Special Notice 10

TRUMP IS WRONG ABOUT INTEREST RATES

By William J. Dodwell October 30, 2018

The president has been quite vocal about his opposition to the Fed raising short-term interest rates, even calling into question the wisdom of his appointing Jerome Powell as chairman. This concern no doubt stems from Trump’s historical sensitivity to interest rates as a real estate developer heavily dependent on borrowing. But now he should concern himself with the entire economy and the need to normalize interest rates long suppressed by monetary stimulus following the financial crisis. It is time to get off the medication and end the artificial comfort. (I was a lone wolf calling for rate normalization in my writings over five years ago.)

To stimulate the economy after the financial crisis the Fed kept short-term rates near zero for ten years. It also tried to suppress long-term rates artificially to stimulate consumption and investment. This was achieved through two years of quantitative easing by which it purchased over $3 trillion dollars of Treasury and mortgage bonds, the proceeds of which flooded the financial system with liquidity. As a result of the low rates, investors sought higher returns in risky financial assets such as stocks, exotic bonds and private-equity.

Barring an impending recession, it is long past the time to normalize artificially low rates to redirect capital away from the inflated financial economy and back to traditional bank loans, savings accounts, C/Ds and corporate bonds that finance the real economy of goods and services, as well as to compensate ordinary savers again. That has started to happen in response to the Fed’s rate hikes. For example, safe bank C/Ds now fetch about 3%, enough to compete with volatile stocks, which recently have declined substantially. But eventually, the Fed also has to unwind its $4 trillion-dollar balance sheet bloated by its aforementioned bond purchases. This will almost inevitably raise long-term rates as capital is withdrawn from the financial system to buy the bonds the Fed is selling. The Fed’s need to liquidate such a massive bond portfolio distinguishes today’s monetary circumstance from any in the past.

Why normalize interest rates while the economy is doing fine with 2% inflation, 3.6% unemployment, around 4% GDP growth, a 2.25% Fed benchmark rate, and a still relatively low 10-year Treasury bond yielding a little over 3 %? Because the Fed thinks the economy is flirting with overheating having reached its long-awaited 2% target inflation rate, the central bank wants to nip potential inflation in the bud. To that end, the Fed seeks an equilibrium rate that is neither stimulative nor restrictive. But some argue there is still enough slack in a possibly structurally changed economy not to warrant more rate hikes yet, as unemployment has uncharacteristically declined in the face of rising interest rates. Indeed, for the first time on record, available jobs substantially exceed job seekers this year.

However, recent growth is primarily a result of Trump’s tax cut and deregulation that have generated new private capital in the place of banks, as well as the capital markets that have been distorted by a yield-chasing escape from low interest rates. Eventually, the economy will need that diverted capital to support production and consumption for continued growth as the effects of lower taxes and deregulation abate. That means raising rates to make traditional saving and investment in traditional bank C/Ds, money market accounts, bank loans and investment-grade corporate bonds attractive enough again to fund the production and consumption of goods and services. Otherwise, that capital will continue to be locked up in the financial economy in the form of stocks and bonds. Current economic conditions probably call for short-term rates in the 4% range and a 10-year Treasury at about 5.5%. Mr. President, brace yourself.