On the Economy: Interest Rates.
The first in a series.
Beginning again.
Returning to where I started on the Internet with ParanoidBull in 2007 (6 years ago?!?) is a little uncomfortable. Putting a stake in the ground on issues where there is a lot of debate is difficult in general, but in an area where feedback is constant like the markets, it is even harder.
Nevertheless, I am excited to be back at it.
Where to begin.
I think the best place to start is at the beginning with a some basics on how I think the Economy and Markets work. Ray Dalio from Bridgewater has a good example of how he thinks the Economy works here (How the Economic Machine Works).
If you have limited time, starting with his stuff is probably a good idea because he is one of the best investors of all time.
However, I will also sketch some thoughts.
The Basics.
At its most basic level, the economy is comprised of the interactions between individuals making decisions about how to allocate their energy and resources.
Thus any explanation must must describe how people make decisions.
Fortunately, some of the ways people make decisions that are most important to understand are relatively straightforward.
The most powerful is also probably the most basic.
Interest Rates.
The post powerful force in the economy is likely interest rates.
Interest rates are the amount people have to pay to borrow money.
This concept applies to individuals, businesses, governments and any other entity would like to borrow money.
The Fed.
The Federal Reserve Board (known as The Fed) is the most important institution for determining what interest rates will be throughout the economy.
As the central bank of the U.S. economy, The board of governers of The Fed establishes rates that banks use to determine what interest rates they charge to everyone else. This is the key to “monetary policy.” From the Fed’s website:
The primary responsibility of the Board members is the formulation of monetary policy.
Thus, the decisions that The Fed makes about interest rates have very powerful effects. When they change interest rates, rates change for everyone throughout the economy.
People can debate the cause of the housing bubble leading up to 2007. However, one clear driver of the last credit cycle was the low interest-rates created by The Fed in the early 2000's. A post I wrote in ‘07 (What’s wrong with a Greenspan/Bernanke Put) discusses some of the backstory.
Briefly, Alan Greenspan, then chairman of The Fed, set interest rates at a low level to support the economy following the bursting of the .com bubble.
Today Mr. Greenspan’s successor, Ben Bernanke, is using a similar approach by keeping interest rates low to help the economy following the deep recession of 2008 and 2009.
As a result, over the last few years borrowing has increased and this has done a lot to prevent a deeper recession.
How Interest Rates Impact the Economy.
Understanding how interest rates impact the economy is an helps to explain why they are so effective.
Low Rates = More Borrowing.
The most basic impact of low interest rates is more borrowing.
When people are able to borrow for very low rates, it often justifies purchase decisions that they otherwise might not make.
The Housing Market.
The most obvious example of this occurrence is in the housing market.
Fortunately for the economy, housing prices have reversed their declines from 2007 through 2011 and are now rising again throughout the country. The below image showing March housing price increases highlights this point.
This piece from Calculated Risk discusses housing prices in further detail. Prices are still far from their highs but are on the rise again:
The reason that housing prices are rising again is that people are able to borrow a very low interest rates, and therefore they feel comfortable buying new homes or second homes.
This driver of demand has been a strong force for the economy, and it continues to be a strong force today. There are many positive effects of increased housing prices that I will discuss in another post, but whether though buying more stuff like cars and washing machines, or simply spending more, the economic effect of higher home prices is strong.
There are many other areas of the economy where low interest rates have effects.
Corporate Borrowing.
One important area where interest rates matter is corporate borrowing.
The effects on the corporate market are more complicated than housing.
But at its most basic level, when companies can borrow more they can do more things like acquisitions and investing.
Whether these decisions are made by small businesses expanding their operations or large companies doing mergers and acquisitions having low interest rates spurs economic growth.
Given the interest rates have been at a record low level since 2009 it is unsurprising the economic activity in United States has picked up significantly since then.
Interest Rates impact Investors.
Perhaps the biggest impact of low interest rates comes not from the direct purchase decisions borrowing entails, but rather it comes from the asset allocation decisions that interest rates create for investors.
Asset allocation describes how investors divide their money between different asset classes, including fixed income (bonds) and equities (stocks).
People want the amount of money they have to increase over time, and that is the driver behind most decisions around allocation.
People need to make money on their investments because they have increasing expenses.
This is most obvious in the case of a pension plan or an insurance plan. For these kinds of investors, there are clear estimates of cost increases over time. These estimated cost increases set a minimum for the amount that these institutions need to make on their investments.
Similarly, individuals expect increased costs over time, and thus, they need to make money on their investments.
Chase for Yield.
When interest rates are low, investing in fixed income brings lower returns. Simply put, if you lend money at a low rate of interest you will not receive very much interest. This means that government bonds (lending to the US government) or other large, safe fixed income investments, offer very low returns.
As a result, investors are forced to invest in less safe or more risky investments so that they can achieve the returns that they need.
This phenomenon is known colloquially as the “chase for yield”.
The “chase for yield” is the demand side of the loan market which creates supply for borrowing in the real estate and corporate markets. When investors want to lend more, the financial system has more money to give to borrowers.
Besides making money more available to borrowers, the “chase for yield” also typically causes investors to increase their allocations to more risky asset classes like equities.
In this economic cycle, because the recession was so deep, investors have been hesitant to increase allocations to equities because they have concerns about long-term economic viability.
Nevertheless, equity markets have risen to historic highs again due to the low interest-rate environment over the last few years.
What happens next?
It is safe to say that the low interest-rate policy of The Fed has had significant benefits for the economy both through the direct impact of increased borrowing (higher housing prices and more corporate borrowing) as well as through the indirect effect of asset allocation which has driven equity markets to all time highs.
This all sets the stage for where we are today - at the point where interest rates have started to rise again.
My next post will discuss what I think might happen as interest rates begin to normalize over the next few years.
