Mon 12 Aug, 2019 12:30 am
From Fortune and The Economist
Resume its bond buying program. That has limitations too.
The Fed’s main recession-fighting tool has long been lowering the benchmark federal funds rate, which governs short-term rates for things ranging from auto loans to credit card charges. In the past, the average reduction needed to fight a recession was a whopping 5.5 percentage points.
Such a bold step is mathematically impossible now. Rely more than before on buying bonds, known as quantitative easing or QE—a maneuver that gives commercial banks fresh money, so they can make loans and thus bolster the economy.
The mechanics of QE are that a central bank creates new money out of thin air and deploys it to buy assets, mostly bonds from commercial banks. With all this fresh cash, those banks can lower their interest rates and make more loans. The theory is that it’s easier then for companies and consumers to get credit, which is supposed to benefit the economic system. The FOMC’s first line of defense during the 2008-09 crisis was a drastic plunge in the fed funds rate, to near-zero from 5.25%. After economic growth appeared to be on a sustainable track, the Fed in late-2015 started to gradually lift the rate back to normal levels.
What happens if the Fed reverses course and starts purchasing bonds once more? There’s a school of thought that this too will be less effective than in the past. Reason: Banks have so much extra funding these days that they don’t know what to do with all the money. The previous rounds of QE, which finally ended in 2014, stuffed banks with trillions of new dollars, which they hold in reserve to buffer themselves against economic bad spells and also to make loans. Plus, loan demand is low, even now in an expansion. Demand will be a lot less in a recession.
“Excess reserves in the banking system are currently so extraordinarily high that it is difficult to imagine” institutions lending out much of the money, said economist Hugh Johnson, who heads Hugh Johnson Advisors.
The Fed started buying Treasury bonds and mortgage-backed securities in 2010 and stopped in 2014, when it has amassed $4.5 trillion. That was a massive ballooning of its balance sheet, which held just $870 billion in August 2007, right before the financial crisis. The Fed had been reducing its asset holdings since late 2017 and intends to stop on Thursday, Aug. 1. Now this hoard has dwindled to $3.8 trillion, as of July 15, which is still a giant number.
As of June, Johnson pointed out, bank excess reserves (not needed to meet regulatory and creditors’ requirements) were $1.27 trillion, well above the pre-crisis average of $1.5 billion. At the same time, loan demand remains low, he said.
fiscal policy—slicing taxes and boosting federal outlays
Corporate earnings (which have been growing robustly, although are forecasted to ebb) and the U.S. economy’s current health (unemployment at 3.7%, one of the lowest levels in a half-century) are strong factors influencing the market’s upward direction. Interest rates, though, are the predominant force, as they affect the cost of every consumer’s and every company’s borrowing.
Lower for longer” has been the adage to describe interest rates since the Federal Reserve and other central banks took short rates to near-zero as a remedy during the 2008-09 financial crisis. These past few days confirm beyond doubt that it’s going to be lower a lot longer.
While that’s good news for consumers with credit card balances and auto loans, perpetually low rates have major downsides. Two of them: Low rates distort the yield curve, which could hasten a recession. And they encourage excessive corporate borrowing.
The Federal Reserve last week lowered its benchmark federal funds rate by a quarter percentage point to a target band of 2% to 2.25%.
both Europe and Japan have negative interest rates, where businesses and consumers must pay to deposit cash. road macro forces are pushing rates below their historical levels. Low inflation is the root cause, the consequence of globalization and automation. And quiet inflation has changed the landscape for rate increase.
Low rates mean the Fed has less room to cut, as a recession-fighting tool. What’s more, low rates bring the economy much closer to deflation, should a brutal recession blow in. And deflation, a nemesis in the Great Depression, makes recovery very difficult.
Yield curve inversion
As many market-watchers have noted, the distorted yield curve (when short term bond yields exceed long term yields) is cause for concern. The yield curve inverted in May, with the three-month Treasury bill higher than the 10-year Treasury note.
The reason this matters is an inverted curve is the financial equivalent of the tell-tale red-ringed skin lesion of the Black Plague in the Middle Ages: It’s a sure-fire sign of doom. The inversion augurs a coming recession. To Joseph Lavorgna, Nataxis’ chief economist for the Americas, it can be a self-fulfilling prophecy. An inverted curve, he said, “is both a predictor and creator of recessions.”
Short rates have trended lower, but long-term bond yields are suppressed by enormous demand, especially from foreign investors, seeking the safety of Treasury paper and, as their domestic rates are even lower than in America, relatively fatter interest payments. The large demand increases bond prices, and yields move down.
To see how this works, let’s plot the rate of decreases. At the year’s start, the three-month yielded 2.42% and the 10-year was 2.66%. Now, the three-year is 2.05% and the 10-year is 1.73%. In other words, the short-term Treasury slid 0.41 percentage point, and the long bond a much more sizable 0.93 point.
Corporate America has been on a borrowing binge. In some cases, the objective was to fund stock buybacks, which support share prices. In others, to underwrite acquisitions. And also to pay for capital spending. Borrowing, aptly nicknamed leverage, is a time-honored way to buy big and important things, necessary for building businesses and creating earnings.
Some argue, with justice, that low rates have taken leverage too far. In the Levy Forecasting Center’s estimation, “companies in dubious financial positions have been able to roll over loans, fill holes in their cash flow and postpone cutbacks.”
As of this year’s first quarter, corporate nonfinancial debt of U.S. companies had surged to a record $9 trillion. And that is higher than before the Great Recession, consultancy Deloitte found. Although earnings growth in recent years has been robust, the second quarter likely will be much more anemic when all the results are tallied.
The low cost of funding is the big catalyst for this mounting debt load. For speculative bonds, a.k.a. junk, the spread to comparable Treasuries has been below four percentage points and only recently ticked up to just under five. Still, the historical average is almost double that.
Mr Trump will cut taxes and spend more public funds on fixing America’s crumbling infrastructure. A big fiscal boost would lead the Federal Reserve to raise interest rates at a faster rate to check inflation. America’s ten-year bond yield has risen to 2.3%, from almost 1.7% on election night. Higher yields are a magnet for capital flows .
Zippier growth in the world’s largest economy sounds like something to welcome. A widely cited precedent is Ronald Reagan’s first term as president, a time of widening budget deficits and high interest rates, during which the dollar surged.
the amount of dollar financing that takes place beyond America’s shores has surged in recent years. As emerging markets grow richer and hungrier for finance, so does their demand for dollars. Since the financial crisis, low interest rates in America have led pension funds to look for decent yields elsewhere. They have rushed to buy dollar-denominated bonds issued in unlikely places, such as Mozambique and Zambia, as well as those issued by biggish emerging-market firms. These issuers were all too happy to borrow in dollars at lower rates than prevailed at home. By last year this kind of dollar debt amounted to almost $10trn, a third of it in emerging markets, according to the Bank for International Settlements, a forum for central bankers.
When the dollar rises, so does the cost of servicing those debts. But the pain caused by a stronger greenback stretches well beyond its direct effect on dollar borrowers. That is because cheap offshore borrowing has in many cases caused an increased supply of local credit. Capital inflows push up local asset prices, encouraging further borrowing. Not every dollar borrowed by emerging-market firms has been used to invest; some of the money ended up in bank accounts (where it can be lent out again) or financed other firms.
A strengthening dollar sends this cycle into reverse. As the greenback rises, borrowers husband cash to service the increasing cost of their own debts. As capital flows out, asset prices fall. The upshot is that credit conditions in lots of places outside America are bound ever more tightly to the fortunes of the dollar.
The trade deficit will widen as a strong currency squeezes exports and sucks in imports. In the Reagan era a soaring deficit stoked protectionism. This time America starts with a big deficit and one that has already been politicised, not least by Mr Trump, who sees it as evidence that the rules of international commerce are rigged in other countries’ favour. A bigger deficit raises the chances that he act on his threats to impose steep tariffs on imports from China and Mexico in an attempt to bring trade into balance.
the Plaza Accord, an agreement in 1985 between America, Japan, Britain, France and West Germany to push the dollar down again
A high debt load. as the debt load grows, efforts by the Federal Reserve to stimulate the economy with lower rates would be more likely to feed runaway inflation. “Then, investors will dump Treasuries.
foreign investors, alarmed both by our crushing debt and the absence of plans to tame it, could dump our Treasuries, pushing interest rates higher. “A one point rise in rates adds $200 billion every year to the debt,” says Cote. A jump in yields would also raise the threshold at which new investments become profitable, forcing companies to retrench.
The February federal budget deal, meanwhile, hikes outlays in both of the two categories of “discretionary” spending, defense and federal programs from foreign aid to housing subsidies
the Tax Cuts and Jobs Act, which slashed rates for corporations from 35% to 21%. the measure will swell their earnings for years to come,
interest payments would absorb more than $1 in $5 of federal revenue
The cost of servicing the exploding debt would exert tremendous pressure on the government to eliminate investments that could fuel growth.
such colossal borrowings would push interest rates higher as the government competes with business for a limited pool of lendable assets. But for decades, that hasn’t been the case for the U.S.: A worldwide glut of savings from Chinese, Japanese, and other overseas investors holds our rates in check
Americans can get riled over gigantic budget deficits: Deficit anxiety after the excesses of the 1980s prompted a bipartisan deal to raise taxes and shrink deficits under the first President Bush in 1990.
A major reason: a decline in the rate of workforce growth because of our aging population
Trump could force the economy into a recession—one that could be made worse because it would prompt investors to ask for higher interest on our already gigantic debt.
value-added taxes, or VATs, which resemble a sales tax
Many in euro land thought not. QE2, as it came to be known, seemed to them to be mostly a means to a weaker dollar.
goldberg, I'm not an economist, but I did study Economics in college. You make some good points about fed rates, inflations, and recessions, but you should know as well as I that Economics is not science. How many "expert" economists have been predicting the next Great Recession for the past several years? Our economy is now experiencing one of the longest expansions in our history, and looking at current data, growth is looking pretty healthy at current rates; not too fast, and not too slow. China's economic growth at over 6% sounds inflationary to me, especially since they have built many ghost cities with no one living in them. Their deficit is growing, and their government is still on a spending spree. It'll be interesting to watch the outcome.
I notice the Fed recently lowered their interest rate. Usually, they do this to stimulate the economy, yet now we have both high employment and low unemployment. Sounds like they know something we don't, which would not be surprising.
What do you think is going on, here?
If you've been keeping up with the news, American consumers are maxed out on credit for their homes and cars. Most Americans couldn't come up with $400 for an emergency. https://money.cnn.com/2018/05/22/pf/emergency-expenses-household-finances/index.html
The fed's lowering of interest rates is an attempt to give our economy a shot in the arm, but it's useless, because most consumers are already maxed out on debt. According to data from the Federal Reserve, the U.S. surpassed $1 trillion in credit card debt — the highest level since the Great Recession. The average household is carrying a $6,929 balance month to month and coughing up about $1,140 a year in interest, according to a separate report by NerdWallet.Jan 22, 2019
86 million American consumers fear maxing out a credit card: Report
The picture looks dismal for our economy and the world.