If you’re wondering what Federal Reserve Chair Janet Yellen said about interest rates the other day you’re not alone. Is she saying the Fed will move to raise interest rates by June or is she saying the Fed will hold off?
Yellen is simply following in the footsteps of past Fed leaders. As Alan Greenspan once explained, “I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”
Yellen has to be vague to the point of incoherence for a very simple reason: If she says something definitive then regardless of what choice the Fed makes huge numbers of people will get hurt. If she makes indefinite and unclear statements and the Fed keeps doing what it’s been doing, then at least we have some sense of stability.
The catch is that stability is not necessarily a good option. For millions of Americans the economy is not “stable,” it’s contracting — between 2000 and 2013 the middle class shrank in every state, according to Pew research. At the same time inflation continues to eat away at buying power. The result is a financial double-whammy which makes talk of “recovery” questionable in many households.
What could go wrong if the Fed tries to force rates higher? Here are a few issues that will surely arise:
The federal government currently carries debt worth $18.1 trillion. If the Fed raises interest rates then the cost of government will increase substantially — for instance, 1 percent of $18.1 trillion is $181 billion in new federal costs. Where does the federal government get additional revenue to fund this new cost or does it simply let the debt increase? What about state and local governments which also have debts to finance?
In 2014, members of the S&P 500 spent $564.7 billion to repurchase their own shares according to FactSet.
That’s more than half-a-trillion dollars which was not used to construct new factories, further research or create new jobs inside our borders. Why then are companies buying back stock?
The system works like this: A company borrows money at today’s rates to buy back its own shares. There are now fewer shares outstanding, thus in the best situation the value of those outstanding shares might rise, things which make investors happy and perhaps triggering nice, fat executive bonuses. Moreover, dividends can increase because profits are being divided by fewer shares, thus producing higher earnings-per-share without actually increasing production or productivity. The cost to borrow is tax-deductible because interest is a business cost.
A pretty neat package — unless interest rates rise in which case buy-backs can make less sense. Yes, interest on the debt is deductible but interest is still a cost. If interest rates rise enough then the expense of financing buybacks might start eating into corporate profits and with smaller profits stock values on Wall Street could fall.
In a sense it can be argued that the low interest rates pushed by the Fed have encouraged corporate buybacks funded with cheap borrowing. If rates were higher perhaps companies would have more incentive to expand, add jobs and reduce unemployment levels, one of the Fed’s stated goals.
The Housing Market
“The housing recovery is faltering,” observed David M. Blitzer in February. Blitzer — the managing director and chairman of the Index Committee at S&P Dow Jones Indices — said “while prices and sales of existing homes are close to normal, construction and new home sales remain weak. Before the current business cycle, any time housing starts were at their current level of about one million at annual rates, the economy was in a recession. The softness in housing is despite favorable conditions elsewhere in the economy: strong job growth, a declining unemployment rate, continued low interest rates and positive consumer confidence.”
The real question raised by Blitzer is this: If home sales aren’t booming with mortgage rates below 4 percent then what will happen with higher mortgage costs?
The Fed must look at U.S. exports and shudder at the thought of higher interest rates.
Jerry Jasinowski, a former president of the National Association of Manufacturers, explains that “companies in developing countries have borrowed in the U.S. at low interest rates and are now being squeezed because they have to pay back their loans with a higher priced dollar. In the current atmosphere, the Fed finds itself between a rock and a hard place. If it makes any significant increase in interest rates it will serve primarily to slow the U.S. and the world economy.”
It should also be said that even with low interest rates we have a massive and continuing trade imbalance — $41.8 billion just in January. No country can sustain such a situation including the U.S. Other nations lend us money to trade because we buy their goods and services plus the dollar is the world’s standard reference currency. However, there’s no economic rule which says only the dollar can be a reserve currency. Great Britain, Germany, France and Italy have joined a China-led coalition to create a new development bank that rivals the World Bank — something that would not be needed if they were happy with U.S. financial leadership and the dominance of the dollar. If the dollar is not seen as the world’s reserve currency then the ability of the U.S. to borrow will decline substantially while the price of imports into the U.S. will greatly increase.
A Loss At The Fed?
As a result of its quantitative easing policies, the Fed holds an enormous investment portfolio including $1.795 trillion in mortgage-backed securities and $1.692 trillion in “Maiden Lane” securities, the notes bought from banks, Wall Street and a few big corporations after the financial meltdown.
A business with such assets would see current values fall with a rise in interest rates. The Fed is different; it’s in the unusual position of being able to control the value of its fixed-rate investments by raising or lowering interest rates. To make the Fed holdings even more secure, it’s unclear if the Fed can ever have a loss.
Why? As the Fed explains on page 338 of its annual report, “accounting principles for entities with the unique powers and responsibilities of the nation’s central bank have not been formulated by accounting standard-setting bodies. The Board of Governors has developed specialized accounting principles and practices that it considers to be appropriate for the nature and function of a central bank.”
Translation: We monitor our own books and will always have a “profit” because only we get to say what a profit is.
While the Fed plainly has the ability to control its financial destiny it can’t control public opinion and large numbers of people don’t understand what it does or who benefits. Calls for greater “transparency” on Capitol Hill, outside audits, and less power for the New York Fed are now far more plausible than in the past.
The Fed is boxed in. It can’t lower rates and it dare not raise them, so what choice is there but to keep things steady for as long as possible? The end result is not that we have a Fed which has a cautious fiscal policy but rather we have fiscal realities which leave little room for the Fed to maneuver.