I read with alarm this morning, as I tucked into my poached eggs and sausage at the China World Hotel, Beijing, a CNBC article where a previous Fed economist (Marvin Goodfriend) was quoted as saying the Fed would have to target negative 2 per cent interest rates if the US entered a recession. See “Why the Fed might need to cut rates to minus 2 percent: Former Fed economist.”
At this point there are few signs the US will hit a recession any time soon though the US economy is certainly in what might be considered the down-slope from the last growth ‘peak’. Private firms operating margins are being cut which is about the only non-maladjusted metric (as in no government intervention) we can relay on as a sign.
But Mr Goodfriend’s point is logical: in some of the past recessions the Fed has had to push interest rates 2 per cent below long term rates. As it currently stands the 10 year interest rate is at around 1.5 per cent. So logically we should expect a record breaking negative 2 percent interest rate. But this is not going to work.
At near zero interest rates many ofthe economic and behavioral assumptions related to how the market works are distorted and are not working. If negative or near interest rates were a solution to growth and recovery, why hasn’t the US, UK, Europe or Japan bounced out of the current stagnation? With near zero or negative interest rates there are numerous distortions that suggest more of the same medicine would be, to say the least, daft and ineffective:
- Private industry does not open up their strategy play-books due to changes in interest rates. Business strategy precedes interest rates. A change in interest rates simply signals to the CFO or Treasurer that there might be alternative funding models for those strategies that need funding. In other words, if there are no strategies for growth, lowering interest rates does not seem to create them. Thus capital investment seems impervious to interest rates at such low levels.
- Cheap loans fund bad business habits. Where private firms have exploited near zero interest rates is to take out loans to fund both stock buy-backs and fund what I might call non-productive M&A. Stock buy-backs improve earnings per share (EPS) and thus reward executives according to their bonus scheme. But there is no change in the productivity of those firms led by those executives. As such the EPS metric is creating a drug that executives are finding hard to resist but it will rot their, and our, teeth. Second, so much M&A (which is running at record levels), is not actually tied to business strategy developed over time to drive improved performance. So much M&A is short-term or even knee-jerk planning from firms as opportunities to take out a competitor, muddy the market, or upset someone else’s strategy. Thus the companies being acquired are not necessarily sick or struggling. The cheap cash is being used ineffectively and not in accordance with creative destruction.
If you throw on top of this quantitive easing (QE) you can see that the vast majority of the free and cheap money goes to the well-off and investor class and this goes to explain the worsening inequality we see in the US. And top this lot off with anti-business political policies designed to:
- Slow growth of start-ups
- Favor the hegemony of very large, atrophied private business
- Force direct reallocation of funds to the less well-off versus policy to encourage expansion of employment of the same resources at a more productive and therefore higher paying level
One can see that the current medicine was only good insofar as it stalled the collapse of the financial system some 5 or more years ago. The medicine has gone off; it is now as much a poison to the economy.
Should the US fall into recession the Fed should urgently raise interest rates 2 percent. This will cause the following to happen:
- Private industry will look at the data and start to behave more logically. Funding choices will start to resemble normal conditions. To grow a business normal business strategy will return to the fore. Capital investment over cheap M&A should start to look more desirous.
- Stock buy-backs will slow thus forcing a more useful employment of the relatively cheap money. The stock market rally will peak and the economy will start to right itself. Not immediately but over a business cycle money will again flow to firms that grow through innovation and productivity, not intervention and policy.
- Other sovereign nations will have to respond with similar interest rate increases since the dollar will appreciate rapidly and so the Fed could lead the gradual return to normality around the world.
The challenge will be with government for it will and does today, get in the way. Polices, outlined above, are actually preventing growth. If we don’t remove them, the success of the Fed path, to raise rates to head-off a recession, will be at risk. But this risk is smaller than what will happen if the Fed cuts rates as Mr. Goodfriend suggests.