interest rates and economic growth

Over the past few days, I’ve written about two approaches to the question of the appropriate level for interest rates.

fixed income as an investment on its own

The first considers fixed income as an investment, with no reference to current economic conditions or to use of rates as a government policy tool.  According to it, holders of short-term fixed income instruments receive protection against inflation + a small real return; holders of long-term instruments receive inflation + a real return of 3% or so + an extra return if the instrument carries higher risk.

rates and economic policy

The second looks at short-term interest rates as a tool of economic that aims at steering growth along the preferred path of a given nation’s government.  The monetary authority slows the economy down and speeds it up by raising/lowering rates as circumstances dictate.  In the US, the recent preferred metric for judging success has been the employment figures.

quantity of money

There is a third, admittedly subjective, approach to this topic, one that many professional investors have traditionally used to gauge the tone of financial markets.  The idea is that the economy requires a certain amount of liquidity (i.e., money) in order to operate efficiently.  This is to maintain inventories, pay salaries and fund new investments.   It operates best when it has precisely that amount.

In a period like the current one of continuous radical supply chain and financial innovation, it may be hard to judge when too little money is available, and therefore activity is constrained and rates are too high.

On the other hand, adherents to this idea think that when money is too abundant, the excess inevitably finds its way into economically destructive financial speculation.  The signs that rates are too low are easier to spot:  soaring housing prices, bubble-level stock PEs and high-risk, nevertheless covenantless, junk bonds.

recent financial market worries

This third idea is the basis for the recent conversation in financial markets that ultra-low interest rates have passed their best-by date and are now doing more harm than good.  The strongest evidence that this is the case is in the junk bond market, I think.  However,  if there’s speculation in one corner of the financial markets, it must also be at work in the others.

issues with the traditional business cycle picture

As I mentioned yesterday, one BIG problem with the traditional business cycle model (the one taught in business schools) is that although it explains what happens abroad, it no longer fits with behavior in the US economy–which is, after all, the biggest in the world (for believers in purchasing power parity, the second-biggest   …after China).

The model says that lower interest rates energize business capital spending, which produces new hiring, which leads to higher consumer activity as new employees spend their paychecks.

Makes sense.

the US experience

In the US, however, consumer spending recovers first.  Typically, soon after the Fed begins to lower interest rates, US consumers have been back in the malls, spending up a storm.  Rather than industry lifting the consumer, the consumer pulls industry out of its slump.

How so?

Economists theorize that what’s at work in the US is the “wealth effect.”  Two aspects:

–maybe lower rates are like Pavlov’s dinner bell ringing and consumers begin to salivate in advance of recovery  (my personal take on this is idea that the office/plant grapevine signals that the worst is over, that layoffs have stopped and new hiring will soon begin)

–lower rates = house prices start to rise, as do bonds and stocks.  So consumers feel wealthier as rates fall, because their accumulated assets (their wealth) are worth more.

The problem here is that we’ve had zero rates for eight years without seeing the traditional recession-ending spending surge

where’s the capital spending?

Whether capital spending is the locomotive or the caboose, it’s still arguably an integral part of the economic recovery train.  Why haven’t we seen a capital spending surge in the US?  Is the lack of capital spending an indication of continuing weakness in the US economy, as the traditional business cycle theory would suggest?

I think four factors are involved here, the sum of which suggests reality has sped far ahead of theory:

–the internet.   Typically, there’d be a surge in construction of shopping malls as recovery gains speed.  But as online commerce has developed, we’re finding that we already have maybe 20% too much bricks-and-mortar retail space

–globalization.  Continuing industrialization in emerging economies like China during the last decade has decisively shifted lots of low-end US-based manufacturing abroad.  In addition, I’m also willing to entertain the thought that crazy spending in China has produced an enduring glut of manufacturing capacity there, although I have no hard evidence

–software.  For many (most?) US companies, the largest target for new investment spending is not bigger, newer plants but faster, more efficient software. The National Accounts, the government system of tallying economic progress, have no effective way of recording this expenditure for analysis.  The traditional business cycle picture is similarly stuck in the world of fifty (or a hundred) years ago

–skilled vs. manual labor.   This is a thorny issue, and one I have strong opinions about.  Here, I think it’s enough to say that the traditional model doesn’t distinguish between a twenty-year old with a grade school education and a strong back vs. a college dropout like Mark Zuckerberg.  A generation ago, the distinction wasn’t important.  today, it’s crucial.




interest rates, inflation and economic growth

A reader asked me to write about this.  I think it’s an interesting topic, since traditional relationships appear to be be breaking down.

interest rates

Let’s just focus on government debt, since other debt markets tend to key off what happens here.


At the end of the term of a loan, lenders expect the safe return of their principal plus compensation for having made it.  In the case of all but gigantic mutual fund/ETF lenders, participants in government bonds also enjoy a highly liquid secondary market where they can sell their holdings.

The compensation a lender receives is normally broken out into:  protection against inflation + a possible real return.

In the case of T-bills, that is, loans to the government lasting one year or less, the total return in normal times would be: protection against inflation + an annual real return of, say, 0.5%.  In a world where inflation was at the Fed target of 2%, that would mean one-year T-bills would be sold at par and yield 2.5%.

In the case of a 10-year T-bond, the annual return would be inflation + a real return of around 3% per year, the latter as compensation for the lender tying up his money for ten years.  In a normal world, that would be 2% + 3% = a 5% annual interest rate for a bond sold at par.

Compare those figures with today’s one-year T-bill yield of 0.6% and 1.62% for the ten-year and we can see we’re not in anything near normal times.  We haven’t been for almost a decade.

How did this happen?

Fed policy

The highest-level economic objective of the government in Washington is to achieve maximum sustainable long-term economic growth for the country. Policymakers think that growth rate is about 2.0% real per annum.  Assuming inflation at 2.0%, this would imply nominal growth at 4.0% yearly.

expanding too fast

In theory, if the economy is running at a nominal rate much faster than 4% for an extended period, companies will reach a point where they’re ramping up operations even when there are no more unemployed workers.  So they’ll staff up by poaching workers from each other by offering higher wages.  But since there are no net new workers, all that will happen is that wages–and selling prices–will go up a lot.  They’re be no greater amount of output, only an acceleration in inflation.  This last happened in the US in the late 1970s.

Before things get to this state, the Federal government will act–either by lowering spending, raising taxes or raising interest rates–to slow the economy back down to the 2% real growth level.  Typically, the economy ends up contracting mildly while this is going on.

Given long-standing dysfunction in Congress, the first two of these remedies are long since off the table.  This leaves money policy–raising interest rates–as the only weapon in the government arsenal.

growing too slowly/external shock

If the economy slows too much or if it suffers a sharp out-of-the-blue economic shock, the possible government remedies are: lower taxes, increase spending, reduce interest rates.  Washington has elected to do neither of the first two in response to the financial collapse in 2008-09, leaving monetary policy to do all the work of helping the country recover.

Fed policy in cases like this is to reduce the cost of debt to below the rate of inflation.  That hurts lenders (the wealthy, pension funds, retirees) severely, since they are no longer able to earn a real return or even preserve the purchasing power of their money through buyng government securities.

On the other hand, this is like Christmas come early for borrowers.  In theory, they now have many more viable projects they can launch.  They’ll not only be making money on the merits of their new products/services; inflation will also be eroding the real value of the loans they will eventually have to pay back.


More on Monday.



index fund gains in the US

According to a survey reported in the Financial Times and done at the newspaper’s request by Morningstar, assets in US index mutual funds now comprise a third of total domestic mutual fund assets.  That’s up from 25% this time three years ago.

Nevertheless, actively managed assets under management have risen by 14%, despite the market share shift.  So the fees being collected by active managers are up.  This is doubtless due mostly to the fact that markets have been rising.  The S&P 500 is up by about a third over the three-year span, the Bloomberg Treasury index by 12%.  Watch out, though, if markets flatten or begin to decline.


More bad news:  the FT is reporting that 90.2% of US active equity managers underperformed their benchmark, after deducting fees, over the twelve months ending June.  Not numbers that will stem outflows.


Since I’m getting such an unbelievably late start today, I’ll only make two points:

–in the investment organizations I’m aware of, management control is in the hands of professional marketers, not professional investors.  I think their giving a much higher priority to selling rather than making products is a substantial part of the underperformance problem for these firms.  It’s highly unlikely, I think, that marketers will volunteer to step down and turn the reins over to makers.  So I expect underperformance issues will continue.  If I’m correct, the next bear market could prove crushing for these organizations, since the combination of falling prices and client withdrawals will doubtless mean sharp declines in profits.  Where will the money come from to beef up research and portfolio management operations then?

–some large investment management firms known for active management are reported to be finally entering the index fund market themselves.  First of all, this seems to me to show the marketing bent of their managements, giving support to my first point.

In addition, index funds have very large economy of scale effects and the oldest/largest have been in existence for decades.  Because of this, I can’t imagine that Johnny-come-lately firms will ever have profitable index offerings.  The firms may subsidize their index funds  so that the fees for you and me will be on a par with bigger rivals’, but I don’t see how the subsidies can ever be taken away.  Yes, such firms may retain assets, but their bottom lines will be worse off than if they retained them.

the September 7th Job Openings and Labor Turnover Survey (JOLTS) report

The Bureau of Labor Statistics of the Labor Department released its latest JOLTS report on Wednesday.

The main results:

–nationwide job openings are now at 5.9 million, the highest figure in the 16 year history of the report.  This is substantially above the 4.5 million level of 2006-07.

–the rate of new hires has been flat for about two years at just over 5 million monthly.  While this is 5% – 10% below the rate of 2006-07, the very high number of job openings would have been consistent with an unemployment rate of 3% ten years ago.  This seems to me to be a point in favor of the idea that the main impediment to filling jobs is finding workers with needed skills.

–3 million workers are voluntarily leaving their jobs monthly.  This is a sign they’re confident of finding employment again without much difficulty.  That’s back to the pre-recession levels of 2006, and almost double the recession lows.

All of this argues that the US is at or near full employment.  On the other hand, however, there’s little sign of the upward pressure on wages that this situation would have produced in the past.


Whatever the reason for slow-rising wages, it seems to me there’s no reason in the employment figures for the Fed to maintain anything near the current emergency-room-low level of short-term interest rates.



Henkel and Sanofi bond issues

Henkel and Sanofi, two European industrials, just completed successful multi-billion euro bond offerings.  Both are reported to have attracted wide interest.

What’s striking to me is that parts of both issues carry negative yields.


The Sanofi website has yet to be updated, but the Henkel issue looks like this:

–€500 million in two-year bonds with an annual coupon of 0.0% and a yield to maturity of -0.05% (meaning that the bond was issued slightly above par)

–€700 million in five-year bonds with a coupon of 0.0% and a yield to maturity of 0.0%

–$750 million in three-year Euromarket (meaning issued outside the US) bonds with a coupon of 1.5%, and

–£300 million in six-year bonds with a coupon of 0.875%.

How can these new issue yields be so low?  

Three reasons:

–for each category, bonds in the secondary market are already trading at these levels,

–global bond investors believe that market yields will become more negative from where they are today, generating capital gains–small ones, in all likelihood, but gains nonetheless–for today’s buyers,

–bond managers don’t really believe yields will get more negative but know that if they are holding cash they’ll be left behind in the dust by competitors who are buying issues like these.  So they hold their noses and participate.

My guess is that there’s a liberal dose of #3 in managers’ thinking.

my thoughts

First is me reminding myself that what I really know about is stocks, not bonds.

The yields for €, £ and $ tranches are all roughly in line with their respective sovereign 10-year bond yields, taking Germany as the € exemplar, yielding -0.09% (Greek ten-year eurobonds yield +8.5%, by the way).

To the degree that these are rational economic commitments, and not just driven by the fear of missing out, buyers must believe that euroland rates will remain low for an extended period of time

They think there’ll be continuing mild weakness in sterling vs. the euro.

They believe that US rate rises over the next couple of years may be significant, given that the pickup over 3-year treasuries is 60 basis points.   The same is true for sterling bonds, but I’m attributing some of that to currency fears.





politics and the Federal Reserve

In my post last Friday on the Labor Department’s most recent Employment Situation report, I commented that I thought it unlikely that the Fed would raise short-term interest rates before the election in November.  How so?   …because the Fed worries about accusations that it would be intruding into the electoral process.

A reader commented that he thought such worries would be silly, either on my part or the Fed’s or both.  I thought I’d respond here.

I agree that it makes little difference for the economy whether the Fed Funds rate is at 0.25% or 0.50%.  In fact, one could easily make the argument that extreme money stimulus is no longer needed and that the US would be better off with higher rates rather than lower.


A generation ago, when controlling nominal short-term interest rates was the Fed’s sole policy tool, it was the norm for the sitting President to pressure the Fed in an election year to lower rates, or refrain from raising rates, in order to keep his party in power.  It was also normal for the Fed to acquiesce.  Monetary policy lore says that Gerald Ford was the first president not to do so–and he lost his reelection race.  This behavior also gave rise to the belief that an election year would usually be an up year for stocks, followed by difficulties during the first year of the next term, as the new president removed the extra stimulus.


The appointment of Paul Volcker as Chairman of the Fed with a mandate to get the runaway inflation of the late Seventies under control changed this situation, making the Fed the de facto government mechanism for implementing economically necessary but politically toxic decisions to slow the pace of growth.


Seeking not to return to its role as a tool of one political party or another, the Fed seems to outsiders to have developed a rule that it will not act within, say, four or five months prior to a presidential election, to either raise or lower rates.  One might otherwise argue that it is giving an economic boost to–or at least signalling its approval of–the sitting president by lowering rates.  It would signal disapproval by raising them.


However, as Alan Kaplan points out, the Fed is political.  One could easily maintain that the Fed has enabled the continuing failure of Congress to enact sensible fiscal measures to support economic growth.  (The other side of the argument would likely be that although members of Congress may have cultural agendas, the ones who show up at briefings by the Fed are shockingly ignorant about basic economics.  So they have no idea of how to craft prudent fiscal stimulus.)

One other issue.  The emergency-low interest rate policy we’ve had in place for eight years places the interests of borrowers ahead of those of savers.  Another political decision.  A generation or two ago the latter would have been the ultra-wealthy.  In today’s world, savers are Baby Boomer retirees, whose ability to establish a secure stream of interest income to support their lifestyles has been diminished by government policy.