Dr. Sherry Jarrell

Healthcare Summit: leadership or grandstanding?

Political leadership or grandstanding?

What has become very clear to me, after watching the U.S. Health Care Summit between Democrats and Republicans as objectively as possible, is that the President's goal was not to craft a thoughtful approach to shoring up and improving the U.S. health care system.

Pres. Obama making one of many points at Healthcare Summit

No, the reason for the President and the Democratic leadership to convene the so-called summit was to grandstand; to make a show; to create a photo opportunity; and, most importantly, to try to garner enough support from the Democrats in Congress to ram through the Reconciliation option on the behemoth, disastrous 2000-plus page version of the bill, filled with incomprehensible, internally conflicting doublespeak.

A sad day for American politics.  A very sad day for American citizens.  We deserve better.

Should you invest in U.S. bonds?

Could the U.S. government default on its bonds?

I’ve been asked many times over the years for advice on investing. “What is the market going to do?” “Should I be invested in stocks or bonds?” And, especially in the last few weeks, “Should I hold U.S. or foreign government bonds?”

A U.S. treasury bill

Those are some good questions!  The answers are not as "good."  The factors that drive the yields on treasury bills and bonds are complex and, despite Ben Bernanke’s pronouncements to the contrary, less well understood than stock returns, and I don’t have a crystal ball, but I can at least begin to frame an answer to these questions here.  I will come back to expand on this topic over time, as markets, economies, and world events evolve.

The return on both bonds and stocks is measured as the percent change between the market price today, and the cash flows received later.  The cash flows of a bond, namely coupon payments and principal, are specified in a contract; if they are not paid, the issuer is in default, and the bondholder has the right to take them to court.  The cash flows on stock, dividends and capital gains, are residual; they are discretionary, and are paid out only after debt payments and other obligations are paid.  For this reason, bonds are considered to be less risky than stocks, and the nominal yields on bonds are generally lower than those of stocks.   The risk-adjusted returns on stocks and bonds may be the same, but the nominal yields on bonds are typically lower.

There is an important distinction between the nature of the returns on bonds and stocks. With bonds, the future cash flows are known.  Movements in the bond’s yield are determined simultaneously with movements in the bond’s price. Once a bond is issued, only changes in interest rates (yield, risk) drive unexpected changes in its price.  Stock prices, on the other hand, fluctuate as either risk or residual cash flows change.  As a result, changes in a bond’s price, hypothetically at least, are a much cleaner indicator of the market’s expectations of future market rates of interest than a stock’s price.

One problem that distorts the information about expected future interest rates that is revealed by changes in the bond’s price is that bonds are less frequently traded than stocks, so the price data on bonds is less comprehensive and complete. In addition, the reported price data that form the basis of bond yield models often diverge from actual market-clearing prices, so that bond pricing models may not describe actual market behavior. Lastly, there is such a tremendous volume of economic and policy information, some of it conflicting, that is crammed into this one variable, the bond price which, given the coupon and principal, summarizes the market’s referendum on future interest rates.

Next time: Sources and types of risk in U.S. and other bond prices.

Does Fed Rate Influence Consumer/Business Interest Rate?

Does the Fed Funds Rate, the rate charged by the Federal Reserve to make short-term loans to banks, directly influence the interest rate consumers and businesses pay on credit cards, mortgages, and consumer and business loans?  If you took the word of the average business news commentator, you would think not.  But the answer, of course, is yes.   

One way to view the market rate of interest, although certainly not the only correct or useful way, is to think of it as a base rate that represents the risk-free rate, a rate that compensates the population for its impatience to consume the goods it would have consumed had it not lent the funds out in the first place. This risk-free rate is also influenced by the efficiency and functioning of the capital markets that bring borrowers and lenders together.

A risk premium is then added to this base rate of risk-free interest, one that varies depending on the degree of uncertainty of the lender getting repaid.  The risk of default, the risk of prepayment, the risk of political uprising, exchange rate risk, and many other sources of uncertainty -- including the risk of inflation -- raise the level of the risk premium commanded by lenders in the market.  As an example, over the last 100 years or so, the average annual risk-free rate in the U.S. has been about 4%, and the average annual risk premium for equity securities has been about 8%, bringing the average annual observed interest rate or rate of return to about 12% on these securities.

So what happens to the interest rate charged to consumers and businesses when the Fed raises the fed funds rate?  Basically, the level of the risk-free rate in the economy rises and, as debt contracts expire or new lending takes place, this higher base rate gets factored into the market rate of interest charged.  

Overall, the demand for loanable funds falls, the aggregate demand curve for the economy falls, and equilibrium output and employment fall, RELATIVE to where they would have been without the rate increase.  The bright side is that a reduction in the money supply that accompanies an increase in the fed funds rate is absolutely essential to curtailing inflation, which drives the risk premium, and represents a much greater cost to the economy.

Why Did the Fed Raise the Interest Rate?

What does it mean when the Fed raises the interest rate? It helps to first understand how the Fed raises the rate, which may surprise some people.  The Fed does not "set" the interest rate as it might, for example, by declaration or edict or by fixing prices.  No, it targets a higher interest rate by contracting the money supply until that money supply intersects the market demand for money at a higher market-clearing rate of interest.
 

How does the Fed reduce the money supply? Typically by conducting open market operations, which is the purchase or sale of government securities by the Fed.  To raise the money supply, it purchases new government securities, paying for them by creating--out of thin air--reserves for the commercial banking system. To reduce the money supply, it sells securities which shrinks the amount of deposits in circulation in the economy. In other words, it reduces the liquidity or amount of credit in the system.  This is equivalent to reducing aggregate demand for the goods and services in the economy. (Yes, you heard right; an increase in the money supply increases the aggregate demand for goods and services by businesses and consumers.)

Raising interest rates is a contractionary policy decision.  It is designed to slow down the economy, reducing output and employment, and raising the equilibrium prices of goods and services in the economy.  Why would the Fed choose to contract an already anemic economy?  To head off inflation, which has its own set of insidious costs and distortions that significantly hurt the economy.

The Fed has always had to tread a very fine line between increasing the money supply enough in the short run to minimize the depth and length of a recession, but not increasing the money supply so much that it creates inflation in the longer run.   Excessive money growth is what causes inflation.  And over the last two years, the U.S. has witnessed a record-shattering increase in the money supply as policymakers struggled to deal with an unprecedented financial crisis.

I have been saying for months that this behemoth money supply would inevitably lead to significant inflation unless steps were taken to shrink it.  I believe the Fed has now begun to take those steps.

Oh, the Irony: The Market Speaks, and Obama Has to Listen!

In a recent article, Moody’s announced that because of the U.S. federal government’s excessive spending and historic debt levels, it might have to reduce the Aaa rating of U.S bonds (http://thecitysquare.blogspot.com/2010/02/us-aaa-bond-rating-threatened-by-obama.html and http://risingpowers.foreignpolicyblogs.com/category/multipolarity/)
 

What this means in practical terms is that the cost of borrowing by the U.S. government will rise, which will increase spending via more borrowing or higher taxes or more money creation to pay for the higher interest costs.  Sound like a vicious cycle to you?  

Has anyone noticed the absolute irony of the world capital market having a seat at the table that assesses the viability of Obama’s policies? Obama has spent the last year denigrating free markets, and has laid the blame for the credit crisis squarely at the feet of those "greedy capitalists." Now he has to deal with a rating agency, which plays a pivotal role in the functioning of those very capital markets, evaluating the creditworthiness of the policies of the White House and its Budget Director, Peter Orszag.  

How wonderfully ironic! 

 

Every Economist, Mr. President? No, sir!

The President seems to believe that he can say whatever he wants and no one will hold him accountable. He now claims that "every economist, from both sides of the aisle, believes that the stimulus program created jobs." http://www.washingtonexaminer.com/opinion/blogs/beltway-confidential/Obama-says-every-economist-back-claim-stimulus-saved-or-created-two-million-jobs-83550017.html

I am an economist, Mr. President, and I know, based either on simple first principles of economics, or on a more rigorous controlled study of labor markets in each major sector of the economy, that the unemployment rate would have been much lower today had the stimulus program never occurred.  

You are either woefully unaware of the facts, Mr. President, or are purposefully distorting the facts. Neither is good.  When are you going to realize that just because you say something does not make it so. The world does not contort itself to support your version of the truth.

Do not put words in my mouth, sir.