Once again this morning President Trump berated the Federal Reserve via Twitter. This time he is calling for the Fed to immediately cut interest rates to zero in order to 1) offset the effects of the monetary stimulus being pursued by other central banks, and 2) allow the federal government to refinance its outstanding debt at lower rates. The president has been very clear in his belief that our relatively high interest rates are causing a number of negative side effects, which include slower economic growth, low inflation and the reduced competitiveness that comes with a stronger dollar. But now he has added another element to his argument. He appears to believe that if the Fed cuts rates to zero the US Treasury could then refinance its debt, saving many billions in interest costs. Is he right?
First a little background. The Federal Reserve has just two statutory mandates. The first is to maximize employment, and the second is to maintain price stability. With regard to employment, it’s hard to conclude that the Fed’s mandate has not been achieved. The unemployment rate is at 3.7%, wages are rising at over 3%, and labor shortages are even being reported for certain types of workers. Moreover, access to cheap capital has not been a big factor holding back corporate investment. Capital has been cheap and abundant for many years, and therefore another reduction in the cost of capital is unlikely to unleash a big increase in corporate investment. In my estimation, the relatively sluggish rates of corporate investment in recent years have been the result of weak and uneven demand as well as policy uncertainty. Until and unless those issues are rectified, we are unlikely to see better rates of corporate investment (and the large-scale hiring that goes with it).
As its second mandate, the Fed also seeks to maintain price stability. The central bank has told us that its definition of price stability is an inflation rate of 2%. Unfortunately for the Fed, its track record on this mandate is not as good. The economy has been running at inflation rates of less than 2% for almost the entirety of the 10-year economic expansion. This begs the question, why do we need any inflation at all? Wouldn’t it be more advantageous for the economy if prices never rose? Well, there are a couple major reasons why the Fed targets an inflation rate of 2% rather than simply shooting for no price increases.
The first reason is that an environment of steadily rising prices incentivizes consumers and businesses to spend and invest now rather than deferring those actions. Consumer spending and private investment typically make up about 85% of US GDP, so these two categories are of critical importance. If inflation expectations begin to fall, we run the risk of a deflationary spiral, which occurs when consumers and businesses defer consumption and investment because they know they can consume/invest at ever cheaper prices in the future.
The second reason that some inflation is desirable is that it makes it easier for borrowers to service their debt. Let’s say you purchased a house at the high end of your affordability range using a 30-year, fixed-rate mortgage at 4%. If the economy is running at a 2% inflation rate, you are more likely to receive annual pay raises. These pay raises make it easier for you to stay current on the principal and interest payments, freeing up money to be spent elsewhere. The same goes for fixed-rate debt at the corporate and government levels. Some inflation should cause corporate and tax revenue to rise faster than in an environment of no inflation, allowing these entities to flourish while keeping their bond investors happy.
So why hasn’t the Fed cut the Fed Funds rate to zero so that inflation rises to 2% or more? If moderate inflation is so much more desirable than no inflation or deflation, why not just be bold and stoke the fire in earnest? Well, I can think of several reasons why cutting interest rates to zero would be a bad idea:
- Those living off fixed incomes, including a very powerful voting bloc of retirees, would find it much harder to make ends meet if they are unable to earn a return on their money without taking excessive risk;
- If rates are cut to zero, the Fed will have very little ammunition if and when the economy falls into recession;
- If rates are cut to zero in the US, there would be large-scale capital flight and businesses could find it harder to fund their operations.
- And finally, the banking system would be severely handicapped as banks become unable to earn an acceptable spread on loans. If loans become unprofitable, then the supply of credit will dry up and cause great harm to the economy at large. Europe is learning this lesson the hard way right now.
President Trump is now introducing a new element to his argument for lower interest rates. Rather than advocating for lower interest rates (to my knowledge, he hasn’t targeted 0% rates until today) simply to boost economic growth, he is now saying that sharply lower interest rates would allow the federal government to refinance its over $16 trillion in debt held by the public. Doing so, he says, would save the US Treasury many billions in interest costs.
The problem with this argument is that federal government debt is not like a residential mortgage whereby the borrower can simply pay off the outstanding balance without penalty. Rather, the lion’s share of outstanding US Treasury debt is non-callable, carries fixed interest rates and trades on the deepest, most liquid and transparent market in the world. Refinancing the entire US Debt is not practicable for a huge host of reasons. Issuing new debt at low rates is less expensive, but it is already happening as old bonds mature and new ones replace them. Before he was elected, the President advocated the issuance of 50 year and 100 year bonds. We haven’t heard much about this lately, but it sure strikes me as a very good thing to do.
Economist Mohamed El-Erian wrote and excellent article this week (A Shrinking Corner) discussing the bind in which the Federal Reserve and Central Bankers find themselves: rates are already so low, will there be any significant effect if they are taken lower still? Corporate America has been benefiting from very low interest rates for years and had been taking advantage of relatively inexpensive borrowing. In recent years the borrowing hasn’t led to additional hiring or investment in plants and equipment; it was largely used for stock buy backs. As they were provided greater liquidity from the tax cuts, they continued the buyback cycle. It is puzzling why one would think that additional cash via lower rates would stimulate anything other than more buybacks. El-Erian suggests that the bang for lower rates is fizzling and that fiscal policies need to be better coordinated in order for stimulus to maintain its effect. El-Erian writes, “Absent a significant fiscal commitment from governments and other policy makers, the central banks’ dilemma will only become more acute.”
Please remember that this isn’t a political or policy critique, but a factual description of the mechanisms of the bond markets.
We are relatively confident that all this Fed badgering will lead to nothing. The Federal Reserve understands all these issues and will continue to act with independence in its stewardship of the US economy. As long as that is the case, these tweets are a great example of background noise that the average investor should simply drown out. Ear plugs in. Eschew the thin branches of risk.