The Fed and interest rates

[JimBowerman]

 

No, it's important thought experiments! If they bought $100T the USD would tank and vice versa. You can't view rates in isolation.

 

Agree that the Dollar would tank. But its my contention that LT nominal rates would clearly go through the roof if they printed that much money. 

 

The bigger point is that a central bank can (almost) always get any sort of nominal interest rate and nominal GDP growth rate that it chooses. 

 

Its a bit worrying that the Fed, etc don't realize its own power and instead blame the low nominal growth and low nominal interest rates since 2009 on other factors like demographics, etc. These have some affect, but the Fed can always overwhelm these factors.

 

As a final thought experiment, if the Fed truly cannot do anything about low long term rates, why do we bother to collect taxes at all?  why not just finance all government expenditures through money printing?  Of course, in reality, at some point, printing money will cause inflation and raise long term rates.  We just haven't done enough money printing since 2009 (and the money we have printed, has not been very permanent as we are now seeing with QT).  The bond market was right in being skeptical of the Fed's willingness to print enough permanent money.

[Guest Schwab711]

 

No, it's important thought experiments! If they bought $100T the USD would tank and vice versa. You can't view rates in isolation.

 

Agree that the Dollar would tank. But its my contention that LT nominal rates would clearly go through the roof if they printed that much money. 

 

The bigger point is that a central bank can (almost) always get any sort of nominal interest rate and nominal GDP growth rate that it chooses. 

 

Its a bit worrying that the Fed, etc don't realize its own power and instead blame the low nominal growth and low nominal interest rates since 2009 on other factors like demographics, etc. These have some affect, but the Fed can always overwhelm these factors.

 

It's a fair point on the first. I should also note (which I think you assumed), that I can't know the truth any better than you (or the Fed). There's a ton of factors that set FX/rates which can't be studied with any precision. I should correct my prior post that the Fed not having any effect on LT rates is almost certainly wrong. Surely there is some effect. I suppose my argument is on the idea that it's not very meaningful after liquidity and such. I don't have any great math to back this up. I'm just not convinced a single participant can alter a market in the long-run. Maybe it can, but knock-on effects will render the effort worthless. Small quibble if this is our big disagreement.

 

As to inflation, I never had much of a thought back in the day so this is 20:20 hindsight, but I think the money never ended up in the hands of consumers was the predominate factor for low CPI (which may be a big 'duh' since RE and some other assets are valued generously right now). Agreed that somehow the bond market in aggregate figured out the effects of the program. Kind of fascinating to think through the ways it all could have gone.

 

As a final thought experiment, if the Fed truly cannot do anything about low long term rates, why do we bother to collect taxes at all?  why not just finance all government expenditures through money printing?  Of course, in reality, at some point, printing money will cause inflation and raise long term rates.

 

Yes. At some point in these experiments there has to be an assumption there's a state/revenue generation ability behind the rates/FX, which is probably very important to note in the context of this thread. No matter how many or few schwab711 dollars I print and no matter how strong my guarantee of 'full faith and credit of schwab711' is, I'm guessing you won't hand over a single USD for them :) Taxes is patient zero in the value of the USD since you must pay them with USD.

[SHDL]

Some thoughts:

 

1

 

Why is the Fed not making an effort to keep the yield curve from inverting? 

 

I think that is because they don’t really care. 

 

Now it is certainly true that inverted yield curves have historically tended to predict upcoming recessions and that the Fed wants to avoid recessions.  But there is no sense, as far as I can tell, in which an inverted yield curve caused any of those recessions.  (As they say, correlation does not imply causation!)  I therefore find it hard to believe that the Fed would do anything just for the sake of keeping the yield curve nice and steep. 

 

(If anyone has a convincing theory as to why inverted yield curves are bad for the real economy, I’m all ears.)

 

2

 

The Fed continues to get a lot of scolding in certain circles for waiting so long to raise rates.  That is understandable. 

 

So why did the Fed do what it did?  A short answer is: they wanted to avoid repeating Japan’s experience since the 1990s-.  (I don’t have time to write about it here but you can look it up, it’s very interesting.)  Given what I know about this, I am squarely in the camp that thinks the Fed has done an excellent job post crisis. 

 

[Cigarbutt]

Some thoughts:

1

Why is the Fed not making an effort to keep the yield curve from inverting? 

I think that is because they don’t really care. 

Now it is certainly true that inverted yield curves have historically tended to predict upcoming recessions and that the Fed wants to avoid recessions.  But there is no sense, as far as I can tell, in which an inverted yield curve caused any of those recessions.  (As they say, correlation does not imply causation!)  I therefore find it hard to believe that the Fed would do anything just for the sake of keeping the yield curve nice and steep. 

(If anyone has a convincing theory as to why inverted yield curves are bad for the real economy, I’m all ears.)

2

The Fed continues to get a lot of scolding in certain circles for waiting so long to raise rates.  That is understandable. 

So why did the Fed do what it did?  A short answer is: they wanted to avoid repeating Japan’s experience since the 1990s-.  (I don’t have time to write about it here but you can look it up, it’s very interesting.)  Given what I know about this, I am squarely in the camp that thinks the Fed has done an excellent job post crisis.

On curve inversion and a job well done.

 

I’ve been critical and will continue to be, concerning various distortions and unintended consequences introduced in the market by the Federal Reserve and think that the interest rate “conundrum” has not been resolved. However, if animal spirits do lift growth and interest rates going forward in sustainable manner, such as suggested by the Fairfax team for instance, I take the pledge to openly recognize that I’m wrong. If that’s the case, I will also dissociate from the morbid fascination about what happened in Japan.

 

First, some would say that flattening or inverted curves don’t matter and there was some interesting work that came out in 2006 suggesting that curve inversion no longer really mattered and, using Fisherian and Wicksellian concepts, that the curve was not inverted even if it was!? At this point, if long term rates don’t increase, the inverting curve will become inverted with the next short term hikes. Maybe, in a way, not that relevant for most investments, but useful concept when looking at something like the Bank of the Ozarks. Even if the underwriting culture at that bank was very strong, IMO the distorted interest rate market may have very well insidiously introduced a bias to underestimate the risk premiums and decisions to enter certain markets to an extent that credit mistakes have been made. When purely looking at reported numbers, this bank would constitute a good opportunity but, given the historical perspective and the tightening of the term spread which, if it continues, will invariably manifest the stress between borrowing short and lending long, the recent negative developments represent a leading indicator of things to come.

 

Possibly cherry picking to some degree here but, when you look back at actual comments made by Mr. Greenspan (before the 1990, 2001 and 2007 recessions) and Mr. Bernanke, concerns about an inverting or inverted yield curve were put aside. Example (forecast vs foresight?):

https://www.marketwatch.com/story/greenspan-discounts-flatter-yield-curve-as-warning-sign

 

FWIW, here’s a recent, interesting and balanced study by the none other than the San Francisco Fed:

https://www.frbsf.org/economic-research/files/el2018-20.pdf

 

So what?

 

When I was a young kid, my parents, sometimes tired of never ending questions, would send me to my grandfather who had been born before the 1913 Federal Reserve Act and who had no formal education. But he was one of the wisest man I’ve come to know and never answered questions in a conventional way. One day, looking at the sky, watching the V-shaped flocks of birds convincingly moving in a southern direction, after a typical run of questions, my grandfather explained some “principles”. First he said, “One swallow does not a summer make, nor one fine day; similarly one day or brief time of happiness does not make a person entirely happy" from which I understood that he meant that complex systems are complex, exact timing is difficult and false signals could lead one astray. Then he explained that Canadian geese, some time during the fall, migrate south. But why? My grandfather said I was lucky because, in the new era of Great Moderation (he may have said era of great abundance), I could get educated and hear from the masters as to why birds migrate but he also said that for him, winter coming meant that he had to prepare for survival (food supply reserved and preparation for the next year’s sowing) and that he did not need to understand why the birds were migrating. He just needed to know that no seasons were exactly the same, that occasionally birds, especially the younger ones, did not fly exactly in the right direction and that there were natural and deep-ingrained forces “telling” the birds when and where to go.

 

The future is indeed unknowable and to each our own as we have to decide how to balance profits and protection but I wonder what my grandfather would say today. He always seemed to focus on the real and the enduring. It’s hard to be a contrarian when one “sees” a certain amount of collective foolishness but today, I look at the sky and I see tightening in a late cycle.

I assume John has finished his book on cycles and wonder if I’m off-base here.

 

Speaking of tightening and of a job well done and linking to what Cardboard opened with, and basically asking the question: Why suffer if we don’t have to?  I read some interesting stuff today and will finish with a question.  It’s from Horizon Kinetics Q3 2018. “The U.S. has $71.3 trillion of total debt, including everything from a car loan and credit cards to a U.S. Treasury Bond.  If rates were to increase, across all instruments, by 1%, the additional debt service would be $713 billion. The U.S. consumes about 20 million barrels of oil a day. At roughly $70 a barrel, it costs $1.4 billion a day to pay for the oil, or $511 billion a year.  So imagine, using the 1% increase in debt service as a reference point, if the country had to pay another $713 billion for its oil. That would be a 140% increase over what it is right now. That works out to an oil price of $168 a barrel.”  Yields have been increasing across the board and there’s more in store. If gas prices at the pump would have gone to 5 bucks a gallon and were moving to about 8 bucks a gallon and more in such a short time, the 70’s oil shock induced consumer suffering would pale in comparison. Yet, in the context of a job well done, deleveraging, in the main, has not occurred and fiscal deficits are heading up without any sign of suffering. Why is that?

 

There is a rare disease where some people don’t ever feel pain (those familiar with the Millenium movies will understand). Despite what first level thinking would suggest, people who never feel pain don’t do well. Unnecessary suffering is unnecessary but pain has to be felt. It’s unfortunate but it’s evolutionary.

[rukawa]

Issuing debt (fiscal policy) does not shrink money supply. What shrinks money supply is when the central bank sell debt that has already been issued (monetary policy) from their holdings.

 

Buying bonds from banks increases bank reserves with the FED but it doesn't really increase the money supply in any direct way unless banks are reserve constrained and there is both willingness of banks to isssue loans, willingness of other regulators to allow this and willness of borrowers to take on loans. The true money supply is bank IOUs which are determined by bank loans and may be considered as the sum total of bank deposits. Currency is a part of this but its very minor. In a fractional reserve system the money supply is not determined by the central bank directly...its determined by the uncoordinate, unplanned market behaviour of the banks and bank customers. The FED can attempt to influence this behaviour and if it wants to in can even use reserve ratios and other tools to force banks to do things...but it almost never does. Indeed banks as a whole are never reserve constrained in Canada/US...they are capital constrained and that capital is determined by other regulations.

 

The FED influences short term interest rates directly by market operations..the buying and selling of bonds. Central banks can also pretty much directly control the interest rates banks pay on loans of reserves between banks. Presumably low interest rates increase demand for loans (which banks might not be able to issue anyways because they are constrained by regulators) and high interest rates discourage loans. In addition the FED can increase the price of assets which has a wealth effect...people who are richer tend to spend more money and probably take more loans. But the FED cannot force people to take on loans and it can't force banks to lend which means it can't increase the money supply directly.

 

This paper is a must read for anyone who is trying to understand how the money supply actually works:

https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf

 

 

[Viking]

Some thoughts:

1

Why is the Fed not making an effort to keep the yield curve from inverting? 

I think that is because they don’t really care. 

Now it is certainly true that inverted yield curves have historically tended to predict upcoming recessions and that the Fed wants to avoid recessions.  But there is no sense, as far as I can tell, in which an inverted yield curve caused any of those recessions.  (As they say, correlation does not imply causation!)  I therefore find it hard to believe that the Fed would do anything just for the sake of keeping the yield curve nice and steep. 

(If anyone has a convincing theory as to why inverted yield curves are bad for the real economy, I’m all ears.)

2

The Fed continues to get a lot of scolding in certain circles for waiting so long to raise rates.  That is understandable. 

So why did the Fed do what it did?  A short answer is: they wanted to avoid repeating Japan’s experience since the 1990s-.  (I don’t have time to write about it here but you can look it up, it’s very interesting.)  Given what I know about this, I am squarely in the camp that thinks the Fed has done an excellent job post crisis.

On curve inversion and a job well done.

 

I’ve been critical and will continue to be, concerning various distortions and unintended consequences introduced in the market by the Federal Reserve and think that the interest rate “conundrum” has not been resolved. However, if animal spirits do lift growth and interest rates going forward in sustainable manner, such as suggested by the Fairfax team for instance, I take the pledge to openly recognize that I’m wrong. If that’s the case, I will also dissociate from the morbid fascination about what happened in Japan.

 

First, some would say that flattening or inverted curves don’t matter and there was some interesting work that came out in 2006 suggesting that curve inversion no longer really mattered and, using Fisherian and Wicksellian concepts, that the curve was not inverted even if it was!? At this point, if long term rates don’t increase, the inverting curve will become inverted with the next short term hikes. Maybe, in a way, not that relevant for most investments, but useful concept when looking at something like the Bank of the Ozarks. Even if the underwriting culture at that bank was very strong, IMO the distorted interest rate market may have very well insidiously introduced a bias to underestimate the risk premiums and decisions to enter certain markets to an extent that credit mistakes have been made. When purely looking at reported numbers, this bank would constitute a good opportunity but, given the historical perspective and the tightening of the term spread which, if it continues, will invariably manifest the stress between borrowing short and lending long, the recent negative developments represent a leading indicator of things to come.

 

Possibly cherry picking to some degree here but, when you look back at actual comments made by Mr. Greenspan (before the 1990, 2001 and 2007 recessions) and Mr. Bernanke, concerns about an inverting or inverted yield curve were put aside. Example (forecast vs foresight?):

https://www.marketwatch.com/story/greenspan-discounts-flatter-yield-curve-as-warning-sign

 

FWIW, here’s a recent, interesting and balanced study by the none other than the San Francisco Fed:

https://www.frbsf.org/economic-research/files/el2018-20.pdf

 

So what?

 

When I was a young kid, my parents, sometimes tired of never ending questions, would send me to my grandfather who had been born before the 1913 Federal Reserve Act and who had no formal education. But he was one of the wisest man I’ve come to know and never answered questions in a conventional way. One day, looking at the sky, watching the V-shaped flocks of birds convincingly moving in a southern direction, after a typical run of questions, my grandfather explained some “principles”. First he said, “One swallow does not a summer make, nor one fine day; similarly one day or brief time of happiness does not make a person entirely happy" from which I understood that he meant that complex systems are complex, exact timing is difficult and false signals could lead one astray. Then he explained that Canadian geese, some time during the fall, migrate south. But why? My grandfather said I was lucky because, in the new era of Great Moderation (he may have said era of great abundance), I could get educated and hear from the masters as to why birds migrate but he also said that for him, winter coming meant that he had to prepare for survival (food supply reserved and preparation for the next year’s sowing) and that he did not need to understand why the birds were migrating. He just needed to know that no seasons were exactly the same, that occasionally birds, especially the younger ones, did not fly exactly in the right direction and that there were natural and deep-ingrained forces “telling” the birds when and where to go.

 

The future is indeed unknowable and to each our own as we have to decide how to balance profits and protection but I wonder what my grandfather would say today. He always seemed to focus on the real and the enduring. It’s hard to be a contrarian when one “sees” a certain amount of collective foolishness but today, I look at the sky and I see tightening in a late cycle.

I assume John has finished his book on cycles and wonder if I’m off-base here.

 

Speaking of tightening and of a job well done and linking to what Cardboard opened with, and basically asking the question: Why suffer if we don’t have to?  I read some interesting stuff today and will finish with a question.  It’s from Horizon Kinetics Q3 2018. “The U.S. has $71.3 trillion of total debt, including everything from a car loan and credit cards to a U.S. Treasury Bond.  If rates were to increase, across all instruments, by 1%, the additional debt service would be $713 billion. The U.S. consumes about 20 million barrels of oil a day. At roughly $70 a barrel, it costs $1.4 billion a day to pay for the oil, or $511 billion a year.  So imagine, using the 1% increase in debt service as a reference point, if the country had to pay another $713 billion for its oil. That would be a 140% increase over what it is right now. That works out to an oil price of $168 a barrel.”  Yields have been increasing across the board and there’s more in store. If gas prices at the pump would have gone to 5 bucks a gallon and were moving to about 8 bucks a gallon and more in such a short time, the 70’s oil shock induced consumer suffering would pale in comparison. Yet, in the context of a job well done, deleveraging, in the main, has not occurred and fiscal deficits are heading up without any sign of suffering. Why is that?

 

There is a rare disease where some people don’t ever feel pain (those familiar with the Millenium movies will understand). Despite what first level thinking would suggest, people who never feel pain don’t do well. Unnecessary suffering is unnecessary but pain has to be felt. It’s unfortunate but it’s evolutionary.

 

Cigar, one of my favourite posts of the year. Thank you for taking the time to write it!

[John Hjorth]

... I assume John has finished his book on cycles and wonder if I’m off-base here. ...

 

I'm kicking in a tiny footnote here. I'm not finished with the book yet. It's tough on me, so it takes time, and I'm getting diverted by outside paint jobs in the beautiful autumn weather, juicy European banking scandals and such. I will post about the book in the book topic when done, also as per request from Cardboard.

 

- - - o 0 o - - -

 

Please continue the topic.

[Viking]

“Of course this is not the reality and there is uncertainty tied to this, but essentially the 10yr treasury trades on whatever the market thinks inflation is going to be for the next 10 years+some compensation for growth+some compensation for uncertainty (aka term premium, right now this is negative - prob because of QE - and a whole other subject).”

 

Chesko, i am trying to understand QE and now that it is being unwound what that means for financial markets. Given it appears to have stoked financial markets when it was implemented it makes sense it will be a headwind moving forward. Any thought you or others have would be appreciated :-)

 

[meiroy]

 

So why did the Fed do what it did?  A short answer is: they wanted to avoid repeating Japan’s experience since the 1990s-.  (I don’t have time to write about it here but you can look it up, it’s very interesting.)  Given what I know about this, I am squarely in the camp that thinks the Fed has done an excellent job post crisis.

 

Q: Why did the Fed leave interest rates so low for so long?

A: Because sometimes the people that work at the Fed just suck, as history has shown many times. They are not as good at forecasting or understanding the economy as they think they are.

 

It would not be the first time they fuck up the economy by messing with the interest rates.

 

'the natural state of the markets/economy is disequilibrium', this is something people working at the Fed are unlikely to accept so by trying to have things nice and flat and delaying the inevitable they end up causing a bigger mess.

 

 

[JimBowerman]

But the FED cannot force people to take on loans and it can't force banks to lend which means it can't increase the money supply directly.

 

 

I might be arguing semantics, so we if we agree let me know, but while in theory a CB can't directly influence money supply, in practice it can make the money supply whatever it wants.  Again, I always like to think in extremes, but if the CB increased MB by 1000x tomorrow and promised to not remove it, then banks in theory could just sit on the money and refuse to lend it out.  But that would never happen.  Instead this huge increase in the supply of money would decrease the demand for money which would lower the threshold at which banks lend out money (hot potato effect). The money would certainly get lent out because banks would know inflation was imminent. The banks know that the CPI will go up ≈ 1000x...are they really going to sit on excess reserves earning 2% in such a scenario? No, they will lend out the money, likely at a very high interest rate.  This process would work in reverse if the CB decreased reserves drastically.

 

Bigger picture, I think the fixation on interest rates has made us lose sight of looking at the actual money supply, which is ultimately much more important.  The monetarists certainly had some flaws in their thinking, but a myopic fixation on interest rates also cause problems, as we've seen since 2009. Shameless plug, but a lot of this stuff in covered in more detail here --> http://bit.ly/2S3Y6P9.

 

Look at Japan, they are setting their interest rate target at 0%.  This ensures that they will never have significant nominal growth. The goal of QE is to ultimately RAISE rates, not lower them.  BOJ should instead promise to print permanent money until rates rise to 3% (or whatever their goal is).  Counterintuitively, if they credibly promised to print permanent money like this, the increase in velocity would do much of the work, and the ultimate size of the BOJs balance sheet would eventually be much smaller than the current 100% of GDP.

[SHDL]

 

So why did the Fed do what it did?  A short answer is: they wanted to avoid repeating Japan’s experience since the 1990s-.  (I don’t have time to write about it here but you can look it up, it’s very interesting.)  Given what I know about this, I am squarely in the camp that thinks the Fed has done an excellent job post crisis.

 

Q: Why did the Fed leave interest rates so low for so long?

A: Because sometimes the people that work at the Fed just suck, as history has shown many times. They are not as good at forecasting or understanding the economy as they think they are.

 

It would not be the first time they fuck up the economy by messing with the interest rates.

 

'the natural state of the markets/economy is disequilibrium', this is something people working at the Fed are unlikely to accept so by trying to have things nice and flat and delaying the inevitable they end up causing a bigger mess.

 

It’s true that they know way less than they would like to. Whether they f- things up again this time, we shall see. So far the economy is booming and inflation is not too high — and to me that’s all I want from them.

[SHDL]

Cigarbutt, I don’t have any strong objections, but one thing I would like to mention is that if interest rates go up borrowers will experience pain but the lenders will gain. So it’s not just pain all around.

[Spekulatius]

I really have given up almost upon trying to understand economics. I just try to observe and it seems to me that we are about to see higher inflation amd higher interest rates. I think thet all I need to know as far as investing is concerned.

 

I suspect the effect changes are hard to product , because a lot them are mass physiological in nature and more determined by trend that the absolute numbers. I mean a 2% or 3%  base interest rates shouldn’t really make any difference in rational business environment, where return expectations are mostly in the double digits anyways, but there is a psychological effect when interest  rates are near zero for a long time and heaven forbit , they rise to 2% all of a sudden.

[Cigarbutt]

I really have given up almost upon trying to understand economics. I just try to observe and it seems to me that we are about to see higher inflation amd higher interest rates. I think thet all I need to know as far as investing is concerned.

I suspect the effect changes are hard to product , because a lot them are mass physiological in nature and more determined by trend that the absolute numbers. I mean a 2% or 3%  base interest rates shouldn’t really make any difference in rational business environment, where return expectations are mostly in the double digits anyways, but there is a psychological effect when interest  rates are near zero for a long time and heaven forbit , they rise to 2% all of a sudden.

Fair enough. Individual securities need individual evaluations of merits.

But this thread is about the FED and Mr. Buffett, in his usual apparent low level of interest, has said that the low level of interest has been fun to watch, adding: "QE is like watching a good movie, because I don’t know how it will end". Hmmm…

Also, when evaluating an investment, a 1% increment from 2% to 3% does not have the same impact as from 8 to 9% (in terms of valuation, interest expense etc especially if higher leverage is in the picture).

And when you're buying a security in the market or privately, you have been competing, for a few years during which there was a huge and incomplete experiment, with buyers using very low discount rates, having access to a large amount of cheap leverage and being driven by the hot potato effect that JimBowerman describes above.

I wonder if the cash balance that has been rising at Berkshire has anything to do with the fact that is easier to buy than it is to sell (or wind down). I tend to think that Mr. Buffett is often on the right side of transactions. Don't you think?

 

@JimBowerman

The definition of the hot potato effect that you describe does not correspond to my understanding. You seem to imply that the 1,7 trillion injected by the FED through the QEs was transmitted to the economy because banks were induced to lend more. That does not seem to be the case and I understand that even the FED acknowledges that the real economy was not really affected, apart from the unverifiable comment that a worse depression was prevented, which is really something, if true. The hot potato effect that you describe seems to be related to the fact that, through an induced new equilibrium, the new money that found its way into the system eventually stayed at the banks but somehow encouraged chasing for yield behavior. Money did change hands but made it back to the banks as reserves but the result of the flow of new money was higher asset prices (wealth effect), especially in stocks, junk bonds, leveraged loans etc When the "excess" reserves are retired from the system, how do you call the hot potato effect? And what is the opposite of chasing for yield or wealth effect?

I read some of your stuff and look forward to becoming more educated.

 

[Cigarbutt]

Cigarbutt, I don’t have any strong objections, but one thing I would like to mention is that if interest rates go up borrowers will experience pain but the lenders will gain. So it’s not just pain all around.

Don't want to derail this thread but what you mention is interesting (and debatable because your conclusions need a certain set of assumptions).

So this post is about the net interest margin and will try to keep it in line with the spirit of the thread.

 

The net interest margin at US banks has been relatively compressed since the sudden economic deterioration in 2007 but the trend seems to be changing.

https://www.federalreserve.gov/econresdata/notes/feds-notes/2015/why-are-net-interest-margins-of-large-banks-so-compressed-20151005.html

 

Overall, I understand that your comment means that rising rates will be a positive for lenders and if you look at the long term trend in rates, an interesting picture emerges. The curve does look like a smoothed version of the Treasury rate curves.

https://fred.stlouisfed.org/series/USNIM

 

Many factors involved and every cycle is different but, when you focus on certain aspects, the net interest margin, in general, seems to decrease when there is a tightening environment and typically increases after the curve has inverted and after the environment becomes accommodative again. This rise in margins typically happens during a period of a significant decrease in the volume of loans.

https://www.richmondfed.org/publications/research/economic_brief/2016/eb_16-05

 

But the initial message of the thread is the possibility that Fed over-tightens and affects demand for the typical citizen. So far, in this cycle, uncharacteristically, Fed tightening has resulted in rising net interest margins but I wonder if more tightening, especially if sufficient to cause an inverted curve, will be beneficial to the net interest margin or the volume of loans. History seems to provide some potential answers.

 

 

Here's a final link coming also from the Federal Reserve Bank of Richmond (this time from early 2007). The article talks about net interest margins, term spreads, chasing for yield and credit risk during inversion as well as the solidity of banks due to their robust levels of equity capital etc. The authors suggest vigilance which may always be a good idea afterall.

https://www.richmondfed.org/-/media/richmondfedorg/publications/research/econ_focus/2007/spring/pdf/feature5.pdf

 

[JimBowerman]

@JimBowerman

The definition of the hot potato effect that you describe does not correspond to my understanding. You seem to imply that the 1,7 trillion injected by the FED through the QEs was transmitted to the economy because banks were induced to lend more. That does not seem to be the case and I understand that even the FED acknowledges that the real economy was not really affected, apart from the unverifiable comment that a worse depression was prevented, which is really something, if true. The hot potato effect that you describe seems to be related to the fact that, through an induced new equilibrium, the new money that found its way into the system eventually stayed at the banks but somehow encouraged chasing for yield behavior. Money did change hands but made it back to the banks as reserves but the result of the flow of new money was higher asset prices (wealth effect), especially in stocks, junk bonds, leveraged loans etc When the "excess" reserves are retired from the system, how do you call the hot potato effect? And what is the opposite of chasing for yield or wealth effect?

I read some of your stuff and look forward to becoming more educated.

 

 

My fault, I didn't clarify some of my points (btw Scott Sumner, David Beckworth, etc have forgotten more than I'll ever know on this stuff...would highly recommend them).

 

I think the first issue is: we don't really know what would have happened without QE.  Many point to low inflation/growth as a sign of QE's failure, yet don't talk about the increase in demand for money.  Imo, the rise in supply of money from QE was almost entirely offset by the rise in demand for money.  With the shock to the system, the demand for money clearly skyrocked, and if we hadn't at least printed enough money to offset this rise in demand, then we would've had massive deflation and a depression. So I think QE had a huge (positive) affect, it was just a bit hidden.

 

Regarding the hot potato effect...its really only works if the money printed is permanent. As a thought experiment: what would happen if a CB says it will increase MB by 1000x tomorrow, but then promises to remove all this new money in 2 months time?  Would inflation result? (I don't think inflation would result, and there would be very little hot potato effect). In the real world, things aren't this extreme.  But the Fed increased money supply from 5% of GDP to 25% of GDP, and implied it would remove it in 10-20 years (and is proving that point with QT).  Imo that won't cause very much inflation.  Increasing money supply from 5% to 25% but promising to never remove it would cause much more inflation.  Even better would be promising to print as much money as needed so that NGDP growth stays at 4-5%.

 

Look at Japan: They've increased MB to 100% of GDP but the whole time they've said/implied "The second growth gets above 0% we will remove the money". So its not surprising that growth never takes off. They snuffed out growth before it ever got started. They've said (almost explicitly) that all the money they've printed will not be permanent.

 

As for chasing yield/wealth effect, I'd actually take the opposite view.  I believe PE ratios would be lower today if we had more QE. Stocks are influenced by 1) P/E ratios 2) earnings growth. If we (overly simplistically) assume earnings grow about in trend with nominal GDP (and remember, a CB can make NGDP whatever they want) then the low growth we've seen since 2009 has kept the absolute levels of earnings low, but this pushed up the PE ratio for stocks.  Most, when they talk about bubbles, talk about the high PE ratio, so in a way people equating the fed's actions to stock market bubbles have it a bit backward.  PE ratios would likely be lower if the Fed had printed more money. (my logic here isn't airtight, but I just mention it as a counterpoint to the bubble talk - I actually think stocks are fairly valued given the likelihood of low growth going forward)

 

When we have true inflation (1980's) we see PE ratios plummet and nobody talks about bubbles, etc. When we have depressions, stocks plummet and again there's no bubble talk.  Its in this small window of "very low, but positive interest rates" where it gets confusing.

 

[SHDL]

Cigarbutt,

 

What I meant when I said “lenders” is something simpler. If I have a pile of cash now I can lend it to the US treasury for 3 months and earn a >2% yield. 5 or 6 years ago I could only get perhaps 0.2%. And I, as a lender, am benefiting from that change.

 

With banks it’s more complicated because they are both lenders (by making loans) and borrowers (by taking deposits) at the same time. You’re right that it’s not so easy to predict what will happen to their profitability as the Fed further raises rates.

[Cigarbutt]

Cigarbutt,

What I meant when I said “lenders” is something simpler. If I have a pile of cash now I can lend it to the US treasury for 3 months and earn a >2% yield. 5 or 6 years ago I could only get perhaps 0.2%. And I, as a lender, am benefiting from that change.

With banks it’s more complicated because they are both lenders (by making loans) and borrowers (by taking deposits) at the same time. You’re right that it’s not so easy to predict what will happen to their profitability as the Fed further raises rates.

Hoping for a diversity of opinions and will keep the reply short.

 

Your simplified answer is at the heart of the issue as I find that the rule for every lender, there must be a borrower has been blurred IMO by what, in the end, could be called black box economics, which is a layer of complexity above voodoo. Looking for perspective and I'm a slow learner as am still trying to fully understand the circumstances that led to the TARP program and maybe simply need to move on. All I know is that Mr. Powell and his team will try to move cautiously and without disruption and it is impossible to "predict" what will happen but it will certainly be interesting to watch.

 

When everything is said and done, this may all come down to instinct.

I suspect that George W. Bush, who often used instinct for decisions, did not go into the details of the the controversial bail out but, after the audience with the father, the son and the holy ghost, came out with the right solution: "If money doesn't loosen up, this sucker will go down". Under present circumstances, hard to figure out what he would say but it may have sounded like: "Like it or not, it's time to bite the bullet."

[SharperDingaan]

Cigarbutt,

 

What I meant when I said “lenders” is something simpler. If I have a pile of cash now I can lend it to the US treasury for 3 months and earn a >2% yield. 5 or 6 years ago I could only get perhaps 0.2%. And I, as a lender, am benefiting from that change.

 

With banks it’s more complicated because they are both lenders (by making loans) and borrowers (by taking deposits) at the same time. You’re right that it’s not so easy to predict what will happen to their profitability as the Fed further raises rates.

 

We have a very good idea as to what will happen, we just don't know the timing.

 

(1) The higher the fed rate goes the smaller the 'aggregate' lend (asset to the bank) becomes; simply because as rates goes up, more projects fail their IRR and NPV tests (and are shelved as a result), and the PV of securitized assets declines - significantly reducing demand for money. Same 'spread' on a smaller asset = less interest income.

(2) Declining collateral values push corporate borrowers over the edge, and bankers into 're-structuring' - to avoid booking losses. Raise rates too quickly and credit-card/line-of-credit defaults absorb too much of the loan loss cushion, producing strings of sizeable 'one-time' quarterly write-offs. Less net income + lots of downside risk = P/E compressiion ... and the possibility of dilution through new capital raises.

(3) The other name for large-scale, industry-wide restructuring, is QE. Most would suggest that now the 'system' is stable - CB's would highly prefer loan-loss write-offs to agressively hit the P&L; both to enforce 'moral hazard', and because there is still so much QE capital on the books to unwind. Further P/E compression, particularly if a 'zombie' bank is either broken-up or allowed to fail.

 

Banking has gone nearly TWO generations without the discipline of 'moral hazard' - so it is long overdue for 'change'. The proportion of 'brick and mortar', to 'virtual' (& blockchain related) banking , is also very 'out-of-line' for todays global age. 'New pipe' versus old pipe, is coming to a bank near you - and a lot sooner, versus later.

 

It's still a great industry, but the times are rapidly changing.

Not a bad thing.

 

SD

 

 

 

 

 

[SHDL]

Hoping for a diversity of opinions

 

Me too!  :)

[bluejoseph]

I just wanted to point out that the rise in 5yr and 10 yr US Treasury Yield most recently (and much of the year as well) has been a real yield phenomenon and not an inflation expectation one. Data current as of mkt close Friday (10/19/18)

 

First attachment - Breaks the nominal 5yr & 10 yr UST yield into the real yield and inflation expectation components (the 5yr components are charted in orange and the 10yr components in green). The Inflation expectation component (Top panel) rose early in the year, flattened and has declined. The rate of change on the right panels shows this as well with the most important rate of change measured from late last year. The Real Yield component (Middle Panel) has risen all year with a more recent acceleration. Again the side panels show this with attention to the late 2017 to today rate of change. The bottom panel shows the spread between the nominal 10yr UST & 5yr UST (black line) and the spread between their real rates (purple line). The real rates have inverted several times this year but are not presently so. The nominal has pulled back from its trend toward inversion. All data points except the most recent were taken about 15 days apart. So the visual may be relied upon as an accurate spacial depiction of the numbers.

 

Second attachment - Primarily charts the UST 5yr Real yield component (orange line) over the last decade and a half. The background brownish area is the UST 5yr inflation expectation components (nominal yield - real yield). As you can see the real yield has risen markedly to 1.07% which is really the highest level since the 2008-2009 period. It is at a 2005 level... is this considered a normal real yield? Real yield rose from 2005 into 2007 considerably and if this current period identifies with that one there is room for real yield to further continue to rise as well.

 

Inflation expectations have not been moving higher. They only reflect a reflation from the depressed early 2016 period. Perhaps this will change... but there is no current expectation that higher inflation is a phenomenon to currently be priced into yield.

[Liberty]

Independent fed?

 

https://www.wsj.com/articles/trump-steps-up-attacks-on-fed-chairman-jerome-powell-1540338090

 

President Trump escalated his attacks on Federal Reserve Chairman Jerome Powell, blaming him for threatening U.S. economic growth and saying he appeared to enjoy raising interest rates.

 

In an interview Tuesday with The Wall Street Journal, Mr. Trump acknowledged the independence the Fed has long enjoyed in setting economic policy, while also making clear he was intentionally sending a direct message to Mr. Powell that he wanted lower interest rates.

 

“Every time we do something great, he raises the interest rates,” Mr. Trump said, adding that Mr. Powell “almost looks like he’s happy raising interest rates.” The president declined to elaborate, and a spokeswoman for the Fed declined to comment.

 

Mr. Trump said it was “too early to tell, but maybe” if he regrets nominating Mr. Powell. [...]

 

The president’s caustic comments about Mr. Powell came as Mr. Trump repeatedly described the economy in personal terms. He referred to economic gains during his time in office as “my numbers,” saying, “I have a hot economy going.” He described his push for growth as a competition with former President Obama’s record, saying that increases under his Democratic predecessor were skewed because of low-interest rates. [...]

 

Asked an open-ended question about what he viewed as the biggest risks to the economy, Mr. Trump gave a single answer: the Fed

 

“To me the Fed is the biggest risk, because I think interest rates are being raised too quickly,” the president said just before he pushed a red button on his desk, summoning an iced cola delivered to him on a silver platter.

[Cardboard]

https://www.cnbc.com/amp/2018/10/23/former-fed-chairman-paul-volcker-thinks-were-in-a-hell-of-a-mess.html

 

2% inflation target is a number picked out of thin air according to Volcker.

 

Oh yeah, and all Presidents push the Fed. Maybe less publicly but, when the big guy tells you to do something, you tend to obey. I actually think that words behind closed doors are stronger than what Trump is doing: Trump will get backlash if the Fed bends.

 

Cardboard

[rb]

Well, Duh! Of course the Fed is happy to raise rates if it can.

 

Also, while 2% is just a number. It's actually not so random. It was set at 2 because of a lot of pushback from conservatives. Which are/were? hard money types. Economists wanted a higher number. In reality 3% should work better. We may even get away with 4%.

[Gregmal]

The interest rate whining is absurd. Trump is right that it's cooling the economy a bit, but that's the whole point. But there's a lot of stupidity out there otherwise. People sent the real estate market through the roof a decade plus ago buying homes at 6% rates. A decade earlier they were over 8%. So yea, the bozos bidding down homebuilders to 5x earnings because of 5% mortgages? Pure stupidity. Otherwise, this is largely IMO the product of the people at CNBC needing something to talk about.

 

Also, god forbid savers finally get some interest!

 

It's been pretty well documented that the Fed really doesn't have a clue what it's doing, and that people claiming to be calling a top, or "peak cycle" are full of shit.