeply.  Whether or not this rise will be resisted by the Federal Reserve is a question that remains unanswered at this time.  Resisting the rise will just cause to Fed to flood the banking system with more excess reserves, which may cause other problems.  But, this is something that the monetary authorities are going to have to face.

The second reason for a rise in interest rates is that there should be, sooner or later, demand pressure on interest rates due to a pick up in economic activity…or,  Right now, commercial banks are awash with funds while at the same time loan demand seems to be particularly weak.  Thus, there is little or no pressure for interest rates to rise.  This is certainly something we need to watch out for. 

However, we could see interest rates rise for a third reason…a rise in the expectation of future inflation.  This is something many people…like John Paulson…are worried about.  Never before has the commercial banking system had so many excess reserves “hanging around.”  In August 2008, before things fell apart, the excess reserves of the whole banking system amounted to less than $2.0 billion.  In the two banking weeks ending August 8, 2012, excess reserves in the banking system averaged $1.5 trillion. 

The monetary base, the foundation of credit expansion in the United States, was around $2.7 trillion in the banking weeks ending August 8: it was at $842 billion in August 2008!

Few people believe that the Fed can withdraw a major part of these funds from the banking system once banks start lending again…and inflation starts to increase.  Inflation and credit expansion go hand-in-hand.   And, the lending could pick up even if real economic growth does not pick up.

A further question exists: how can the Federal Reserve withdraw funds while the federal government is still running annual budget deficits of $1.0 trillion or more?

So the third reason for interest rates to rise is that as inflation accelerates in the United States, the expectation of future inflation will also rise.  When this will begin and how fast will it take place is, of course, the big question.

There are other possible “macro” effects surrounding this picture.  For example, what will happen to the value of the dollar given this view of the world?  These will be addressed in future posts.

Does one get a sense of potential “stagflation” in what is written above?  Slow economic growth, rising inflation, and rising interest rates.  How does a central bank combat such a situation?

The situation that Mr. Bernanke and the Fed face is a very challenging one.  It is a situation that they have helped to create.  But, getting out of it will not be much fun for them.

As far as the private investor is concerned…a situation like this presents a ton of possible “investment” opportunities.  And, one should always ask, “How can I make money from a situation like the ones described above?” 

As one reads a book like “More Money than God” by Sebastian Mallaby, one observes that lots and lots of money is made off of government mistakes.  The problem is that generally the people that make the money off of these mistakes are people that have the information, the access, and the scale to take advantage of the mistakes.  However, these “tools” are not available to most people.  Maybe that is why the distribution of wealth in the United States has become so skewed.    

Thursday, August 9, 2012

No Pressure on Interst Rates


When are interest rates going to rise?  Risk-free interest rates that is?  Short-term interest rates?

Interest rates have risen…and fallen…on government debt that was once considered risk-free because these governments have faced solvency problems. 

But, what about interest rates on United States Treasury debt?  And, what about money market interest rates?   And, what about the Federal Funds rate?

The Federal Reserve has indicated that the target Federal Funds rate will remain where it is now until the end of 20--, you put in the last two numbers. 

The upper limit of the target Federal Funds rate has been at 25 basis points since December 16, 2008.

The upper limit of the target range will only be challenged if the Federal Reserve decides to tighten up on monetary policy…something that is out-of-the-question at this time…or if business activity picks up and the demand for funds increases, thereby putting pressure on short-term interest rates to rise.

Certainly, QE1 and QE2 impacted the supply side of the market and helped to keep the Federal Funds rate below 25 basis points. 

Over the past year, however, there has been next to no demand pressure on the Federal Funds rate to rise.  Over the past year, the effective Federal Funds rate, on a daily basis, has varied between six basis points and eighteen basis points.  Although the rate has been toward the upper end of this range in the past three months, the Federal Reserve has actually seen its portfolio of securities decline over this time period indicating that there has been little or no pressure on the Federal Funds rate to rise. (See my August 7 post about recent Fed activity.)

This lack of pressure on short-term interest rates is a sign of two things at this time.  First, it is a sign of the weakness in economic growth in the United States economy and the consequent lack of pressure on the banking system to lend. 

This lack of weakness is also seen in the financial instruments with a longer term.  Mortgage interest rates are at historically low levels, yet analysts claim that they could be even lower than they are now.  A New York Times article points up the fact that mortgage interest rates could even be lower than they are now but commercial banks have not let them fall as much as they could.  The demand for mortgages is just not that strong.  

One argument given for why the banks are keeping rates as high as they are in the current market is that their costs have risen due to the new regulations that the banks are facing.

Still, the indication is that there is no demand side pressure on interest rates in the current market.

There is a second argument for the lack of pressure on United States interest rates and this has to do with the fact that the United States Treasury market is receiving a substantial amount of funds seeking a “safe haven” in a world of great uncertainty. 

The United States is not the only beneficiary of this “move to safety”.  David Wessel, in the Wall Street Journal, writes about the “subzero” interest rates that now are being “paid” on the two-year government bonds of Switzerland, Denmark, Germany, among others. 

And, we have seen a negative yield on the ten-year inflation-adjusted Treasury bond (TIPS) since August of 2011. 

The point is, that the demand for funds is close to non-existent and this is not a good sign. 

Sure, some firms are borrowing but these are generally the larger companies who are taking advantage of the very low interest rates.  But, these funds are not being used to expand plant and equipment. 

But, with the demand for funds being so low and with little or no indication that a pickup in demand will appear anytime soon, other problems exist.  Savers are earning next to nothing on their money and the many of the elderly are finding it hard to make ends meet.  And, as Wessel points out in the Journal article, “banks and insurance companies start to run into trouble.  They make much of their money by borrowing at short-term rates and lending at higher long-term rates, or effectively, guaranteeing higher rates to their customers.  That doesn’t work so well when yields on two- or three-year securities are negative.”

To me, this is a place we must look to pick up signs of an improving economy.  Demand pressure must start to build in the financial markets indicating that the economy is growing stronger.  The must be some indication that demand pressure is being felt in the Federal Funds market forcing the Federal Reserve to react in an effort to keep the effective Fed Funds rate from rising. 

This is a reason, in my mind, for opposing any kind of further quantitative easing (QE3) in the near term.  If there is no demand side pressure on the money markets, shoving more money into the banking system will not create more demand given where interest rates currently are. 

Business loan demand has been increasing slightly but there is no indication that what we have seen is significant to put any pressure on the banking system.  And, merger and acquisition activity remains week thereby providing us with another sign that the demand for financial resources is remaining tepid.

Right now the Federal Reserve has stated that it can see the Federal Funds rate target remaining in place to the end of 2014. 

If they really believe that this will be the case then they are indicating that they expect the economy to stay extremely week until that time.  This would mean that the economic recovery would be in its sixth year.  And for there to be no demand pressure on short-term interest rates during this time, economic growth would still need to be around two percent and unemployment would have to hover around eight percent.

The fact that there is little pressure on interest rates to rise is not a good sign!