Here is our latest macro note. The results of the FOMC meeting confirm that most of the media and investor communities don't get the joke on Fed policy since the crisis. The narrative is about jobs and inflation, but the actions are all about spreads. This is a no-win scenario for Chair Yellen, thus no action. Our guess is no change in rates this year. Link is on the bottom if you want to see the footnotes or the chart. Best, Chris
"Turn him to any cause of policy,
The Gordian Knot of it he will unloose,
Familiar as his garter"
(Shakespeare, Henry V, Act 1 Scene 1. 45–47)
Discussion
The debate among investors as to when and how much the Federal Open Market Committee (FOMC) will raise short-term interest rates is following a familiar pattern seen over the past several years. At first, a number of analysts predicted that the FOMC would raise rates in the first quarter of the year, this optimistic view based on the promise of an economic “lift off.” With a number of disappointing economic statistics and the end of the first month of Q2, the analyst community is quickly retreating, revising estimates of when a rake hike will occur into the second half of 2015 and beyond.
Kroll Bond Rating Agency (KBRA) believes that the FOMC is facing an impossible and increasingly untenable situation. On the one hand, economic indicators such as employment, inflation, GDP and particularly credit demand do not justify an interest rate increase. Based upon the indicators publicly identified by Chair Janet Yellen and other committee members, the U.S. economy is not yet close to a lift off.
On the other hand, the U.S. central bank must soon allow rates to rise to restore market function and avoid further damage to investors, financial institutions and the economy as a whole. As we have noted in previous comments, the wasting effect of low interest rates and the burden of uncollectible debt are depriving the global economy of trillions of dollars in income annually.
We believe that the decrease in income for savers and investors that is part of the FOMC policy mix is making it increasingly difficult to achieve the committee’s stated job and inflation targets and is, in fact, driving global deflation. The FOMC has been able to successfully stave off a liquidity crisis and also manipulate asset prices for equities, debt and other asset classes, yet there has not been a commensurate increase in personal or aggregate income. KBRA believes that the Fed and other agencies in Washington must now shift focus from ensuring market liquidity to increasing investment, and thereby income and growth.
Low Rates are Driving Deflation
As illustrated in the chart that follows, the Federal Funds rate was close to zero from 2001 through 2004. The FOMC then increased short-term rates as the mortgage market peaked at the end of that year, but was forced to again reduce rates down to present levels as the 2008 crisis exploded, sending credit spreads soaring as market liquidity disappeared.
During that terrible year, credit spreads exploded to crisis levels, with the high-yield minus investment grade spread over 1,500 basis points (bps). When this indicator exceeds 500 bps, this indicates that financial intermediation has broken down and the economy is destroying value. The low rate policy put back into place by former Fed Chairman Benjamin Bernanke in 2008 was meant to counteract the negative effects of the financial crisis by focusing on reducing credit spreads.
Thanks to Chairman Bernanke’s genius in understanding the significance of credit spreads in a deflationary environment, low interest rates were used successfully to address the run on liquidity that followed. In his 1983 analysis of the cost of credit intermediation (CCI), Bernanke noted that a rise of CCI from 250 bps to 800 bps, between 1929 and 1932, explained all the damage done during the Great Depression. He also observed that the less than 200 bp rise caused the recession of 1920-22 which preceded the Crash of 1929.
The media and the FOMC both have adopted a public narrative that describes the Fed’s low interest rate policies as being focused on creating jobs and increasing inflation. In fact, what the FOMC has primarily achieved is the lowering of credit spreads. Low interest rates and credit spreads by themselves, however, are not sufficient to restore economic health and have also led to the creation of new asset bubbles. Although low interest rates did stave off calamity in 2008 and thereafter, the diminution of income for consumers and investors alike is retarding economic growth and job creation, and is arguably driving down demand for globally traded commodities.
Seen in a realistic light, the Fed’s low rate policy has merely been a palliative remedy for addressing the alarming level of public and private debt accumulated over the past decade and more, but is now hurting growth. Michael Lewitt, publisher of The Credit Strategist, states the case succinctly:
“It is becoming increasingly clear to me that just like everyone was wrong about the effects of lower interest rates – they suppress growth not stimulate it – they are likely wrong about the impact of higher rates (modestly higher rates not radically higher rates) – they would promote economic growth by imposing more discipline and giving banks more incentive to lend. Basically consensus thinking is upside-down. Until it gets right side-up we are doomed to a bevy of serious problems.”
By subsidizing debtors at the expense of savers via low interest rates, the FOMC has put off the day of reckoning with respect to excessive debt, but has not solved the underlying problems of flat income and weak job creation that are the result of decades of debt fueled “growth” in the major industrial nations. Should credit spreads start to widen with even a modest change in Fed rate policy, the FOMC would be forced to quickly reverse course. This is a key reason, KBRA believes, that the FOMC has been so reluctant to actually make a change in policy.
Since 2008, the overall indebtedness of the industrialized world increased by $57 trillion, according to McKinsey & Co., encouraged by the low rate environment maintained by the Fed. McKinsey notes that this “raises the ratio of debt to GDP by 17 percentage points. That poses new risks to financial stability and may undermine global economic growth.” Even as markets have issued trillions of dollars’ worth of new public and private debt, financial institutions continue to see their income from earning assets decline. Industry leader BB&T (NYSE:BBT) is the latest major U.S. bank to report lower earnings due to the FOMC’s “rate squeeze.”
KBRA believes that investors and policy makers need to reconsider the basic assumptions driving U.S monetary policy and appreciate that low interest rates are part of the problem, not the solution, when it comes to avoiding deflation and restoring growth. We believe that the FOMC needs to embrace a shift in policy away from subsidizing debtors and toward restoring income for both consumers and investors. Such shift will necessarily require governments and policy makers to focus on resolving bad debts and slow the accumulation of new obligations that are not focused on investment.
Part of the solution to the global threat of deflation is to allow for a gradual and relatively modest increase in interest rates, starting with an immediate increase in the rate the Fed pays on bank reserves. By hiking the interest rate paid on bank reserves from 0.25% to 0.5%, the Fed will slow the deflationary wave now threatening U.S. financial institutions, pension funds and the global banking system as a whole.
This change will also reduce the regressive transfer of resources from the Fed to the U.S. Treasury. Instead of transferring to the Treasury the spread earned on bank reserves via FOMC investments in government debt and mortgage securities, the Fed should instead leave these earnings in the banking system. By enhancing the profitability of bank assets, the Fed will avoid the dangerous compression of bank interest margins.
Another part of the solution must come from fiscal authorities in the form of policies to encourage both private and public sector investment, and loosen laws and regulations that impede prudent credit creation. The political reaction to the 2008 credit bubble, an orgy of ill-considered risk taking that was fueled by the very same low interest rate polices of the FOMC, has been to constrain lending for legitimate risk taking in a way that harkens back to the 1930s. One of the great ironies that confront investors and policy makers, KBRA believes, is that prolonging low interest rates and increased regulation have combined to create the very deflationary environment that the FOMC has fought so valiantly to avoid.
KBRA believes that policy makers need to re-learn the key lessons of the 1930s and appreciate that simply lowering the cost of credit and boosting asset prices is not sufficient to address the damage done by the 2008 crisis. We must also boost income and cash flow to validate these enhanced asset prices, otherwise the efforts by the FOMC over the past five years have been for naught.
Chair Yellen and the other members of the FOMC need to address the need for a fiscal response in their public statements and make the case the U.S. central bank cannot alone fix the problem of uncollectible debt, mounting deflation, falling consumption and stagnant income. A combination of debt restructuring, increased public infrastructure spending and private tax initiatives are needed to complete the task.
In 1932, when John Maynard Keynes saw economies deflating with 0% government borrowing rates, his visceral reaction was that of any good real estate developer – borrow and build until the credit markets re-price the cost of the debt. Keynes told Congress and FDR that their responsibility in a zero-bound rate environment was to borrow and spend until investors caused them to change their priorities. There are many tens of billions of dollars’ worth of badly needed infrastructure projects in the U.S. and EU that could be easily justified at today’s interest rates.
You don’t need to be an advocate of deficit spending or big government to understand that financing valid infrastructure spending at 0% real interest rates is a good deal for investors and the national interest. Private corporations and financial institutions have already taken advantage of low interest rates to re-price long-term liabilities and reduce funding costs, but lower financing costs are not sufficient to ensure economic health if consumption and national income remains constrained.
Conclusion
Now seven years since the 2008 financial crisis, KBRA believes that it is clear the FOMC needs to end its extraordinary low interest rate policy and restore function to the private money markets. Just as the Federal Reserve System had to win back its independence from the Treasury at the end of WWII, today the U.S. bond market needs to again become independent of active Fed market manipulation. By ending its low interest rate policy, the Fed can make clear that the next step in the process of recovery must come from Congress in the form of policy changes to increase both private and public investment. For example:
* Restoring full funding for the federal Highway Trust Fund, which runs out of money by the end of Q2 2015
* Providing vehicles for the states to finance infrastructure spending
* Lowering or eliminating entirely corporate taxes
* Addressing the plight of the millions of Americans who are still underwater on their home mortgages, and
* Modify the bankruptcy laws to roll back many of the changes made in 2005 and, in particular, allow the holders of delinquent student debt to modify or discharge these obligations.
All of these changes, combined with a gradual and relatively modest increase in interest rates, could help turn the threatening tide of deflation that now threatens the global economy. But the first necessary step is for the Fed to end its extraordinary policy efforts and make clear to the White House and the members of both parties in Congress that it is time for them to get into the game.