Why interest rates matter

Some context: I find that almost no one understands what interest rates are and what the Federal Reserve did last week when it “left rates unchanged.” But interest rates are important. Below is my brief, basic explanation of what interest rates are, what the Federal Reserve is doing when they set interest rates, and why timing interest rate hikes is a delicate task.

Interest is a price.

This isn’t a figure of speech. Interest is the literal price of borrowing money. It’s what we pay, in terms of future money, for the privilege of using someone else’s money in the present.

All prices, in turn, are informative. In fact, this is their essence: prices are a mechanism for communicating information about the world—specifically about how supply and demand conditions change. Friedrich Hayek explains:

We must look at the price system as such a mechanism for communicating information if we want to understand its real function … In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned. It is more than metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.

This information isn’t just incidental. It doesn’t just help “those concerned” find opportunities that otherwise would have simply gone unrealized. It’s vital to the successful functioning of business everywhere. It facilitates rational economic calculation and makes sustained profit possible.

Interest is a price, prices are information, and information is essential to the rational economic order. Clearly, the implications here are many. One in particular is of unique importance this year, as the Federal Reserve begins to tinker with interest rates after more than 80 months of near-zero rates following the financial crisis.

Now, I’ve been skeptical of talk that the Fed was ever serious about raising interest rates this year. I predicted in December 2014 that we’d see no rate hike in 2015, and I was almost correct (missed it by a month). But whether I was right or wrong doesn’t change how interest rate hikes (and cuts) affect economic activity. Whether the Fed does or does not raise rates doesn’t dampen the unprecedented risk the Fed takes by artificially manipulating interest rates in pursuit of even the noblest of goals.

We’ll start with premise #1: That the Fed manipulates interest in order to effect change in the economy. This is undisputed. Monetary policy actions (like manipulating interest rates) is the central bank’s tool to combat recession, and the only sphere over which it maintains an almost absolute controlling power. By lowering interest rates following the 2008 recession, the Fed sought to boost the availability of credit (that is, make borrowing money easier by lowering the price of borrowing money) in an otherwise recessionary environment which would likely have seen rates skyrocket. This would put downward pressure on things like business creation and investment, home and car ownership, etc.

Premise #2 is related: Interest rate manipulation has real effects on economic activity. If this weren’t the case, why would the Fed fix rates? By lowering interest rates, the Fed did stimulate lending and business activity that otherwise would not have happened. It staved off further liquidation by purchasing bad assets from banks, and infused confidence into markets that likely propped up things like household spending and borrowing, employment, and investment.

Conclusion: Mistiming an interest rate hike could have seriously traumatic implications for global economic health. If the Fed raises rates too soon (that is, before the “natural” rate has risen equivalently), it risks destabilizing an unrealized equilibrium and undoing what steps entrepreneurs have taken thus far to re-establish their economic footing. If it raises rates too late, it risks inflating a speculative bubble–the type that burst in 2008, after a quick rate hike followed by several years of low rates.

Now, whether it’s possible for the Fed to accurately time an interest rate hike is, itself, a worthwhile question…

Brief musings on the market

  1. The DJIA lost 3.57 percent today. Last Friday it lost 3.12 percent. This is nowhere near even the 20th worst day in the DJIA’s history—a 6.98 percent loss on September 29, 2008. But the past two trading days do represent the DJIA’s 19th and 20th worst daily point losses ever.
  2. Most economists think Greenspan’s Fed left interest rates too low for too long when rates hovered between one and two percent for 32 months between December 2001 and May 2004. But that’s nothing compared to today, which marks roughly 80 months of near-zero rates.
  3. Even if the U.S. stock market recovers somewhat in the next few weeks, problems in China have proven to be very fundamental and very serious. I take this as another good reason to believe my 8-month old prediction—that the Fed will not raise rates in 2015. China is in full-on stimulus mode, and sharp divergence between central banks’ policies makes conducting monetary policy in the U.S. difficult. If the Fed continues to flirt with the idea of a rate hike, it will be while China, Japan, and the Eurozone still meddle with stimulus. At the very least, this risks boosting the dollar’s value even further and weakening U.S. exports in the process. Larry Summers made this point in the Financial Times today. I explained it last fall.

An educational outlook

I try to read First Trust’s Monday Morning Outlook every week. Today’s was especially good. Here’s a highlight:

The good reason for slow economic growth is that government statisticians are having a hard time measuring true output. Productivity and GDP growth are not as slow as the official numbers say. For example, when people download free apps to improve their communication and travel, that isn’t measured in GDP, yet our standard of living is clearly higher.

One thing we are confident about is that quantitative easing (QE) hasn’t made a dime’s worth of difference. Although it stuffed the banking system chock full of idle excess reserves, new figures from the government show weaker economic growth in 2012-13, while the Fed was engaged in expansive QE3, and then slightly faster growth in 2014, when the Fed was tapering and then ending QE.

When we put all this together, the picture is reasonably clear. The economy has been in recovery for six years and the unemployment rate has finally fallen to a level even the Fed thinks is close to full employment. Unemployment claims have been below 300,000 for twenty-one straight weeks, and at less than 0.2% of total jobs are at historical lows.

So, even though growth remains slow, it’s hard to argue rates should stay at zero. While some investors fear rate hikes, we see them as ratifying the strides the economy has made in the past several years. Surely, this is no economic boom like 1980s or 1990s. But even a modestly growing economy should have short-term rates higher than zero.

A new piece, and a great interview

Here’s my new piece at EnhancingCapital.com on interest-sensitive investments — a handy little read, I hope, for anyone concerned about how an interest rate hike might affect their portfolio. Then again, I still stand by my prediction from last December: The Fed won’t raise interest rates in 2015. Inflation is just too low. In fact, I don’t think raising rates in 2015 was ever a serious possibility when rate-hike-talk began last fall.

Switching gears…

Here’s great interview with some great thoughts on immigration (and other things) from someone who could very well be the next President of the U.S. At the least, it’s encouraging to know that someone running for president actually believes his message is robust enough to convince millions of people (i.e. Republicans) that they are wrong on a big issue (immigration).

The Fed is frustrating (and won’t raise rates in 2015)

The Editors at BloombergView are spot on with this one:

Here’s the point, and it’s really quite simple: The Fed doesn’t know when it will start to raise interest rates, nor should it have to know, nor should it indulge analysts’ misconceived determination to find out. Interest-rate changes are not, and should not be, on a schedule. They depend entirely on what happens in the economy, and the Fed — like every last one of those analysts — doesn’t know what will happen. What it can and should do is draw attention to the economic indicators it is following — in particular, indications of inflation pressure in the labor market. The rest just sows confusion.

On a related note, I made a public prediction earlier this week that the Fed will not raise rates in 2015. Inflation, as measured by the Fed’s preferred PCEPI, is just too low. Fears of runaway inflation are totally unfounded in the data. Yes, stock values are soaring high enough to scare some investors, but Yellen has insisted that the presence of speculative bubbles is no reason to raise rates. That decision will come, she says, only once the two arms of the Fed’s dual mandate—unemployment and inflation—look good. And right now, inflation looks anything but. Yellen has always been a deflation hawk, anyways.

For more of my views on this topic, see my recent piece at Enhancing Capital. This is the startup I’ve mentioned on my blog before—an investments e-newsletter that “brings market analysis to life.” In this case, that’s more than just a cheesy slogan. They do some pretty cool stuff with data visualization that keeps things simple and straightforward without sacrificing depth of research. Most of my content there regards larger economic trends, but stock picks and sector analyses are their specialty. Check ’em out!

Central banking like it’s 1989

Ashley Kindergan writes a great piece at The Financialist on the growing divergence between central banks, the likes of which we haven’t seen in 25 years.

In 2015, global monetary policy could look like a mirror image of its 1989 self. The Bank of Japan already expanded the scope of its asset purchases in October. The European Central Bank is expected to announce quantitative easing as early as the first quarter, while the U.S. and the U.K. are expected to start tightening monetary policy in mid-2015. That’s because policy makers’ concerns have been reversed as well, with deflation a bigger worry than inflation in Europe and Japan (a 40 percent drop in crude oil prices since June has exacerbated the deflationary dynamic), and inflation emerging as a potential concern of the Fed and the Bank of England.

One qualm: I’m a little skeptical that inflation fears will be the prime mover behind Fed policymaking in 2015. The economy may be looking up as equity values soar and unemployment continues to decline, but inflation itself remains low. Janet Yellen is a deflation hawk, anyway, having repeatedly dismissed inflation fears in the past. The collapse of oil prices adds deflationary pressures to the mix that, I think, will dissuade Fed officials from raising rates in 2015. Near-zero rates through 2016 is what Janet Yellen originally wanted, anyways.

But either way, how the world’s central banks respond to these contrasting inflationary and deflationary pressures will certainly be one of the coming months’ big stories. Here’s Barry Ritholtz saying as much at Bloomberg today:

The central bankers of the world are out of synch with each other. If the U.S. economy continues to accelerate, this disparity may become even more pronounced. How that plays out could be the big question facing central bankers in 2015.

The Fed especially has an interesting puzzle, as unemployment drops ever lower while inflation remains low—a situation The Economist calls “contradictory pressures” in it’s print edition this month. A working assumption behind the economics of the Fed’s dual mandate is that inflation and unemployment should move somewhat in tandem, and that the decision to ease off the monetary gas pedal should come when both indicators look good. But what happens when one indicator moves opposite the other—when inflation drops as job growth rises, as we’re seeing today? Can unemployment get “too low” as the Fed waits for inflation to pick up before raising interest rates? Will a rate hike spark deflationary fears if the Fed acts in response to strong jobs reports while inflation remains low?

(On that note, remember when 6.5 percent unemployment was supposed to trigger a rate hike? In retrospect, that was probably one of Ben Bernanke’s worst ideas. Pegging the end of easy money to a specific unemployment rate might have eased fears of a rate hike when unemployment was still well above 6.5 percent, but pegging the two events together like that created a perverse incentive—one I wrote about last year—that turned low unemployment into something stimulus-addicted markets didn’t like.)