How the Federal Reserve Discourages Consumer Demand

The Fed has, for the past four years, waged a relentless war on interest rates, suppressing them to zero at the short end of the yield curve and to record lows at the long end. This was all done in the hope of encouraging lending and fostering consumer demand. With about 70% of the U.S. economy coming from consumption, there is good reason to try to encourage consumers. But the Fed's basic approach has been to tilt the playing field sharply toward borrowers and punish savers for having the temerity to be frugal, all with questionable impact on consumer demand.

The boost given to borrowers appears to be limited. Interest rates on credit cards have, if anything, been rising. This is in part due to changes in the law that have limited some of the fees with which banks previously whacked their customers. But the sharp drop in short term rates since 2008 has not been mirrored in the credit card market. With recent credit card rate increases, borrowers have the incentive to reduce balances, not boost spending.

In the mortgage markets, rates are reaching all time lows. But only a limited segment of mortgage borrowers are able to qualify for refinancing (and a lot that can refi have already done so). The people who need help the most (i.e., those underwater on their mortgages) find refinancing a tough slog, if possible at all.

In the business world, rates may or may not be dropping, depending on the creditworthiness of the borrower. Business people tend to be cautious right now, with all the headwinds from slowing economies in America and Asia, recession in Europe, the unsolvable Euro crisis, and near complete political dysfunction in Washington. Drops in interest rates aren't likely to greatly affect their view toward business borrowing, investment or hiring. That's evident from the fact that businesses are choosing to hold billions of dollars in cash for essentially no return rather than invest or hire. If you're not deploying your own cash to invest or hire, why would you borrow even at a low interest rate to invest or hire?

But the impact of low interest rates on savers is significant. Let's hypothetically take a relatively frugal American who is approaching or in retirement, and in 2006 had $750,000 in a diversified portfolio. During the financial crisis of 2007-08, this portfolio, we'll assume, was pummeled down to $500,000. Many investors victimized in this fashion have fled equities and put their reduced savings into fixed income investments. For the sake of simplicity, let's assume the Fed's war on interest rates kept the yield curve 1% below where it might have been with a somewhat more balanced approach by the Fed. (Thus, at the low end, the Fed would today be targeting a fed funds rate of 1 to 1.25% instead of today's 0 to 0.25%.) The interest lost by our hypothetical saver would be $5,000 a year. Compounded over 4 years, the saver would have lost about $20,302 before taxes. While this amount after taxes wouldn't buy a yacht, and only a modest car, consumption would probably be noticeably boosted if millions of Americans had enough additional money to buy a modest car.

Given that the Fed has promised to keep interest rates ultra low until late 2014, the lost income will reach approximately $30,760 per hypothetical saver in a couple of years. And this amount could increase if the Fed extends that promise into 2015 (a serious possibility).

It's important to keep in mind that these income losses are permanent. There is no way savers can recoup these losses. The Fed won't boost interest rates extra high later on in order to bail out the frugal. So savers' consumption will be permanently reduced.

The Fed claims to be greatly concerned with consumer expectations and their general state of mind, believing that public confidence is crucial to restoring demand and prosperity. The message sent by the Fed's long and continuing war on interest rates is that things are bad and will be bad for a long time. Any rational consumer, particularly those that are frugal to begin with, will hunker down, dig the fox hole even deeper, cover it with a sturdy layer of thick logs, camouflage it with an abundance of branches and brush, and never even dare to peek out.

The situation in Japan is illuminating. The Japanese central bank has, since its own financial crisis in 1989-90, banished positive interest rates from the land (encouraging the so-called carry trade, where Japanese citizens deploy their savings or borrowed yen into investments in foreign currencies that offer positive returns; thus Japan's capital is productively used in other nations). Japanese consumers have gone from being luxury hounds to penny pinchers and bargain hunters. Japan has been stagnant for more than two decades, and its most recent economic statistics show that the stagnation has become a seemingly permanent and undesired house guest. America appears to be headed down the same path. Although the headlines generated by politicians and candidates for political office promise solutions, hard evidence to be optimistic remains scarce. Even the tech sector, America's economic sweetheart, has offered a lot of disappointment lately, with Facebook's stock losing almost half its IPO valuation and other familiar tech companies serving up results akin to the financial equivalent of Spam quiche. Will America become Japan? This is no longer the question. The question now is how will America stop being like Japan.

Did Someone Forget to Tell the Bond Market About Quantitative Easing?

The idea behind the Fed's quantitative easing program is the Fed will print money that will be used to buy long term Treasury bonds. Its purchases, to total as much as $600 billion by September 30, 2011, are supposed to push down interest rates, thereby stimulating the moribund economy with lower borrowing costs.

A problem, it would appear, is that someone forgot to tell the bond market. A month ago, the yield on the 30-year Treasury bond was about 3.75%. Today, it trades around 4.25%. The 10-year Treasury note was yielding around 2.4% a month ago. Today, it hovers in the range of 2.6%. Are the bond traders crazy? Received wisdom in the financial markets is never to fight the Fed. But the bond market seems to be determinedly paddling upstream.

Then again, what if bond traders have it right? What if quantitative easing will be inflationary? It increases the quantity of dollars in the financial system, which is a precondition to inflation. Additionally, it puts downward pressure on the dollar, which raises the price of imports. That will have an inflationary impact. Bond investors demand higher yields when confronted with the prospect of inflation. And higher interest rates dampen economic growth. So QE, before it's hardly out of the gate, has already made things worse.

The Fed, however, has a reply: raising expectations of inflation would be good, since that would stimulate consumer spending. Beleaguered consumers, desperately trying to save some of their stagnant or shrinking incomes as a buffer against hard times, will be strong armed into spending their money whether or not they like it. It's for their own good, and the Fed is destroying their financial security in order to save them.

So quantitative easing is a win-win for the Fed. If QE lowers long term interest rates, it stimulates the economy by lowering borrowing costs. If QE increases inflationary expectations, it coerces consumers into spending. With the U.S. economy 70% consumption, a revival of consumption means revival of the economy. Of course, this works only if the Fed can prevent inflation from spinning out of control. High inflation doesn't produce prosperity--the late 1970s, a time of double-digit inflation, were an American nightmare, not the American Dream. The Fed has to produce Goldilocks inflation: not too hot and not too cold. Chairman Bernanke insists the agency can do that.

We must be in Lake Wobegon, where all monetary policy is above average. Here, a pure money print, which is what QE amounts to, cannot produce a bad result. One would have thought that conjuring up money from thin air would be undesirable. At least, so it would appear to those of us who had always thought money was supposed to be earned from productive work.

When the Federal Reserve comes across like a late night TV ad for no money down real estate, we know we're in trouble. The enduring foundational principle of all economics is that there ain't no such thing as a free lunch. The Fed is coming close to transgressing this, the most fundamental of the laws of economics. Those who put themselves above the law set themselves up for a fall. Perhaps it is true that actual national wealth can be created by flushing printed money into the financial system and deftly removing it when inflation flares. Then again, desperate times are when hope is most likely to triumph over experience. When it does, experience can administer painful lessons.

If the Fed Lowers Interest Rates, It's Not About You

Much of the debate over how to deal with the ongoing credit crunch is whether or not the Fed should assist investors holding real estate-related investments with a cut in the fed funds rate. Free market purists believe that any hint of a bailout would be anathema. Investors, they contend, should be required to act like adults and suffer the consequences of their decisions. If they made a poor investment decision, they should incur the loss. This allows the market to function properly and allocate resources efficiently.

If the Fed bails out investors, moral hazard infiltrates the market and resources are misallocated by government subsidy. The purists note that government subsidies, once created, are never repealed. The misallocation of resources becomes a permanent distortion of the economy. Agricultural interests and homeowners in flood plains are prime examples of this phenomenon. While very little farm subsidy money is paid today to American Gothic-type family farmers, agricultural subsidies have become as permanent a part of America as the freedom of speech and religion. Houses that should never have been built have been constructed and reconstructed dangerously close to threatening waters.

The Fed is clearly intent on protecting the banking system, as is its legal mandate. Banks are at the heart of the financial markets. If the banking system doesn’t function properly, money—which today consists largely of credit, not green pieces of paper—stops flowing. In colonial America, if you had no money, you could swap a few beaver pelts and buckskins for bacon, flour, powder and lead. Today, however, money is the currency of the land. The Fed has been providing liquidity to the banking system in order to keep things steady. However, it has resisted lowering the fed funds rate, to avoid the specter of a government bailout of wealthy, but reckless, investors.

Recently, however, the government has reported a bad job growth number. Even though this datum is one bit of information in a sea of ambiguous information, numerous market participants, observers, and pontificators have seized upon it and cried out for a reduction of the fed funds rate. If monetary policy were dictated by majority vote of the punditocracy, a rate cut would be beyond doubt.

The Fed’s members, by all indications, have no appetite to bail out the Bentley-buying hedge fundies who, in spite of their name brand Bachelor degrees and MBAs, thought that real estate values would rise forever. But one must ask whether circumstances will force the Fed’s hand. What if the banks are among the investors who made foolish real-estate related investments and are now facing serious losses?

As we discussed in our earlier blog (http://blogger.uncleleosden.com/2007/09/conduits-and-sivs-chill-from-shadow.html), many large banks have set up affiliated entities not included on the banks’ financial statements, called conduits and SIVs (structured investment vehicles). They use these affiliates to borrow money in the commercial paper market and invest in mortgage backed securities and derivatives. This strategy of borrowing short term to invest long term carries significant risks, as the savings and loan associations found out in the 1980s. It seems especially reckless when one considers the inverted yield curve we’ve had during much of the past few years. To make this risky strategy work, a bank, through its conduit or SIV, would have to find medium or long term investments that provide returns exceeding its elevated short term cost of borrowing. It appears that some institutions climbed up the risk ladder to get higher yields from asset-backed investments. That would be a brilliant strategy as long as real estate values never stopped rising.

The conduits and SIVs were backed by standby lines of credit offered by banks, usually the ones that sponsored them. These lines of credit gave the conduits and SIVs the credibility to borrow in the commercial paper markets. But when commercial paper buyers got the asset-backed heebie jeebies, conduits and SIVs had to draw on their standby lines of credit to repay maturing commercial paper. As a consequence, the mortgages and other assets that the conduits and SIVs held were effectively added to the banks’ balance sheets. In other words, the banks held the risk of loss on these tamales after all. And, as the tamales got hotter, the banks’ losses grew.

There’s the rub for the Fed. The banks, as well as $1,000 a bottle champagne-drinking hedge fund managers, were making reckless investment decisions. They were doing so in conduits and SIVs that they kept off their financial statements, so the risks weren’t immediately obvious. But chickens, even though they strut and peck wherever they might, eventually come home to roost. And the losses for the conduits and SIVs are strutting towards the banking system. While the federal banking regulators might do well to investigate whether or not banks were inappropriately reckless, they also have to worry about the stability of the banking system.

The major banks appear to be well-capitalized. But no one knows the full extent of the credit crunch losses. Banks have direct exposure to conduits and SIVs to which they've loaned money. Enumerating the losses remains a challenge, as many of these assets have been accounted for by mathematical models, and the reliability of those models has been Yugo-like when confronted with the realities of a falling real estate market. (See our blog at http://blogger.uncleleosden.com/2007/08/how-computers-did-in-financial-markets.html). And what about the banks' indirect exposure? The credit crunch has pushed down all kinds of asset values. Financial institutions all over the world are sustaining losses in disparate markets. Every week, another bank somewhere needs a bailout. Last week, a U.K. bank called Northern Rock was bailed out by the Bank of England. The American banks surely want a fed funds rate cut, because it would likely improve the third quarter financial results they report in early October. And the Fed, which lives in fear of a run on the banking system, would be sorely tempted to help them in order to maintain confidence in the banking system.

The Fed meets on Tuesday, September 18, 2007. If it lowers interest rates, many will applaud. The applauders will be unable to resist the temptation to think that they had something to do with it. Hedge fund operators will believe that their lobbyists in Washington came through for them. Real estate interests will think that they were astute in manipulating financial journalists to take their point of view. Politicians will take credit in publications mailed to their constituents at taxpayer expense. Editorial page editors across the nation will think that the Fed heeded the outcry from the citizenry.

That the Fed might have been simply discharging its lawful mandate to protect the safety and soundness of the banking system may be lost amidst the surge of acclamation and credit-taking. All of the beneficiaries of a rate cut will think it was done for them, and will conclude that the Fed should always be there for them. Thus it is how government subsidies become a permanent part of our national landscape. The iron rice bowl proved untenable in Communist China. The laws of economics do not make it any more tenable in America. When, however, the iron rice bowl is provided to the wealthy and powerful, learning that lesson will be time-consuming and costly.

Crime News: a bathroom gets its 15 minutes of fame. http://www.wtop.com/?nid=456&sid=1249367.