The Problem With Low Interest Rates

Fed Governor Jerome H. Powell spoke on “Low Interest Rates and the Financial System“. Monetary policy may sometimes face trade offs between macroeconomic objectives and financial stability. He argues that”low for long” interest rates have supported slow but steady progress to full employment and stable prices, which has in turn supported financial stability. But, there are difficult trade offs to manage. Over time, low rates can put pressure on the business models of financial institutions. And low rates can lead to excessive leverage and broadly unsustainable asset prices.

Whilst there are times when all of these objectives are aligned. For example, the Fed’s initial unconventional policies supported both market functioning and aggregate demand. More broadly, post-crisis monetary policy supported asset values, reduced interest payments, and increased both employment and income. All of these effects are likely to have limited defaults and foreclosures and bolstered the balance sheets of households, businesses, and financial intermediaries, leaving the system more robust.

But at times there will be tradeoffs. Low-for-long interest rates can have adverse effects on financial institutions and markets through a number of plausible channels.

After all, low interest rates are intended to encourage some risk-taking. The question is whether low rates have encouraged excessive risk-taking through the buildup of leverage or unsustainably high asset prices or through misallocation of capital. That question is particularly important today. Historically, recessions often occurred when the Fed tightened to control inflation. More recently, with inflation under control, overheating has shown up in the form of financial excess. Core PCE inflation remained close to or below 2 percent during both the late-1990s stock market bubble and the mid-2000s housing bubble that led to the financial crisis. Real short- and long-term rates were relatively high in the late-1990s, so financial excess can also arise without a low-rate environment. Nonetheless, the current extended period of very low nominal rates calls for a high degree of vigilance against the buildup of risks to the stability of the financial system.If we look at the channels listed here, the picture is mixed, but the bottom line is that there has not been an excessive buildup of leverage, maturity transformation, or broadly unsustainable asset prices.

Low long-term interest rates have weighed on profitability in the financial sector, although firms have so far coped with those pressures. Net interest margins (NIMs) for most banks have held up surprisingly well. NIMs have moved down for the largest banks
Return on assets, has recovered but remains below pre-crisis levels. Life insurers have substantially underperformed the broader equity market since 2007, suggesting that investors see the low-rate environment as a drag on profitability for the industry. Even so, data on asset portfolios do not suggest that life insurers have increased risk-taking. The same is true for banks. Both the regulatory environment and banks’ own attitudes toward risk following the financial crisis have helped ensure that the largest banks have not taken on excessive credit or duration risks relative to their capital cushions.

Low rates have provided support for asset valuations–indeed, that is part of their design. But I do not see valuations as significantly out of line with historical experience. Equity prices have recently increased considerably, pushing the forward price-earnings ratio further above its historical median.

And equity premiums –the expected return above the risk-free rate for taking equity risk– have declined, but are not out of line with historical experience.

In the nonfinancial sector, valuation pressures are most concerning when leverage is high, particularly in real estate markets. Residential real estate valuations have been in line with rents and household incomes in recent years, and the ratio of mortgage debt to income is well below its pre-crisis peak and still declining. In contrast, valuations in commercial real estate are high in some markets. And in the nonfinancial corporate sector, gross leverage is high by historical standards. Low long-term rates have encouraged corporate debt issuance at the same time that some regulations, particularly the Volcker rule, have discouraged banks from holding and making markets in such debt. High-risk corporate debt (the sum of high-yield bonds and leveraged loans) grew rapidly in 2013 and 2014, although growth has declined sharply since then.

However, firms also are holding high levels of liquid assets, so net leverage is not elevated. Firms have also lengthened their maturity profiles, and interest coverage ratios are high. Greenwood and Hanson’s measure of the share of high-yield debt in overall issuance is at a relatively low level. And this debt is now held more by unlevered investors. Overall, I do not see leveraged finance markets as posing undue financial stability risks. And if risk-taking does not threaten financial stability, it is not the Fed’s job to stop people from losing (or making) money.

As I said, a mixed picture. Low interest rates have encouraged risk-taking and higher leverage in some sectors and have weighed on profitability in others, but the areas where there are signs of excess are isolated.

Why Doesn’t Capital Always Flow to High-Growth Areas?

From St. Louis Fed, On The Economy Blog.

It seems natural that capital would flow into countries with higher capital productivity and economic growth. A recent Economic Synopses essay, however, explores why capital doesn’t always flow to the highest growth regions.

The Case of Latin America and East Asia

Economist Paulina Restrepo-Echavarria and her co-authors1 used capital flows to East Asia and Latin America following World War II as an example. Economic growth and capital productivity were quite high for East Asian countries during this period, yet little investment flowed into the region.

Conversely, Latin America received substantial capital despite neither capital productivity nor economic growth being high. The authors wrote: “In fact, Latin American economic growth substantially lagged behind the economic growth of virtually all other countries in Western and Northern Europe, the Asian Tigers and North America during this period.” (For figures showing these trends, see the essay “The Direction of Capital Flows.”)

International Capital Market Imperfections

Restrepo-Echavarria and her co-authors noted two reasons why capital doesn’t always flow to high-growth areas. The first is that international capital market imperfections, such as capital controls, and other impediments to international transactions prevented capital from flowing into high-growth regions. Put another way, local controls—such as tariffs, taxes, laws and quantity restrictions—prevented or discouraged capital from flowing into these high-growth regions.

The authors explained that, under this belief, more capital would have flowed to these regions had international capital markets been more open.

Domestic Imperfections

The other possibility given by Restrepo-Echavarria and her co-authors was that domestic imperfections, specifically domestic capital market distortions, played a role in preventing inflows of capital to high-growth regions.

The authors wrote: “So, for example, for the domestic (East Asian) capital market, credit controls, interest controls, privatization of banks, entry barriers to banking, and bank reserves and requirements, among others, kept international capital from flowing into East Asia.”

International Vs. Domestic Distortions

The authors turned to their working paper, “Bad Investments and Missed Opportunities? Postwar Capital Flows to Asia and Latin America,”2 for insight to some of the economic forces driving these flows.

They found that domestic distortions played a much larger role in accounting for international capital flows, though both international and domestic imperfections played significant roles. They also found that international capital market distortions have continued to play a role despite many countries liberalizing their international capital markets over time.

Restrepo-Echavarria and her co-authors concluded: “This ongoing distortion partly reflects the legacy of accumulated international capital market distortions over time. Thus, even if international capital market imperfections are ultimately removed, their history can continue to have very large impacts into the future.”

Notes and References

1 Restrepo-Echavarria’s co-authors were Lee Ohanian of UCLA and Mark L.J. Wright of the Federal Reserve Bank of Chicago.

2 Ohanian, Lee E.; Restrepo-Echavarria, Paulina and Wright, Mark L.J. “Bad Investments and Missed Opportunities? Postwar Capital Flows to Asia and Latin America.” NBER Working Paper No. 21744, National Bureau of Economic Research, November 2015.

Additional Resources

Do Central Bankers Know a Bubble When They See One?

From Mises Wire.

Between 2000 and 2008, two of the largest financial bubbles in history — in technology stocks and housing, respectively — suffered spectacular collapses. Opinions vary, but some market commentators believe at the peak of the tech bubble, total stock market capitalization exceeded 180% of US GDP. To put this in perspective, the tech stock bubble was over twice the size of the 1920s stock bubble!1 As large as the bubble in tech stocks was, it was child’s play compared to the housing bubble. When the US housing bubble collapsed, the credit losses were so large the entire worldwide banking system was considered to be in mortal danger.

One of the primary justifications behind the 1913 founding of the Fed was to prevent financial crises. Logic then dictates if a major motivation behind forming a central bank is the prevention of a financial crisis, then a financial crisis that breaks out under the nose of a central bank must be due — at least in part — to mistakes of that bank. The Fed’s mistakes and its subsequent leading role in causing the housing bubble will be seen by reviewing speeches given by Alan Greenspan and Ben Bernanke that praised the housing bubble era Fed. In addition, a review of statements made in the wake of the tech bubble’s collapse will reveal senior Fed officials taking positions diametrically opposed to positions Alan Greenspan claimed formed the basis for the Fed’s policy toward bubbles, namely, allowing bubbles to burst and dealing with the consequences later.

From its March 2000 peak to its October 2002 bottom the NASDAQ declined 80%. Throughout the 1990s no one cheered on the “new economy” more than the “maestro,” Alan Greenspan. After the bubble collapsed, Greenspan recognized a need to explain his and the Fed’s actions while the tech bubble grew. In August 2002 Greenspan gave a speech at the Fed’s conference in Jackson Hole. In this speech, which Jim Grant called “self-exculpating revisionism,”2  Greenspan offered this rationale for the Fed’s actions during the late 1990s:

The struggle to understand developments in the economy and financial markets since the mid-1990s has been particularly challenging for monetary policymakers. … We at the Federal Reserve considered a number of issues related to asset bubbles — that is, surges in prices of assets to unsustainable levels. As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact — that is, when it’s bursting confirmed its existence.

Less than two years later, in January 2004, Greenspan would congratulate himself on the apparent success of the Fed’s strategy. In doing so he would expose the Fed’s role in creating the far more ruinous housing bubble.

There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble’s consequences rather than the bubble itself has been successful. … As I discuss later, much of the ability of the U.S. economy to absorb these sequences of shocks resulted from notably improved structural flexibility. But highly aggressive monetary ease was doubtless also a significant contributor to stability.3

The “monetary ease” — slashing interest rates — Greenspan was taking credit for here was not helping the economy heal. Instead it was fueling an enormous bubble in housing whose negative consequences can best be described as world-altering.

One month later, in February, Greenspan’s partner in criminal economic ignorance, Ben Bernanke, gave a speech titled, “The Great Moderation.” In this speech Bernanke would, unknowingly, provide further evidence of the Fed’s enormous role in fueling the housing bubble. Bernanke claimed the Fed’s monetary policy was a source of stability and helped to reduce variations in economic output. The irony in giving this speechat this time should not be lost. Bernanke’s speech, like Greenspan’s, betrays a total ignorance of the enormous housing bubble that was only a few weeks from peaking. (Homeownership peaked in April 2004!) With just these two speeches, the criminal incompetence of the Greenspan/Bernanke and the leading causal role the Fed played in the housing bubble are demonstrated.

The Fed’s bubble befuddlement was not limited to a few speeches. For years on end Fed officials would take positions in contradiction to those established by Greenspan in his Jackson Hole, Wyoming, speech. For example, in July 2005 and in his capacity as head of the president’s council of economic advisors, Ben Bernanke was asked on CNBC if there was a housing bubble. He does not answer by saying bubbles can’t be seen until after they burst. Instead he says the following:

Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in housing prices on a nationwide basis, so what I think is more likely is house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it will drive the economy from its full employment path.

Later in October 2005, other Fed officials would also contradict Greenspan’s Jackson Hole speech. By then, homeownership had already peaked and the bubble had started to collapse. Amazingly,  two Fed economists investigated if there was a housing bubble. They — erroneously, of course — concluded home prices are high but not out of line.4 Obviously, if Fed officials were investigating to see if a housing bubble existed, then they believed it could be observed without first having to collapse.

Often, the most damning indictments of the bubble-era Fed come from other Fed officials. The most loquacious of these officials is current St. Louis Fed president James Bullard. Among the truths Bullard accidently exposed was the one concerning the obvious nature of the recent stock and housing bubbles. In a September 2013 interview Bullard said, The bubbles we had in the past were gigantic and obvious.5 Later, in a November 2013 interview, he said the housing and tech bubbles were blindingly obvious.”6

Amazingly, Alan Greenspan would eventually completely contradict Greenspan! Here is “Mr. Chairman,” as CNBC lovingly refers to him, discussing the Lehman Brothers failure in October 2013, “We missed the timing badly on September 15th, 2008 [the day Lehman Brothers went bankrupt]. All of us knew there was a bubble.”7 So which is it Mr. Chairman? Can bubbles be “obvious” or something “everyone knew” to exist before they pop — as you indicate here — or do you have to wait until after they pop to confirm their existence as you said in Jackson Hole?

Our brief review here demonstrates both the leading role the Fed played in creating the housing bubble — the January and February 2004 speeches — and the many mutually exclusive positions the Fed took on bubbles. In spite of being exposed in what is either a self-exculpating lie (the claim that bubbles can only be seen after they burst) or a sign of gross incompetence (the failure to see two of the largest financial bubbles in history), no Fed official has ever been asked to explain or rationalize the Fed’s contradictory positions on bubbles. Whether anyone from the Fed is ever forced to do so or not, it is obvious the Fed has much to answer for concerning all the economic hardships their bubble befuddlement has caused.

  • 1. Marc Faber, “The Monetization of the American Economy,” DailyReckoning.com, January 16, 2002 https://dailyreckoning.com/the-monetisation-of-the-american-economy/
  • 2. Jim Grant, Mr. Market Miscalculates (Mt. Jackson, Va.: Axios Press, 2008), pp. 241.
  • 3. “Risk and Uncertainty in Monetary Policy”, Remarks by Chairman Alan Greenspan at the Meetings of the American Economic Association, San Diego, California, January 03, 2004.
  • 4. Jonathan McCarthy and Richard W. Peach, “Is there a Bubble in the Housing Market Now?” Federal Reserve Bank of New York, 2005.
  • 5. Steven C. Johnson, “Fed Need Not Rush to Taper While Inflation is Low,” September 20, 2013, CNBC, http://www.cnbc.com/id/101051526/
  • 6. Matthew J. Belvedere, “Fed’s Bullard: $1-trillion a year QE pace torrid,” CNBC, http://www.cnbc.com/id/101166475
  • 7. Matthew J. Belvedere, “Bubbles and leverage cause crisis: Alan Greenspan,” October 23, 2013 CNBC, http://www.cnbc.com/id/101135835

How the U.S. Debt-to-GDP Ratio Has Changed

From The St. Louis Fed On The Economy Blog.

The new incoming president and Congress will likely engage in vigorous discussions about economic policies, including ones that will impact the national debt.

This post will give a thumbnail report on the recent history of this important macroeconomic indicator.

Economists typically measure the size of the national debt as the ratio of the total publicly held federal debt to the current level of the gross domestic product (GDP). By looking at only publicly held debt, the measure excludes government bonds owned by the government itself, such as those in the Social Security Administration’s portfolio. In scaling the debt by GDP, the resulting ratio accounts for the fact that a larger economy may more easily sustain a larger debt.

In the six or so years preceding the most recent recession, the debt-to-GDP ratio was relatively constant, around 34 percent. Although stable, it still sat relatively close to its post-World War II era peak experienced in the mid-1990s.

This stability was upset dramatically with the onset of the recession. The federal debt increased largely because falling incomes led to lower tax receipts. Also, unemployment and poverty rose, which increased the cost of social insurance programs such as Medicaid and unemployment insurance. The figure below shows average increases in the debt-to-GDP ratio for the past 10 years. (Each year is as of the second quarter.)

debt gdp ratio

In the two years containing the 2007-09 recession, the debt-to-GDP ratio grew by about 16 percentage points. By the second quarter of 2009, this ratio equaled 50 percent.

Following the recession, there was no (at least successful) effort to bring this ratio down. Instead, a number of factors, including the implementation of the $840 billion American Recovery and Reinvestment Act, caused the debt-to-GDP ratio to increase at a rapid pace. Between 2009:Q2 and 2012:Q2, the ratio increased by 6.2 percentage points on average per year.

In the following three years, a dramatic slowdown in the growth rate of the debt-to-GDP ratio returned. It grew by 1.4 percentage points on average per year over that period.

This relatively slow pace of increase seems to have quickened over the past year. Between 2015:Q2 and 2016:Q2, the ratio increased by 2.9 percentage points. During that one-year period, the debt-to-GDP ratio crossed the 75 percent level for the first time in most Americans’ lifetimes. 2016 put the ratio at its highest value since the WWII drawdown.

The End Is in Sight for the U.S. Foreclosure Crisis

From The St. Louis Fed.

The extended period of historically elevated rates of extreme mortgage distress and defaults in the U.S. housing market, better known as “the foreclosure crisis,” has faded from view as the economy continues its slow recovery. A deeper look at mortgage performance data from the Mortgage Bankers Association suggests the crisis has ended in some states, while it is not quite over yet for the nation as a whole. However, the end is near. The condition of current mortgage borrowers considered as a group—nationwide or state by state—is once again comparable to the period just before the Great Recession and the onset of the foreclosure crisis.

As explained below, we identify the fourth quarter of 2007 as the beginning of the nationwide foreclosure crisis; we judge that it had not yet ended as of the third quarter of 2016. Based on current trends, we expect it should end in early 2017. This nearly 10-year nationwide foreclosure crisis will have been longer and deeper than anything we’ve seen since the Great Depression. As many as 10 million mortgage borrowers may have lost their homes.

Some states and regions have experienced severe recessions and housing crises worse than the nation as a whole, while others have suffered less. The result is a wide range of foreclosure-crisis experiences. Among the seven states that make up the Eighth Federal Reserve District, we conclude that only Missouri and Tennessee have exited their foreclosure crises as of the third quarter of 2016 when judged by a national standard; Arkansas likely will follow soon. Meanwhile, Illinois, Indiana, Kentucky and Mississippi may be a year or more away from exiting. If we take into account long-standing differences in mortgage conditions across states, our conclusions are more favorable. Only Illinois has failed to return to its own pre-crisis level and, even there, the end of the foreclosure crisis appears imminent.

Using Data to Define the Start and End of the Foreclosure Crisis

We define the recent foreclosure crisis as the period during which the share of mortgages that are seriously delinquent (90 days or more past due) or in foreclosure in a particular state or nationwide was above the worst level experienced in recent memory (i.e., not including the Great Depression).2 To recognize secular changes in mortgage practices and performance—in particular, steadily rising levels of outstanding mortgage debt and a proliferation of new types of mortgages—we calculate a crisis threshold for the nation and for individual states as the combined rate of serious delinquency plus foreclosure inventory that first exceeds its own five-year moving average by an amount greater than any previously experienced in the data.

We define the end of a foreclosure crisis as the first quarter in which the combined rate drops below its initial crisis reading.

The Foreclosure Crisis at a National Level

Mortgage Bankers Association data show that the U.S. foreclosure crisis started in the fourth quarter of 2007, when the combined rate reached 2.81 percent, a level that exceeded its five-year moving average by 0.67 percentage points, more than any other previous level. Given that the combined rate stood at 3.2 percent in the third quarter of 2016, this suggests that the nationwide foreclosure crisis has not yet quite ended. However, based on the rate of decline in recent quarters, the data-defined end of the crisis on a national scale is likely to occur as soon as the first quarter of 2017. Indeed, comparable data from Lender Processing Services, as shown in the recently released Housing Market Conditions report from the St. Louis Fed, also suggest the foreclosure crisis is nearing its end.

It Has Been a Long, Hard Slog

However it is defined, the mortgage foreclosure crisis will go down as one of the worst periods in our nation’s financial history. For the nation as a whole, the crisis will have lasted almost a decade—about as long as the Great Depression. For most states in the Eighth District, the slightly shorter duration of their foreclosure crises, when measured against their own data trends, has been offset by higher average rates of serious mortgage distress seen even in non-crisis periods.

The conclusion that the foreclosure crisis has been a long, miserable experience for many is unavoidable. And many Americans continue to suffer lasting financial, emotional and even physical pain as a result of their experiences during this time. However, a look at the data today shows that, at least, the end is in sight.

The Fed Admits The Good Old Days Are Never Coming Back

From Zero Hedge.

The dots that the FOMC members contribute to the plot indicate their expectations for the federal funds rate.

Technically, it’s what they think rates should be, not a prediction of what rates will be on those dates. Is that a forecast? You can call it whatever you like. I think “forecast” is close enough.

But before we analyze the whatever-you-call-it, let’s look back at the not-so-distant past.

Here’s a rate history of the last 16 years:

I’ve highlighted this fact before, but it’s worth mentioning again: In 2007, less than a decade ago, the fed funds rate was over 5%. So were the interest rates for Treasury bills, CDs, and money market funds.

People were making 5% on their money, risk-free. It seems like ancient history now, but that year marked the end of a halcyon era of ample rates that most of us lived through.

The chart below shows historical certificate of deposit rates—but remember, you could put your money in a money market fund and do better than the six-month certificate of deposit yield, back in 2007.

Today’s young Wall Street hotshots have never seen anything like that. To them, the jump from 0.5% to 0.75% must seem like a big deal. It’s really not. If the chart above were a heart monitor readout, we would say this patient is now dead and that last blip was an equipment glitch.

The point to all this is that these near-zero rates to which we have all adapted are by no means normal or necessary to sustain a vibrant economy.

We’ve done fine with much higher rates before. They are even beneficial in some ways—they give savers a return on their cash, for instance. But there are likely to be consequences once we embark on this rate-increase cycle.

The FOMC cast members are all old enough to remember those bygone days of higher rates as well as I do. So, we would think they might at least foresee a return to normalcy at some point in the future.

Not so.

The FOMC members see nothing of the sort

Here is the official dot plot published by the FOMC. (I have included their preferred heading so that no one complains about my calling it a forecast, even though that’s what it is.)

Each dot represents the assessment of an FOMC member. That group includes all the Fed governors and the district bank presidents. All 17 of them submit dots, including the presidents of districts who aren’t in the voting rotation right now. There would be 19 dots if the two vacant governor seats had been filled.

That flat set of dots under 2016 represents a rare instance of Federal Reserve unanimity: They all agree where rates are right now. (See, consensus really is possible.) The disagreement sets in next year. For 2017, there’s one lone dot above the 2.0% line, but the majority (12 of 17) are below 1.5%.

Nevertheless, it will be a much different year than this one if they follow through. The dots imply that the fed funds rate will rise a total of 75 basis points next year.

Presumably, that would be three 25 bps moves, but they can split it however they want. They could ignore their expectations completely, too. This time last year, the FOMC said to expect a 100 bps rise, or four rate hikes, in 2016. We got only one.

Follow the dots on out and you see that their assessments trend a little higher in the following two years, and then we have the “longer run” beyond 2019. Most FOMC participants think rates at 3% or less will be appropriate as we enter the 2020s.

The most hawkish dot is at 3.75%.

Think about what this means

Today’s FOMC can imagine raising rates only to the point they fell to about halfway through their 2007–2008 easing cycle. They see no chance that overnight rates will reach 5% again. None.

Here is another view of the same data, that shows how the dots shifted.

Looking at each set of red (September) and blue (December) dots, we see only a slightly more hawkish tilt than we saw three months ago. The “Longer Term” sets are almost identical—two of the doves moved up from the 2.5% level, while the two most hawkish hung tight at 3.75% and 3.50%.

That word hawkish is relative here. By 2007 standards, these two voters are doves. But, Toto, I’ve a feeling we aren’t in 2007 anymore.

Federal Reserve offers vote of confidence in US economy (so there’s no reason to panic)

From The Conversation.

No one was really surprised that the Fed raised its target interest rate by one-quarter of a percentage point. Yet some people are really upset about it and worried this will slow down a fragile economic recovery.

I would disagree with that view for several reasons.

My biggest reason is that a quarter-point is not a very big change. I recognize that the economy isn’t yet chugging along at full steam yet, but the Fed acknowledged that by making the smallest increase it could and implying that it’s unlikely to be followed by another increase in January or even in March or May. If we did get another increase that soon, it would only be in response to clear signs of strong economic growth in the U.S.

No magic wand

We should remember that monetary policy is not a magic wand.

Changes like this take time to percolate through the economy and are made with the expectation that their full impact won’t be experienced for several months. What the Fed really said today was that it fully expects that the economy will continue to strengthen over the coming three to six months.

One argument made by those against today’s rate hike (and any others the Fed might be considering) is that there’s still considerable slack in the U.S. labor market. Put another way, our recovery from the Great Recession hasn’t yet reached everyone – meaning a lot of people are still out of work or can’t get the jobs they want – and we should keep rates as low as possible to continue to encourage businesses to expand and to hire more workers.

There’s some merit to this concern. The Bureau of Labor Statistics’ broadest measure of labor underutilization is still at 9.3 percent (including discouraged workers and people who can’t find full-time work). While that certainly sounds bad, this rate was over 17 percent during the worst parts of the recent recession, so we’ve made tremendous progress.

The economy continues to create jobs at a healthy pace – adding 178,000 jobs last month and adding an average of 188,000 per month over the past year. In other words, the Fed is giving our economy a vote of confidence that this level of job creation is likely to continue.

Why a stronger dollar isn’t a concern

Another big concern is that this increase will lead to the dollar getting even stronger in international currency markets.

There are several reasons for the dollar’s rise – most of them have nothing to do with monetary policy. This means that the dollar would continue to strengthen even if the Fed did nothing. One way to look at the dollar’s recent rise is the world is saying they are confident that the U.S. economy will continue to outperform most other regions.

A rate increase is probably a good thing right now because we’ve had the lowest interest rates ever for nearly a decade, and loose monetary policy has probably done about as much as it can for now. It’s not that I think higher rates will be even more helpful, but that I think low rates aren’t likely to help the economy much anymore.

I’d like to see rates return to a slightly higher level so that we have the flexibility to decrease them if needed. In the past, we’ve relied almost exclusively on monetary policy to moderate the ups and downs in the economy and that flexibility isn’t available to us right now.

Some risks

The Fed has certainly heard President-elect Donald Trump talk about his ideas for significant tax cuts and infrastructure investments. Congress has expressed mixed feelings about these proposals, so it’s not certain that they will actually happen. If they do, each of these would boost the economy some, although not right away.

Another reason to raise rates earlier rather than later stems from the beliefs of some economists that loose monetary policy has been a causal factor in several past recessions.

I’m not a strong proponent of this view, but I agree that this potential exists. I’m a more worried about the potential for inflation when banks decide to start using the US$2 trillion they have saved up and deposited at the Fed, but that’s a conversation for another time.

Looking ahead to 2017, a lot will depend on how well the new administration does and how successful they are at getting their proposals through Congress. Assuming the economy continues to plod along, I’d expect another quarter-point increase in mid- to late 2017.

Author: Robert Rebelein, Associate Professor of Economics, Vassar College

Yellen’s Fed faces a tricky rates dilemma in 2017 that may end up tripping up Trump

From The Conversation.

Editor’s note: The Federal Reserve’s policy-setting committee raised its target interest rate a quarter-point to a range of 0.5 percent to 0.75 percent, only the second such move in eight years. In the widely anticipated decision, the Fed signaled it anticipates raising rates another 0.75 percentage point in 2017 – likely in three quarter-point hikes – a faster pace of tightening than previously expected. We asked two experts to analyze what this will mean for the not too distant future.

Between a rate hike and a hard place

Steven Pressman, Colorado State University

As almost everyone expected, the Fed raised interest rates, and banks will now pass their higher costs on to companies and consumers, leading to higher borrowing rates throughout the economy.

The bigger issue, however, concerns likely increases in 2017. Here the message was somewhat ambiguous. While indicating that three 0.25 percentage point increases were possible in 2017, compared with the previous guidance that only two rate hikes were likely next year, Janet Yellen stressed in her press conference that any changes would be small and remain highly uncertain. She continually noted that the Federal Reserve would have to adjust its thinking in 2017 based on actual economic circumstances.

The Federal Open Market Committee press release was likewise rather ambiguous. It indicated that monetary policy “remains accommodative” and that future adjustments will depend on the “economic outlook” and “incoming data.”

The important takeaway from all this is that it is really not clear what the Fed will do next year. The reason for this is that the Fed is damned if they raise interest rates considerably in 2017 and damned if they don’t.

On the one hand, debt remains a Damocles sword hanging over the U.S. economy, and a rise in rates could cut the thread. Household debt is approaching levels reached before the 2008 financial crisis, which suggests that households may be approaching the point at which they cannot repay their loans – something that can bring down banks and the U.S. economy. And real median household income remains US$1,000 below pre-Great Recession levels and $1,500 below its all-time peak in the 1990s. U.S. households, responsible for 70 percent of all spending in our economy, face a double squeeze that cannot continue.

Worse still, many households remain underwater on their mortgages. Others are slightly above water, unable to come up with the realtor commissions and moving expenses that would let them sell their home and find a more affordable place to live. Higher interest rates will worsen this problem by reducing home affordability and prices.

On the other hand, at some point, perhaps soon, the U.S. economy will enter another recession. If the tax cuts and spending increases proposed by President-elect Trump get enacted, a ballooning budget deficit (made worse by the onset of a recession) will hinder the ability of fiscal policy to create jobs. Interest rate cuts then become our only viable policy tool.

So with rates already near zero, central banks cannot lower them very much. For this reason, they want to load up on ammunition, and push them up some. At the same, time they fear the consequences of doing this. Today’s Fed guidance was ambiguous for a good reason – they are caught on the horns of a nasty dilemma.

How higher rates will hurt Mexico and tie up Trump

Wesley Widmaier, Griffith University

Donald Trump has promised to build a wall and make Mexico pay. But the Fed’s decision to continue raising rates higher – known as tighter monetary policy – may push Trump to send money abroad, even to Mexico, a common target of his scorn on the campaign trail.

History shows that monetary policy decisions can have complex effects.

With a U.S. recovery continuing, the Fed’s tightening is raising fears of a reaction similar to the 1994 Mexican peso crisis. If this happens, the Trump administration may face hard choices.

Just like today, early 1994 saw then-Fed Chair Alan Greenspan move from an easy money stance and resume raising rates. Greenspan argued that the stock market was flirting with a bubble, bank earnings were low and inflation might revive. Raising interest rates was seen as the solution to ease the market bubble, pull money back from emerging markets and tamp down on a return of inflation.

However, the Fed’s moves back then had unexpected effects. Like many middle-income countries today, Mexico had issued dollar-denominated tesobonos to insure against exchange rate risk. But as the Fed raised rates over 1994, Mexico found it harder to make payments on the bonds, prompting a run on the peso.

The U.S. responded with a $50 billion rescue. Dollars had to flow south – or a Mexican collapse might send immigrants north.

Of course, this is not a dynamic unique to Mexico. As Fed moves raise the cost of servicing dollar-denominated debts, increased debt-servicing costs could have global repercussions.

However, Mexico’s economy has been a subject of some recent concern. If Fed restraint heightens those concerns, Trump may need to forget the wall – and pay Mexico instead.

Fed Lifts Rate As Expected

The Fed has lifted its target rate by 0.25%, the second move up in 10 years. They signalled only gradual increases in the federal funds rate which is likely to remain, for some time, below levels that are expected to prevail in the longer run.

Information received since the Federal Open Market Committee met in November indicates that the labor market has continued to strengthen and that economic activity has been expanding at a moderate pace since mid-year. Job gains have been solid in recent months and the unemployment rate has declined. Household spending has been rising moderately but business fixed investment has remained soft. Inflation has increased since earlier this year but is still below the Committee’s 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation have moved up considerably but still are low; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will strengthen somewhat further. Inflation is expected to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further. Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1/2 to 3/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.

US Regulators Say Wells Fargo Has More To Do

The Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Board on Tuesday announced that Bank of America, Bank of New York Mellon, JP Morgan Chase, and State Street adequately remediated deficiencies in their 2015 resolution plans. The agencies also announced that Wells Fargo did not adequately remedy all of its deficiencies and will be subject to restrictions on certain activities until the deficiencies are remedied.

Resolution plans, required by the Dodd-Frank Act and commonly known as living wills, must describe the company’s strategy for rapid and orderly resolution under bankruptcy in the event of material financial distress or failure of the company.

In April 2016, the agencies jointly determined that each of the 2015 resolution plans of the five institutions was not credible or would not facilitate an orderly resolution under the U.S. Bankruptcy Code, the statutory standard established in the Dodd-Frank Act. The agencies issued joint notices of deficiencies to the five firms detailing the deficiencies in their plans and the actions the firms must take to address them. Each firm was required to remedy its deficiencies by October 1, 2016, or risk being subject to more stringent prudential requirements or to restrictions on activities, growth, or operations. The review and the findings announced today relate only to the joint deficiencies identified in April 2016.

The agencies jointly determined that Wells Fargo did not adequately remedy two of the firm’s three deficiencies, specifically in the categories of “legal entity rationalization” and “shared services.” The agencies also jointly determined that the firm did adequately remedy its deficiency in the “governance” category. In light of the nature of the deficiencies and the resolvability risks posed by Wells Fargo’s failure to remedy them, the agencies have jointly determined to impose restrictions on the growth of international and non-bank activities of Wells Fargo and its subsidiaries. In particular, Wells Fargo is prohibited from establishing international bank entities or acquiring any non-bank subsidiary.

The firm is expected to file a revised submission addressing the remaining deficiencies by March 31, 2017. If after reviewing the March submission the agencies jointly determine that the deficiencies have not been adequately remedied, the agencies will limit the size of the firm’s non-bank and broker-dealer assets to levels in place on September 30, 2016. If Wells Fargo has not adequately remedied the deficiencies within two years, the statute provides that the agencies, in consultation with the Financial Stability Oversight Council, may jointly require the firm to divest certain assets or operations to facilitate an orderly resolution of the firm in bankruptcy.

The Federal Reserve Board is releasing the feedback letters issued to each of the five firms. The letters describe the steps the firms have taken to address the deficiencies outlined in the April 2016 letters. The feedback letter issued to Wells Fargo discusses the steps the firm has taken to address its deficiencies and those needed to adequately remedy the two remaining deficiencies.

The determinations made by the agencies today pertain solely to the 2015 plans and not to the 2017 or any other future resolution plans. In addition to requiring that the firms address their deficiencies, in April the agencies also identified institution-specific shortcomings, which are weaknesses identified by both agencies, but are not considered deficiencies.

The agencies in April also provided guidance to be incorporated into the next full plan submission due by July 1, 2017, to the five firms, as well as Goldman Sachs, Morgan Stanley, and Citigroup, and will review those plans under the statutory standard. If the agencies jointly decide that the shortcomings or the guidance are not satisfactorily addressed in a firm’s 2017 plan, the agencies may determine jointly that the plan is not credible or would not facilitate an orderly resolution under the U.S. Bankruptcy Code.

The decisions announced today received unanimous support from the FDIC and Federal Reserve boards.

Feedback letters:
Bank of America (PDF)
Bank of New York Mellon (PDF)
JP Morgan Chase (PDF)
State Street (PDF)
Wells Fargo (PDF)