The Chairman of the Federal Reserve, Ben Bernanke, gave a speech in Jackson Hole, WY, on Friday in which he said that the Fed was planning to potentially step in and provide another boost to the now-slowing economy. These remarks paralleled the report that 2nd quarter GDP was indeed much lower than the original 2.4% forecast that had come out in late July, and had been revised downward to 1.6%. Stock markets reacted positively to the dual revelations that not only would the Fed be willing to take more action, but the economy didn’t slow as much as expected (traders actually thought GDP would revise down to 1.4%).
In Bernanke’s speech, he noted some of the tools the Fed has at its disposal to try and influence the economy:
1) Buy long-term Treasury bonds, thus increasing demand for them and raising their prices, and subsequently lowering their yields (bond price and yield move opposite to each other).
2) Articulate a more emphatic commitment to keeping interest rates low for a longer period of time than originally forecast.
3) Reduce the interest the Fed pays to banks that keep surplus reserves at the Fed, thus motivating them to lend that capital and earn a better return.
So to the first point, why might this kind of purchasing of long term bonds help anything? Well, if the Fed buys long term bonds, it will increase the demand for those bonds and raise their prices and lower their yields, as noted above. When this happens, the lower yields would ostensibly influence lending rates, such as mortgages, car loans, etc, thus incentivizing people to borrow (and spend) more.
On the second proposed action, the Fed regularly comments on its interest rate policy about every six weeks when it conducts its policy meetings, and reports its conclusions to Congress. The interest rate decision is usually the main thing investors look for from these Fed meetings. So Bernanke is saying that instead of repeating the usual language of short term commitment to keeping rates low in the 0-0.25% range, he’s now saying that a stronger commitment to keeping them there for a longer duration is in order. The assumption here is that if people know that rates will stay low for a long time, they may shed some hesitation for doing any borrowing, especially of the variable rate kind. (Of course, you could argue that this will actually accomplish the reverse, and people may wait longer to borrow assuming they have more time to do so, but I digress.)
Thirdly, Bernanke noted that the Fed can lower the interest rate it offers banks that have reserves kept at the Fed. The thought here is that it would get banks lending this money rather than hoarding it on the balance sheet as a capital reserve. If banks start to think they can get better returns on loans to consumers and business owners, they’ll start moving in that direction.
Now, it’s true that the Fed has taken actions in the past that have aided economic recovery, although this is a little like applauding the arsonist for putting out his own fire. Some of you may recall the inflation-busting policies of Chairman Volcker during the early 1980’s, when the US economy was mired in an economic climate of rising inflation (and hence rising prices), with slowing economic and wage growth. So the Fed raised interest rates (as high as 19% in the summer of ’81) and kept them high long enough to reduce inflation and return things to a period of significant growth later that decade.
But the problem now is, the Fed’s actions as listed above all essentially encourage the same thing – more debt, and by extension, more debt-fueled consumption. The last thing we need in this country right now is more borrowing and spending. It’s the exact prescription for getting us right back to the problems we’ve had that triggered this recession. Americans are right to cut down on their spending and start saving, and they should be encouraged to do so in order to restore the capital reserve base in our banks (the more savings on deposit in our banks, the more capital available to businesses that are looking to borrow). More Fed action to loosen lending and increase money supply will serve to cheapen the dollar, thus punishing savers and rewarding spenders. When an individual goes into significant debt, they would never conclude that the best way to get out of that debt is to spend more money. So why is our country using this approach?
I’d also like to note here that the Kansas City Federal Reserve bank chief, Donald Hoenig, has maintained a curious stance in all this that I suspect might get lost in the noise. Essentially, as Yahoo Finance reports, he has “warned repeatedly that a long period of low rates could fuel speculative bubbles.”
I wonder if he lived through the housing bubble in the late 2000’s.
Well, he’s an older gentleman, so I suspect he was alive over the last decade.
I guess, all kidding aside, it’s not always wise to assume that the obvious will always be, well…obvious. So let me state it in my own way here: long periods of artificially low interest rates will always lead to speculative bubbles. Okay, so maybe I should caveat that a bit and say “almost” or “virtually” always. But it matters not. The probability is so high that it will create a bubble that as an investor you have to prepare for that bubble nonetheless. So your orientation during these periods of cheap money and easy lending, from an investing standpoint, should not change by much even if you don’t know the exact outcome of these monetary policies.
I think one of the things that we need to keep in mind here is that consumers ultimately have to go out and borrow the money for any of these measures to take serious effect. And right now, the American consumer simply has little appetite remaining for increasing the liabilities on his or her balance sheet. I take this as an encouraging sign, but unfortunately, current (and probably future) policies are doing all they can to discourage that.
In Bernanke’s speech, he noted some of the tools the Fed has at its disposal to try and influence the economy:
1) Buy long-term Treasury bonds, thus increasing demand for them and raising their prices, and subsequently lowering their yields (bond price and yield move opposite to each other).
2) Articulate a more emphatic commitment to keeping interest rates low for a longer period of time than originally forecast.
3) Reduce the interest the Fed pays to banks that keep surplus reserves at the Fed, thus motivating them to lend that capital and earn a better return.
So to the first point, why might this kind of purchasing of long term bonds help anything? Well, if the Fed buys long term bonds, it will increase the demand for those bonds and raise their prices and lower their yields, as noted above. When this happens, the lower yields would ostensibly influence lending rates, such as mortgages, car loans, etc, thus incentivizing people to borrow (and spend) more.
On the second proposed action, the Fed regularly comments on its interest rate policy about every six weeks when it conducts its policy meetings, and reports its conclusions to Congress. The interest rate decision is usually the main thing investors look for from these Fed meetings. So Bernanke is saying that instead of repeating the usual language of short term commitment to keeping rates low in the 0-0.25% range, he’s now saying that a stronger commitment to keeping them there for a longer duration is in order. The assumption here is that if people know that rates will stay low for a long time, they may shed some hesitation for doing any borrowing, especially of the variable rate kind. (Of course, you could argue that this will actually accomplish the reverse, and people may wait longer to borrow assuming they have more time to do so, but I digress.)
Thirdly, Bernanke noted that the Fed can lower the interest rate it offers banks that have reserves kept at the Fed. The thought here is that it would get banks lending this money rather than hoarding it on the balance sheet as a capital reserve. If banks start to think they can get better returns on loans to consumers and business owners, they’ll start moving in that direction.
Now, it’s true that the Fed has taken actions in the past that have aided economic recovery, although this is a little like applauding the arsonist for putting out his own fire. Some of you may recall the inflation-busting policies of Chairman Volcker during the early 1980’s, when the US economy was mired in an economic climate of rising inflation (and hence rising prices), with slowing economic and wage growth. So the Fed raised interest rates (as high as 19% in the summer of ’81) and kept them high long enough to reduce inflation and return things to a period of significant growth later that decade.
But the problem now is, the Fed’s actions as listed above all essentially encourage the same thing – more debt, and by extension, more debt-fueled consumption. The last thing we need in this country right now is more borrowing and spending. It’s the exact prescription for getting us right back to the problems we’ve had that triggered this recession. Americans are right to cut down on their spending and start saving, and they should be encouraged to do so in order to restore the capital reserve base in our banks (the more savings on deposit in our banks, the more capital available to businesses that are looking to borrow). More Fed action to loosen lending and increase money supply will serve to cheapen the dollar, thus punishing savers and rewarding spenders. When an individual goes into significant debt, they would never conclude that the best way to get out of that debt is to spend more money. So why is our country using this approach?
I’d also like to note here that the Kansas City Federal Reserve bank chief, Donald Hoenig, has maintained a curious stance in all this that I suspect might get lost in the noise. Essentially, as Yahoo Finance reports, he has “warned repeatedly that a long period of low rates could fuel speculative bubbles.”
I wonder if he lived through the housing bubble in the late 2000’s.
Well, he’s an older gentleman, so I suspect he was alive over the last decade.
I guess, all kidding aside, it’s not always wise to assume that the obvious will always be, well…obvious. So let me state it in my own way here: long periods of artificially low interest rates will always lead to speculative bubbles. Okay, so maybe I should caveat that a bit and say “almost” or “virtually” always. But it matters not. The probability is so high that it will create a bubble that as an investor you have to prepare for that bubble nonetheless. So your orientation during these periods of cheap money and easy lending, from an investing standpoint, should not change by much even if you don’t know the exact outcome of these monetary policies.
I think one of the things that we need to keep in mind here is that consumers ultimately have to go out and borrow the money for any of these measures to take serious effect. And right now, the American consumer simply has little appetite remaining for increasing the liabilities on his or her balance sheet. I take this as an encouraging sign, but unfortunately, current (and probably future) policies are doing all they can to discourage that.
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