Yields on the 10-Year Treasury Note remain below 2 percent. Interest rates this low are extraordinarily abnormal. They indicate credit markets are feeble. Moreover, despite the Feds efforts to suppress interest rates, these ultra-low yields may be hurting the economy rather than stimulating it.
How did we get here? Let’s explore…
“Where does credit go when it dies?” asks Bong King Bill Gross in his latest Investment Outlook.
“It delevers, it slows and inhibits economic growth,” says Gross, “and it turns economic theory upside down, ultimately challenging the wisdom of policymakers.”
The critical insight that Gross offers in this article is that once economic policy has forced interest rates to become zero-bound, low interest rates no longer stimulate economic growth; rather, they discourage it. In short, when credit markets do not offer a reward that’s worthy of the risk, lenders take their money elsewhere.
Obviously, this can have negative consequences on the economy…
Monetary Policy Redux
Monkeying with the price of money by the Federal Reserve produces price distortions throughout markets and the economy. During a boom induced by cheap credit, for example, the apparent rise in economic growth misinforms businesses and lenders. Ventures that appear to be profitable really aren’t. Demand that appears to be robust is really a mirage.
Before long, businesses become overextended with credit, and they become reliant on unrealistic rates of economic growth to service their debts and support their operations. Inevitably, something slips and the unsustainable boom roles over. Businesses go bankrupt. Lenders get defaulted on.
When this happens on a large scale the Federal Reserve lowers the federal funds rate, cheapening the price of money, to soften the landing of the economic bust. When the economy sputters, easy credit, via the lowering of the federal funds rate, is the Fed’s way to grease the gears and lube up the cranks of the economy to get things revving again. This has been the standard monetary policy response for at least the last 30 years.
From the Feds perspective, they believe they’ve been successful at creating perpetual economic growth over that time. They look back and see that from 1980 to 2007 the U.S. economy experienced boom after boom with hardly a bust worthy of mention. Even the crash of the dot com bubble was quickly overcome with the Fed’s low interest rate policy.
Yet, despite the Fed’s apparent track record of success, several peculiar things have happened along the way. Public and private debt has exploded. The dollar’s been debased. Additionally, with each interest rate cycle the booms are at a diminishing and ever more anemic return. True economic growth based on capital investment and production has been exchanged for bubble based asset price increases and credit based consumption.
Credit Market Killing Machine
Since the credit crisis in 2008 the Fed’s efforts no longer appear to fuel recovery. The federal funds rate has been at practically zero since December 16, 2008. By all accounts of policy makers and government economists, this should have induced massive economic growth. But it hasn’t.
Instead, what has happened is the Fed has pushed the price of money so low that even if business can find profitable opportunities, lenders are discouraged to lend because the risk premium they’ll receive is so low. The Fed has broken the credit market’s ability to fund economic growth.
“Zero-bound money may kill as opposed to create credit,” says Gross. “Developed economies where these low yields reside may suffer accordingly.”
No doubt, the Federal Reserve’s policy of extending cheap credit to stimulate economic growth has lost its magic. In addition, it encourages speculation. Faced with the choice of a negative real rate of return in CDs or government bonds, some investors will take on greater risk.
“It may as well, induce inflationary distortions that give a rise to commodities and gold as store of value alternatives when there is little value left in paper,” Gross concludes.
Here we’ll also add the stock market to the list of speculative investment vehicles where investors will recklessly chase higher returns. If you haven’t noticed, the stock market’s off to its best start in 25 years. Perhaps Fed gas has something to do with it.
Sincerely,
MN Gordon
for Economic Prism
