The popular Wall Street and investor mindset was laid out in The Wall Street Journal Friday (Aug. 12) article, “Market’s Inflation Story Fights Fed.” (Underlining is mine)
“The peak inflation story that propelled investors back into risky assets this summer got a big boost from Wednesday’s figures showing prices [inflation] fell slightly last month.
“Unfortunately, there’s no sign the Federal Reserve will change its mind and agree with investors that rates should come down again next year.“
“Unfortunately” and “agree with investors” reveal the mindset. It’s the consequence of a prolonged environment of abnormality that has become a comfortable companion. Thus, any change is viewed with nervous skepticism – an uncertainty tainted with fear of the unknown.
Yes. The proof can be found by looking back to October 2009. The stock market was well above its March 2009 Great-Recession-bottom, having anticipated the economic rebound that was then emerging. Regardless, Ben Bernanke was stuck on his 2008-initiated, highly abnormal 0% yield policy.
That policy was determined solely by the few members of the Federal Reserve Open Market Committee. They had usurped the interest rate-setting role from the capital markets, believing they could engineer better results than the normal market process based on capital demand and supply.
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The abnormality is that the “demanders” (users of capital) were thrilled at the bargain pricing. As President Trump once said about infrastructure financing (I’m paraphrasing), “It’s a no-brainer decision because the funding is free.”
The problems began quickly. Instead of borrowing for wise capital investment, excess production was created, leading to supply gluts and, consequently, abnormal price drops. Remember the worries about deflation?
Then came the Great Disappointment. Instead of a boost in economic and employment growth, there was heavy borrowing for dividend payments, share repurchases and simply cash reserve enlargements. As a result, earnings-per-share and stock prices rose nicely, making stock investors and Wall Street happy with the Fed’s actions.
Ignored during those happy days were the ill-rewarded suppliers of capital. In normal times the lowest rate for short-term, riskless securities (think 3-month U.S. Treasury Bills) was the inflation rate. That meant at least a real (inflation-adjusted) interest rate of 0%. During the years on the Fed’s 0% nominal (not-inflation-adjusted) interest rate, those suppliers of capital received a real rate that was negative – generally about -1.5% to -2%. Compound the actual rates over the first ten years, and all those $trillions of short-term holdings lost about 20% of their purchasing power. How’s that for an inflation hit? Now think about what they’re losing currently… Despite the Fed’s rate-raising (the 3-month U.S. T-Bill is now up to 2.6%), inflation has risen faster, making the negative real return larger. Without the Fed’s control, the minimum 3-month US T-Bill rate would likely be 5% to 6%.
The following graph shows the 60+-year relationship between the 3-month U.S. Treasury Bill Yield and the trailing 12-month inflation rate (the CPI less food and energy). Note Alan Greenspan’s two experiments with long, post-recession 0% real (inflation-adjusted) interest rates. He followed those with a slow rise back to capital market-determined rates. The lengthy Bernanke-initiated nominal 0% interest rate period has yet to return to normal.
Why don’t we read about these problems?
On the cover of the October 19, 2009 issue, Barron’s announced its lead story in large, bold print: “C’mon, Ben. Give Them A Break.” The “them” meant all the savers, investors, organizations, companies, funds and state/local governments that were required to hold or desired to hold short-term and/or safe financial instruments. (Underlining is mine)
“IT’S TIME FOR THE FEDERAL RESERVE TO STOP talking about an ‘exit’ strategy and to start implementing one.
“There’s no need for short-term rates to remain near zero now that the economy is recovering. The call to action is clear: Gold, oil and other commodities are rising, the dollar is falling and the stock market is surging. The move in the Dow Jones industrial average above 10,000 last week underscores the renewed health of the markets. Super-low short rates are fueling financial speculation, angering our economic partners and foreign creditors, and potentially stoking inflation.
“The Fed doesn’t seem to be distinguishing between normal accommodative monetary policy and crisis accommodative policy. There’s a huge difference.
“With the crisis clearly past, the Fed ought to boost short-term rates to a more normal 2% — still low by historical standards — to send a signal to the markets that the U.S. is serious about supporting its beleaguered currency and that the worst is over for the global economy. Years of low short rates helped create the housing bubble, and the Fed risks fostering another financial bubble with its current policies.
Then, there is this accurate description of the harm done, about which the Fed has been consistently silent:
“It’s also time for the Fed to consider the plight of the country’s savers, who now are getting less than 1% yields on money market funds and who are being forced to take substantial interest-rate or credit risk if they want higher yields. “The Fed is punishing prudent people and rewarding profligate people,” one veteran investor tells Barron’s. Many unemployed and underemployed Americans may be deserving of some mortgage relief, but there also are millions of Americans — most of them elderly — who diligently saved and now have little income to show for a lifetime of effort.”
Lastly, a reminder of what the beneficiaries of low rates were up to…
“Speculators, meanwhile, have been borrowing in dollars to buy a range of financial assets because of near-zero borrowing costs and the prospect of repaying those loans with a depreciated currency.”
The bottom line: We have been in a historic era that will have repercussions in the years ahead
Those 13-year-old issues described by Barron’s are neither passé nor irrelevant. As has happened following all previous economic and financial periods, comprehensive explanations and analyses will appear when this Ben Bernanke experiment ends – that is, when capital markets regain control. The comparisons and contrasts will highlight the abnormal effects, disparities and inequalities created since 2008.
Hopefully, that day will come soon because a continuation of abnormally low interest rates carries high risk now that the inflation lamp is lit.