Interest rates – raise or lower, do they matter

I saw an article this morning about a few people calling on the Fed to raise interest rates by 2 percentage point. Here is a link to the article.
http://www.bloomberg.com/news/2010-08-22/bernanke-must-raise-benchmark-2-points-in-prescient-rajan-s-latest-warning.html

If you read the article, you will see my yawn on it. You can keep arguing this way or the other and still make sense. This is because these guys talk purely from a monetary point of view and don’t talk about the fundamental hinge of an economy, which is the exchange of goods and services. If all you talk is dollars, interest rates, Fed’s balance sheet etc, you can argue for any monetary policy. Greenspan can argue that the Feds can’t do anything about asset prices but they certainly can do something about the underwriting standards of loans – it is not the low interest rates that fuelled the asset bubble in the US (it may have abetted it) but the asset bubble was created thru NiNa loans and really poor underwriting standards. You can have an asset bubble even in a high interest rate environment if the banks were willing to lend without any proof of income generating capacity.

It is worth asking why even have an interest rate in an economy. Interest rate is needed because the person who has saved money (or who has underconsumed) will not lend the money without seeing value for it – an interest on the loan provides the value. In a large economy, to have an efficient way to lend money, we have institutions called banks to collect deposits and lend money. The bank is the intermediary for us to lend to people who need the money. Why does somebody need to borrow money – because they have to pay for resources now before they can generate a profit. A company can borrow money thru different ways and a bank loan is just one mechanism – equity capital is another.

High interest rates are associated with high inflation. People are willing to borrow at high interest rates because they know they can pay it back with rising prices of their products. If their profit margin is 10% on a sale of $100, it would be $10 of profit. If the profit margin remained the same and the sale price inflated by 10% to $110, the profit will now be $11. So the company has the extra $1to pay a fixed rate loan from last year.

Low interest rates are associated with low inflation. But the interest rates are just responses to an inflationary or deflationary environment. Why does inflation happen – because the people demand more of the products than what can be supplied by the economy. If there is a supply glut, very hard to create inflation.

If you do a zero interest rate, you can theoretically kill the morale of an economy and create zombie banks. In a zero interest rate, nobody wants to lend and so borrowing can't happen (unless the Fed funds the borrowing) but if the borrowing doesn't happen, you could choke new supply coming on line and hopefully that will create an excess demand over supply eventually. But the process to get thru the excess supply will be so excruciating that the govt won't allow it to happen.

Let me talk more on this subject in my next blog.

Supply Destruction

This is the other way to combat deflation I talked about in last blog. If there is an excess capacity in the economy for producing a certain good or services, it will drive down the price being charged for that good or services. Basic microeconomics of supply greater than demand leading to lower prices. and lower average prices of all goods and services in an economy is deflation. In a normal economy, as competitors get more efficient, prices go down, businesses in the lower quartile of operating costs in the industry will shut down when the prices go down below their operating costs. This is a normal economic fundamental and weeds out the inefficient businesses and allocates the resources to more efficient activity. This happens all the time in a competitive economy and is very good for economic growth. The demand for the products is there and the more cost efficient competitor is able to capture a bigger share of the demand by being able to drive down costs and in effect charge lower prices than other competitors.

If the demand for a certain product and services in the economy goes down, that is ok as the human and capital resources could be shifted to other products and services that are high on demand. But what if the demand for all products and services in the economy go down, that creates deflation. Suddenly there is excess capacity in the economy compared to the demand. Companies are cutting jobs just to survive but due to high fixed costs, are willing to cut prices to move products. There are only a few big survivors in any given segment of an industry and they are not willing to shut down to reduce capacity - the govt doesn't want to shut them down and are more prone to bailing them out. This creates deflationary conditions. One prime example is housing industry - there are more homes now than what people need right now. So the supply is greater than demand and the sellers are willing to cut prices just to make a sale. This price cut then affects the value of all the other neighbouring homes.

One way out of this to cause supply destruction. Instead of selling homes at a lower price, the govt or some other body could buy them off and destroy those homes. They may be spending money on buying those homes but they are also taking away future supply from the market, thereby reducing the price fall. akin to a stimulus spending. The problem with this approach is how to implement it. Any way of implementation will be highly unfair to a number of segment of people and that's where it will be conterversial. What price should the govt buy the house at, which houses should the govt buy - it won't be easy. Supply destruction other than thru market forces is very difficult to implement unless nature somehow works to create hurricanes, tornadoes etc nationwide to take supply out of the market but again nature may be taking the wrong supply out of the market, exacerbating the situation.

Negative Interest rates

I had mentioned about some ideas I had to combat deflation and one of the ideas is negative interest rates. The zero interest rate seems to be the floor in interest rates in everybody's mind. Why can't we go lower than that? If we think people aren't spending on goods & services now because they believe that the prices of those goods & services will go down in the future, then a negative interest rate may spur spending now. If the reduction in exchange of goods & services is not due to people's expectation of lower price tomorrow but in general a lower appetite to exchange, then negative interest rates won't help and neither an increased money infusion by the Fed would help. In that case, you need to be thinking of supply destruction to stave off deflation - I will discuss this idea in my later blogs. Negative interest rates may be thrown aside as an impractical one but would the declaration of negative interest rates at the banks spur spending now?

If a consumer is faced with a choice of negative interest rate on his deposits in a bank, he could withdraw all the cash and keep it in a safe besides his bed, he could spend it on goods & services with the thinking it is better to spend than lose value of his savings, he could invest the money in the stock or bond market. Thru this, we may create a business around Cash Safes around the country - where businesses would keep your cash in a safe for a nominal fee/year - this nominal fee/year will be akin to a negative interest rate though but maybe smaller than what the banks would charge. would there be a bank run across the nation because of this? Instead of the retail banks charging negative interest rates, the Feds could charge negative interest rates on excess reserves kept by the banks at the Fed. This is more of a signal by the Fed that it could go negative on interest rates and would the signal itself fuel spending by consumers. kind of opposite to Inflation - in inflation, people buy things now as they expect prices to rise tomorrow and this expectation feeds more inflation. would the expectation of negative interest rates create some psychological behaviour from consumers to buy things now. With negative interest rates at the Fed, the banks then won't keep those excess reserves at the Fed and may feel pressure to lend them out. The mortgage rates may drop further and create some additional refinancing, home buying.

This negative interest rate is just an idea I am throwing out there and I will try to explore it further in my future blogs when I get a chance. I haven't seen this idea being talked about or discussed about in the financial media as one tool to fight deflation. Everybody says that Feds can't go lower than zero on interest rates - is that really true. We may never have had to experiment with going negative on interest rates before but now it is worth talking about and seeing what behaviour it will create in the economy and if it can be another tool for the Fed?

Free Refinancing

There was another news I heard on NPR recently about a proposal by Fannie Mae and Freddie Mac to do a blanket refinancing of all the mortgages they hold in order to reduce the monthly payments of those homeowners. The adminstration is wanting the banks to reduce loan payments to a lot of distressed homeowners and this hasn't happened in practice as refinancing requires paperwork and adhering to the new credit standards set up by the banks (like need to have a certain equity in the home to qualify for the lowest mortgage rates!) and the distressed homeowners won't be able to make it thru the process. So this new idea of blanket refinancing - the homeowners would get a sheet of paper saying that their loans will be modified to the new rates and all they have to do is to sign the paper. This is like giving free money to a certain section of the population and is highly unfair to non-homeowners. This is a selective cash distribution to a group favoured by the adminstration and fails the fairness test of policies in a big way. and I don't know the number of homeowners that would benefit from this. Any MBS security held outside Fannie and Freddie wouldn't be able to go thru this process -that's what I think.

QE2 and Stimulus round 2

Last week, we heard a number of reports on either quantitative easing 2 by the Fed or a call for a new stimulus program by the govt. - one a monetary and the other a fiscal tool to get the economy out of deflationary tendencies. all these people talk about such tools without considering the fundamentals behind the economy's current turmoil. QE2 would mean that the Treasury would buy more Treasury securities to add to it already bloating balance sheet and convert it into monetary units at bank deposits. The idea is that the banks would lend this money into the economy and fuel growth - but the banks already have a trillion dollars that they have kept in fed custody and are not lending out. Why would the banks lend out a new increase in deposits.

The QE2 is a way of printing money to finance the govt deficit - the govt borrows money from the market and issues Treasury securities. The Feds then buy those T securities and give money back in a sense to the initial lenders. Before the Feds bought the Treasury securities, the money was borrowed from one and spent by the other. With the Fed buyout, the govt has essentially gotten free money from the printing press of the Feds. A continual QE2 with deficit spending would steadily increase money supply and so should fuel inflation. But inflation also requires consumers to spend on things that is in short supply and must be able to borrow to spend the money. In an economy with bank lending controlled by the govt., this can be done by doling out free money to the consumers or a select section of the population and this happens in a lot of countries. The free money is then used to demand a lot of products and services, creates a supply shortage and shoots up inflation. But in the US, the banks are not going to lend free money after the mortgage crisis they have gone thru recently. Even with record low interest rates, a lot of people can't qualify for a mortgage loan because it has to be backed by a decent income and down payment - which doesn't exist for a lot of people. All the policy makers should think about the fundamentals of the economy and not just look at the next fiscal or monetary tool. The last monetary tool created the mortgage mess, shot up prices way beyond people's income generating capacity and we are trying all we can to keep it at that high level.