All eyes are on the FOMC’s meeting next week, but many of them are missing the point: the market has beaten the Fed to ultra-low rates when considered – as rates must be — in real, not nominal, terms. There’s a reason why inflation-adjusted interest rates are termed “real” – it’s these rates, not nominal settings, that determine how much I really get when I put my money in the bank or what it costs me to get a loan and what interest rates thus really mean to market structure and economic inequality. Conventional theory has it that lower rates mean more lending and more growth, but we are now in deeply unconventional times not only in terms of how low interest rates have dropped in both nominal and real terms, but also how large the Fed’s portfolio is and how much these two phenomena have contributed to record-breaking U.S. economic inequality. The lower real rates, the worse it really gets.
Why are my worries so high? It’s because real rates are very, very low even before next week’s cut. Just today, ten-year nominal Treasuries are about 2.05 percent – sort of where the Fed wants them. However, the ten year inflation adjusted real rate is 0.25 percent. What will a 25 basis point cut do given how little room there is above the zero lower bound (ZLB)? This depends not only on next week’s nominal rate cut, but also on geopolitical risk, carry-trade flows, inflation fears, and other market factors. However, it’s indisputable that the Fed is skating on very, very thin ice.
Dangers lie first to the real world of financial markets in which nominal rates only matter if you aren’t paying attention. In 2015 and 2016, FedFin issued analyses of the market implications of negative interest rates, many of which have sadly come to pass in terms of market dislocations and yield-chasing. The U.S. hasn’t been as negative as other nations, but the ten-year inflation-adjusted, risk-free rate flirts precariously above the zero lower bound. This leaves the Fed very little margin of error before rates go where no U.S. central bank has ever gone before. Other central banks have plunged below the ZLB, but their example is hardly inspiring. EU growth is at best flat-lining, Japan remains a nation struggling with slow growth, and both regions have still-fragile banking sectors.
Ultra-low rates clearly mean extra-ineffective monetary policy – this has been proven since 2010 by the very slow pace of GDP growth, but at least there’s been some growth. The lower the rates, the less the growth no matter the conventional assumption that low rates spur recovery – they don’t when they’re this low because, when real rates are close to or below zero, real people change their saving, buying, and borrowing behavior. Lowering rates still farther means still slower growth or, worse, a recession unless fiscal policy rides to the rescue (which it won’t).
Lower rates also mean less profitable banks, which then leads to still weaker financial systems due to still more yield-chasing. In ultra-low or negative real rates, banks struggle to sustain profitability as net interest margin dips below capital and operational cost. Banks thus turn away from core growth-producing activity – making loans – to fee-based wealth management and an array of carry-trade operations seeking yield with little regard to risk. The lower the real short-term rate and the higher the capital and liquidity requirements, the better interest on reserves looks and the larger these central-bank holdings in concert with the bigger central-bank portfolio and the greater the fuel poured on equity markets in hopes of returns that are simply unachievable from long-term loans to low-risk customers.
Again, conventional wisdom has it that low rates are good for low-income people, but ultra-low rates are actually equality-destructive. For more regarding this see one of our recent Economic Equality blog posts, but the reason is simple: it’s hard enough for lower-income households to save for a margin of financial error, let alone for long-term wealth accumulation; add in the fact that hard-earned savings in the bank are actually hard-earned savings whittled down to less and less as rates get closer and closer to zero and it’s essentially impossible for a lower-income household ever to get ahead.
Even worse, most low income households have considerably more debt than durable assets. They of course don’t want to be under water, but most are because wage stagnation has combined with high living costs in equality-essential areas such as higher education, health care, and housing. As the Fed’s own data should tell it only two-thirds of U.S. adults are working as much as they want no matter how record-breaking the unemployment data with which the Fed comforts itself. Stunningly, eight percent of households earning over $100,000 skipped a medical treatment in 2018 due to its cost.
The idea behind ultra-low rates is that they spur banks to make more loans that then encourage consumption for durable goods that then stokes recovery which results in prosperity. Ultra-low rates short-circuit this virtuous circle at each link – ultra-low rates no longer spur affordable, long-term credit from banks because banks cannot profit thereby. The loans on offer for all but the wealthiest households are thus high-cost, short-term obligations from banks or – even more expensively – nonbank lenders dependent on vast stores of yield-chasing liquidity to keep average households liquid enough to pay each month’s bills at the long-term cost of still more debt. This debt drives very little durable-goods consumption for most Americans – as we’ve noted, key “marginal propensity to consume” expectations on which Fed policy is premised haven’t worked right for years. Consumption for most households thus is a hand-to-mouth existence in which savings dissipate when judged against inflation, debt grows, and wealth inequality continues to redefine the U.S. into a very few with a whole lot and all too many with pretty much nothing.