Is It Even Possible for the Fed to Raise Rates?

Federal Reserve Chairman Janet Yellin with Sec. of Treasury Jack Lew         PD-USGov

Janet Yellen and other members of the FOMC have expressed their desire to raise interest rates before the end of the year. The main reason they have given to do this is incredibly important, but not the most important one of all: to increase the U.S. savings rate. The reason they give for wanting increased interest rates is to cease “distorting markets” and insure “financial stability”, i.e. to stop inflating asset bubbles. The sooner they do this, the sooner changes in the stock market will reflect underlying economic reality and the capability of companies to earn revenue and grow. Instead, as the markets have pointed out to us over the last three weeks (see the current chart for the Dow Jones 30 Industrials below), what is really important to it is that the Fed continue to feed it “free money” at zero real interest rates. As soon as it became apparent at the beginning of October that the Fed would not raise interest rates, the stock market rallied and gained back much of what it had lost since the end of August. This despite the poor earnings season companies have had.

Yet an even more important reason is to provide an inducement for households and companies to save, as the source of future investments can only come from savings. The federal government contributes a huge amount of negative savings with their annual budget deficits, creating a savings hole that households and companies must fill. Over the last fifteen years or so, other countries – particularly China, Japan, Saudi Arabia, and Switzerland – have saved us from ourselves by plugging this big savings hole with the purchase of long-term U.S. debt. This God-send, however, is probably going to come to a screeching halt. These and many other countries are currently under financial pressure to defend their currencies and obtain scarce capital. In response they are dumping American debt on the international markets in the biggest such sell-off in fifteen years. Other countries are not going to be in any position to pick up the tab for our over-large appetites at least for the foreseeable future.

Yet at the same time the Federal Reserve has been discouraging savings by keeping both short and long-term real interest rates close to zero, as can be seen in the Federal Reserve Economic Database (FRED) graph shown below. In it I have represented short-term rates with the effective federal funds rate (blue curve), the long-term rates with the treasury inflation-indexed long-term average yield (maroon curve), and savings rates with the personal saving rate (green curve). Except for a spike in savings during and just after the Great Recession, the savings rate has been trending slowly downward under the influence of low real interest rates.

Even though the Federal Reserve stopped Quantitative Easing (QE) a year ago, they still maintain all the long-term assets they bought under QE on their balance sheets. Moreover, they do not plan on selling these assets until they begin lowering short-term rates. Until those assets are returned to the open market, such available assets will be scarce enough to maintain low long-term rates, at least for a while. In order to increase long-term interest rates, the supply of long-term bonds on the market would have to be increased to lower their price and thereby increase their yields. Perhaps the dumping of such debt by other countries will begin to raise long-term rates in the near future, but that is yet to be seen. Instead of giving an incentive to save, the zero real interest rates (especially the long-term rates) give not merely an incentive to spend, but to borrow and spend at the same time, an even more catastrophic situation for savings.

As we discussed in The Importance of Personal and National Savings and in The Solow-Swan Model and Where We Are Economically (2), savings must be at least enough to provide for replacement investment just to replace worn out and obsolescent equipment. If there is no more savings than that, there will be no new net investment to increase capital stocks and the GDP. If available savings are not enough to even replace lost capital stock, the GDP will most surely decrease because of the lost productive capacity. Given our desperate need for foreigners to pick up our debt, the international community certainly picked for us an inconvenient time to go into global crisis!

Yet, alarmingly, this is not what is concerning the Fed in picking a time to increase interest rates, at least not publicly. What they seem to be more worried about is stock market volatility and the fact that economic growth, employment, and the inflation rate are not as large as they would like. In addition, Janet Yellin has joined the International Monetary Fund chief, Christine Lagard, in warning that an increase in interest rates could create “panic and turmoil” in emerging markets.

These worries by the Fed, particularly as they are concerned with the conditions of international markets, are not as astounding as one would think from what I have written so far. In fact the Federal Reserve is caught in a “damned if they do, damned if they don’t” kind of situation. While they continue the threat of GDP decline due to insufficient savings if they do not increase interest rates, they also incur the risk of economic collapse if the considerable debt load carried by U.S. households, companies, and governments can not be serviced with increased interest rates. We have already seen how foreign governments are dumping large amounts of U.S. debt and will probably be disinclined to buy more in the near future. These actions all by themselves may make increases in long-term interest rates inevitable. If in addition the Fed increases rates even more, will that be the straw (or ton of bricks) that breaks the proverbial camel’s back? Presently, the national debt is approximately $18.2 trillion and the GDP is about $17.9 trillion. If the real long-term interest rates were increased from their current value of  about 1% to the long-term average of around 3% the increase in interest paid on the national debt every year would be 2% of the debt or about $0.4 trillion or $400 billion. That is just the increase in interest payments. The total interest payment would be 3% of the debt or $0.55 trillion or $550 billion. Current federal government revenues are approximately $3.5 trillion, so that the interest on the national debt would be about 15.7% of federal revenues. So far, this is not an insuperable problem, but this percentage can be expected to grow with time with continual low GDP growth and the usual deficit spending.

These kinds of considerations have led some to think that the Fed will not raise interest rates anytime in the foreseeable future. See here and here and here and here. Just consider the outlook provided by the September jobs report. Job growth was considerably less than expected, and while the unemployment rate was unchanged, wages did not increase appreciably and the labor participation rate is now at a new 38-year low. To cap it all off, the revisions to the August job report were large and downwards, from the original value of 173,000 new jobs down to 136,000 new jobs. Between the problems of keeping this economy growing at all and the problems of this nation financing its debt, it is no wonder the Federal Reserve is postponing rate hikes seemingly forever. And the damage to the country’s savings just keeps growing.

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