Dr. Sherry Jarrell

Fed's Pledge of Low Rates -- Good News or Bad?

The Federal Reserve pledged on August 9th to maintain near-zero interest rates through the summer of 2013.   This was an unprecedented move by policymakers and one has to wonder what they were trying to accomplish by committing themselves now to a specific policy for the next two years.

The federal government really has only two tools for influencing the macroeconomy -- fiscal policy and monetary policy.  By committing themselves now to a specific interest rate target, they have essentially neutralized one of those two tools.   

I see the announcement as an admission on the part of the Fed that they are unable to further stimulate the economy by lowering interest rate targets.  The rates are already as low as they can go; there is no room left for trying to stimulate the economy with actions.  All they have left is talk; tell the market that they are going to keep the rates low.  It's a fairly impotent policy, not just because it's just talk, but because the pledge is vacuuous:  if conditions change, I certainly hope and expect that the actual policy will change as well.

And we have to recall what a low interest rate policy actually means:  the Fed will have to increase the money supply at whatever rate is required to satisfy money demand -- which is beyond their control -- at the target interest rate.   The Fed is clearly banking on (no pun intended!) money demand remaining anemic, otherwise the very increase in money supply which is intended to keep interest rates low would push nominal interest rates up due to inflationary pressures.   

From where I stand, the Fed's handcuffing itself to near-zero interest rates over the next two years smacks of both desperation and gloom.   They are desperate to wield monetary policy, to "do something," even when rates are already as low as they can go.  And for the Fed to commit to near-zero rates over the longer term says very clearly that they do not expect the economy to recover for some time.

S&P Ratings - They either mean something or they don't

You cannot have it both ways. Either the bond credit ratings mean something, or they don't.  Public officials cannot point to the AAA ratings as evidence of good policy, then lambast them as "inaccurate" and "flawed" when they drop to AA+....or below.  

It is a fact that the ratings agency does not originate information; it simply gathers and interprets data that are publicly available to all of us.   The rating itself, however, is unique in that it summarizes a particular agency's forecast of how likely the US government is to repay its debt and sustain its borrowing needs.  

Don't get me wrong -- there is a LOT of information out there about the risk-adjusted rate of return on US debt to be digested.  But we don't have to re-examine it from the ground up -- we need only look at the marginal changes, the most recent developments, the direction of change, to update our expectations, and -- in my view -- to understand easily why S&P downgraded the debt.  

I think most of us realize that all government spending is financed by the private economy but I'm not as sure that everyone realizes that the return on government debt is also enabled by the productivity of the private economy.   The more productive the private economy, the higher rate of real return we can afford to pay on U.S. debt, and the more willing others are to buy our debt.  Being able to generate a return on debt is a good thing -- it's a sign of a healthy economy.   

Then there is the other side of the equation: the required return on debt from the point of view of the lender. The lender assesses the risk (or likelihood or uncertainty) that they will get their money back (and that the "money" is worth the same per dollar....so we are ignoring inflation just to simplify things).   The less certain they are, the higher the return they are going to demand before they buy the debt.  This required rate of return is a cost to the economy -- a higher cost eats away at profits, and makes the economy less productive, less able to reinvest, employ capital and labor, and grow.  

In the simplest terms, government spending is supported first by taxes and then, when those run out, by borrowing.  The debt ceiling debate made it clear that Washington was unwilling or unable to reduce or curtail government spending, which was on its way to starving the private economy of the sufficient earnings, liquidity and financing to continue to be productive.  The wealth creation capacity of the private economy is vast and impressive and has somehow miraculously employed labor and capital and supported AAA rating returns on government debt for a very long time, but it's not limitless.  

No, the ratings do not originate information. They simply publicly confirmed what many of us who understand and respect what private enterprise does day in and day out saw coming:  the current level of government spending is unsustainable. The private economy cannot take much more of the oppression and costs imposed by government policy, taxes, fees, regulations and -- perhaps the most troubling and insidous of all -- the public denigration and disparagement of the private economy, Wall Street and capitalism by our President.

 

It will be very interesting to see if this was a surprise to the markets.