Tuesday , September 17 2019
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Interest rate decreases are a cure in search of an ailment

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Summary:
A question I got last week from the radio audience asked if interest rates needed to go down. In brief, my answer was, and remains, no. It is hard to find a metric by which the economy is not doing at least reasonably well. That is, as long you believe deficits do not matter. I happen to believe they do matter and that fiscal policy is a problem of epic proportions with no sign of resolution. Enter the President with his rhetoric against the Fed and little to no understanding about monetary policy goals, targets, and well anything else, based on his Twitter feed and public remarks. The press releases from the White House claim economic performance under President Trump is already the greatest in history. So what exactly is the rationale for rate cuts. First a comical answer and

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A question I got last week from the radio audience asked if interest rates needed to go down. In brief, my answer was, and remains, no. It is hard to find a metric by which the economy is not doing at least reasonably well. That is, as long you believe deficits do not matter. I happen to believe they do matter and that fiscal policy is a problem of epic proportions with no sign of resolution.

Enter the President with his rhetoric against the Fed and little to no understanding about monetary policy goals, targets, and well anything else, based on his Twitter feed and public remarks. The press releases from the White House claim economic performance under President Trump is already the greatest in history. So what exactly is the rationale for rate cuts. First a comical answer and then what I suspect is the real reason.

The comical answer

The White House approach to the economy seems to be what I call the movie theater popcorn approach. No longer can you buy a small, medium, or large popcorn. Now the sizes are large, super sized, and monstrous buckets of popcorn. Of course these are just small, medium, and large by a different name. So what is better than historic growth? Maybe we should call it pre-historic growth!

While growth is good claims of historic growth are always open to skepticism, criticism, and are falsifiable generally. This is not to say that growth is bad, just that it does not need to be historic to be good.

My suspicion about the real answer

Unfortunately this answer is not a joke. There are three parts to this. The President’s business experience involved typically significant amounts of debt financing. As a result he favors lower interest rates in general and thinks that this helps the business community as a whole. The problem with this is in an environment with low unemployment, and in many cases more job openings than unemployed individuals to fill the openings, lowering interest rates creates little short-run economic benefits. Longer term this could encourage some capital formation, though that is somewhat debatable given the disincentive to save when rates are low.

The second part of this answer is that the President and his advisors equate policy success with stock market performance. This is not a policy performance metric I like because there are too many factors that can influence equity prices beyond the policy instruments. Lower rates, all other things equal, will increase expected stock prices. Lower rates discourage investment in bonds. For example the 10 year Treasury note has been trading around 2% for some time. Who gives up money for 10 years for a mere 2%? People put more funds into equities (increasing demand for equities) and therefore prices and index values rise.

Third, the President feels like rates increasing from historic lows hampers his ability to take hard lines on trade policy. The fact that his trade policy increased costs and ate up significant amounts of the tax reductions to parts of the income distribution is not a welcome outcome for sure. The cost increases are a form of price increase (inflation) and the Fed naturally raises rates to deter inflation expectations. So the outcome of this trade policy (I use the term loosely) is predictable increases in rates.

Downsides

The downsides to all this are unclear because much of the research is ongoing. Do low rates increase income or death inequality? It seems like they might since savings vehicles at the low end of the income distribution are more limited. If you are not in the market you are likely missing out on the principle benefit of the low rates.

Summing up

I avoid the expression conclusion here because there are not really conclusions possible yet. I think an inability to generate outcomes desired through fiscal and trade policy leave the administration looking for scapegoats on this front. A better solution is better fiscal policy and control of debt and deficits. It is also to encourage Americans to save more (consume less). That is not a politically feasible suggestion and has not been for decades it seems. As a result we are left with a policy entity coming under intense political pressure to accommodate other policies failing to yield the desired outcomes and a failure to recognize the suggested policies can, and likely will, create reinforcing negative outcomes.

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