October 19, 2015
Five Bad Reasons For The Fed To Raise
Rates Now – And One Good Reason Not To
A couple of days before the September 16-17 FOMC meeting,
I happened to be listening to the NPR program, “On Point”, the subject of which
was the appropriateness of a Fed policy interest rate increase at that time. Of
the guests on the show, the principal advocate of Fed “lift-off” was a William
Cohan, who had written an August 28 New
York Times op-ed entitled “Show
Some Spine, Federal Reserve”. As much as I disagreed with Mr. Cohan’s
reasons for why the Fed should have raised its policy interest rates on
September 17, reasons that I assume Mr. Cohan still would believe valid now, I
was delighted to hear them. I was delighted because Mr. Cohan’s and others’
arguments in favor of immediate Fed interest rate hikes provided me with
material for this commentary. I would have written it sooner, but I was
otherwise occupied in the waning days of the sailing season up here in
Packerland. So, let’s get at countering three of Mr. Cohan’s arguments and two
that I have heard from others whose names I cannot recall (because I’m old).
Firstly, the claim
by Mr. Cohan is that the Fed’s zero interest rate policy (ZIRP), has hurt
household savers because they are earning next to nothing on their deposits and
other fixed-income investments. It is true that household interest income
relative to household after-tax income fell to its lowest in 2014 since 1968,
as shown in Chart 1.
Chart 1
But, while household
interest income has been weak since the inception of ZIRP, dollar changes
in the market value of total
household assets relative to after-tax income have rebounded to levels above their long-run median in the past
two years, as shown in Chart 2.
Chart 2
A rebound in residential real estate values has
contributed to the rebound in the relative value of total household assets, as
shown in Chart 3.
Chart 3
But just as baseball had been berry, berry good to Chico
Escuela (episode 5 of SNL season 4 – I told
Chart 4
The upshot of all this is that despite ZIRP, or perhaps
more accurately, because of ZIRP,
households have fared rather well in terms of increases in the value of their
assets. Nowhere is it mandated that households store their savings in bank
deposits or Treasury bills. If ZIRP and QE are good for equities and bad for
bank deposits, then allocate more of your assets to equities. There are plenty
of equity mutual funds and ETFs that can accommodate “small” savers.
Secondly, the
claim by Mr. Cohan is that ZIRP has been a gift to banks inasmuch as they are
paying next to nothing in interest to borrow funds. According to this view,
the Fed should raise its policy interest rates in order to lessen the alleged
subsidy to banks from ZIRP. The fed funds rate is the marginal cost of funds to
banks. When the fed funds rate is close to zero, banks’ marginal cost of funds
also is near zero. But bank lending is based on interest-rate spreads over their marginal cost of
funds. For example, the short-term lending interest rate charged by banks to
their most credit-worthy business borrowers, the prime rate, is three percentage
points above the fed funds rate, regardless of the level of the fed funds. So,
banks net interest income is more a function of the volume of bank loans rather
than the level of the fed funds rate.
Plotted in Chart 5 are quarterly observations of the U.S.
commercial banking sector’s consolidated net interest income (interest revenue
earned on loans and securities minus interest costs on deposits and other borrowed
funds) as a percent of interest-earning assets. Also included in Chart 5 are
quarterly observations of the fed funds rate level. In Q1-2015, the latest data
available, banks’ net interest income was 2.52% of their interest-earning
assets – the lowest percentage in the
history of the data series. ZIRP has not
enriched banks in terms of their net interest income. So, ZIRP has been no gift
to bank profits in terms of net interest income.
Chart 5
If ZIRP is such a gift to banks, we would have expected
the stock prices of financial corporations to rally relative to those of
industrial corporations after the Fed failed to raise its policy interest rates
on September 17. But just the opposite happened. As shown in Chart 6, in the
week ended September 18, the value of the S&P stock price index for
financial corporations fell relative
to the value of the S&P stock price index for industrial corporations (the
first red bar after the solid vertical line in the chart). The expected 30-day
average level of the fed funds rate also fell in the week ended September 18
after the Fed “disappointed” market expectations of a hike in its fed funds
rate target.
Chart 6
Actually, there is a reason that short-maturity asset-management
divisions of banks might loathe ZIRP. Under ZIRP, the yield on short-maturity
fixed-income securities is close to zero. But there are fixed costs involved in
managing clients’ short-maturity investments. In order to earn a “normal”
profit on managing these client portfolios, it might require that asset
managers charge their clients fees in
excess of the yield on short-maturity investments, implying a negative
return on client portfolios when fees are included. It’s a hard sell to get
clients to accept a negative return on short-maturity investments. The
potential negative goodwill generated by negative returns might cause the bank
to lose other profitable business from the client, either currently or in the
future. As a result, the asset-management division might choose to forgo some
of its fees in order to retain client goodwill. At least in the short run, this
would have a negative effect on bank profits.
Thirdly, it is
argued by Mr. Cohan that the Fed should lift its policy interest rates above
zero because a Fed-administered zero rate of interest results in the mispricing
of risk in the economy. In order for risk to be properly priced, interest rates
need to reflect the market forces of supply and demand. I would go a step
farther. If risk is to be priced properly, the Fed should abandon all direct interest rate targeting – zero or
otherwise. This is what Milton Friedman (may he rest in peace) advocated
when he prescribed that the Fed target the growth rate of a monetary aggregate,
an element of the supply of credit,
rather than an interest rate, the price
of credit. How do we know that risk will be more appropriately priced at
Fed-mandated federal funds rate of 25 basis points rather than at 13 basis
points?
Fourthly, it has
been argued by others that an important factor accounting for the August and
September declines in U.S. stock market indices was the uncertainty as to when
the Fed would raise its policy rates. The implication of this argument is that
to boost stock prices, the Fed needs to raise its policy interest rates sooner
rather than later in order to remove uncertainty. Let me counter this argument with an
analogous scenario. Suppose, after a routine physical exam with your doctor,
she tells you that you might have a
terminal disease, which, at best, would give you only three more months to
live. But she isn’t sure about this. Further analysis is needed to validate the
diagnosis -- analysis that will take three days. If you are similar to me, this
uncertainty about the diagnosis will
elicit anxiety and depression. Three days later, your physician calls, telling
you the uncertainty is over. You, in fact, do have a terminal disease and you
had better clean up your desk. (The mess on my desk during my full-employment
days was infamous and remains so in my semi-retirement.) Tell me, now that the
uncertainty has been lifted, are you elated?
All else the same, a Fed interest rate hike has negative
implications for risk assets. A Fed interest rate hike implies a reduction in
the supply of Fed-created thin-air credit. (I bet you wondered how long it
would take me to get around to thin-air credit.) So, yes, there is uncertainty
about when the Fed will raise its policy rates. But the removal of that
uncertainty by the Fed actually raising interest rates is akin to your doctor
removing the uncertainty about your fatal-disease diagnosis by telling you that
you do, indeed, have it.
Fifthly and lastly
of the bad reasons, it is argued by others that the Fed needs to raise the
level of its policy interest rates now so that it will have some margin to
lower their level later if the economy weakens. If there is a high
probability of the economy weakening anytime soon, why would it be good policy
to raise policy interest rates now. Wouldn’t that just hasten the economic
weakening? Moreover, haven’t we just observed in recent years that ZIRP doesn’t
preclude QEP (Quantitative Easing Policy)?
Now, for the good reason that the Fed should not to raise its policy interest rates
at this point in time – you guessed it, the current weakness in the growth of
thin-air credit. Plotted in Chart 7 are the year-over-year and
quarter-to-quarter annualized percent changes in thin-air credit, i.e., the sum
of commercial bank credit and depository institution (primarily commercial
banks) reserves held at the Fed. The shaded area in Chart 7 represents a period
in which Fed QE policy was in effect (through the end of Q3-2014). When QE3 was
terminated on a quarterly basis in Q3:2014, thin-air credit was growing
year-over-year at 9.4% and quarter-to-quarter at 8.3% annualized. This compares
with the long-run median growth in this measure of thin-air credit of about
7-1/4%. So, it was appropriate for the Fed to scale back on its contribution to
thin-air credit in order to prevent an asset-price bubble and/or an
acceleration in the prices of goods/services.
But, in my opinion, the Fed has overdone the slowing of thin-air credit
growth. In Q3-2015, year-over-year growth in thin-air credit slowed to 4.5% and
quarter-to-quarter annualized growth slowed to 3.5%. This sharp deceleration in
the growth of thin-air credit represents a tightening in monetary policy in a
Friedman sense.
Chart 7
Chart 8 shows who is primarily responsible for the sharp
slowing in thin-air credit growth in the post-QE period. It is the Fed. Again
in Chart 8 as in Chart 7, the shaded area through Q3-2014 represents a period
in which QE was in effect. As the Fed began to taper its purchases of
securities at the start of 2014, growth in depository institution reserves at
the Fed (the red bars in Chart 8) slowed sharply. At the same time, growth in
commercial bank credit (the blue line in Chart 8) accelerated enough to allow
the sum of bank credit and reserves at the Fed (the green line in Chart 8) –
total thin-air credit – to grow at a robust rate in the range of 7-1/2% to
8-1/2%. But starting in the fourth quarter of 2014 and every quarter thereafter,
reserves at the Fed have been contracting.
Despite relatively strong growth in bank credit through Q2-2015, growth in
total thin-air credit sagged well below its long-run median rate. And in the
third quarter of 2015, growth in commercial bank credit slowed appreciably to
5.3% annualized. This, in combination with the contraction in reserves at the
Fed, resulted in the very slow growth in total thin-air credit of 3.5%
annualized.
Chart 8
The Fed has been engaged in quantitative tightening (QT) for about a year now. Unless
depository institution demand for
reserves were to fall, an increase in Fed policy interest rates would require a
further contraction in the supply of Fed reserves. Barring a
sufficient pick up in commercial bank credit, this would imply a further
deceleration in total thin-air credit.
The pace of economic activity already appears to have
slowed in reaction to the sharp deceleration in thin-air credit growth. Why
would the Fed want to raise its policy rates later this month or in December
and risk having the pace of economic activity stall out? Rather than dithering over whether it should raise interest rates in
December, perhaps the Fed ought to be contemplating another round of
quantitative easing!
Paul L. Kasriel
Founder and Administrative Assistant, Econtrarian, LLC
Senior Economic and Investment Advisor
Legacy Private Trust Co., Neenah, WI
1-920-818-0236
