Low Rates Aren't a Central Bank Providing Accommodation

Low Rates Aren't a Central Bank Providing Accommodation
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It was an especially tense exchange. The Fed Chairman was trying to withstand withering criticism from an openly hostile and substantial segment of Congress. It was the hot summer of July 2012, after two QE’s and a Twist some of the politicians, anyway, wanted some answers. They weren’t getting any.

Jeb Hensarling was the most direct. He began by dryly recalling that 2008 wasn’t just yesterday, already four years in the past by then. Where was the recovery that had been promised?

“MR. HENSARLING. I think it is an inescapable conclusion that we have seen the greatest monetary and fiscal stimulus thrown at an economy in our history, and what do we see but 41 months of 8 percent-plus unemployment, 14.9 percent real unemployment, if we look at those who have left the labor force and those who are seeking full-time employment. We have anemic GDP growth, probably half of what it should be by historic standards. And my interpretation of your testimony is you are predicting much of the same. Why shouldn't the American people come to the inescapable conclusion that we have either had a profound failure of monetary policy or a profound failure of fiscal policy, and which is it?”

With Hensarling unassailable in his statistical recall, Bernanke would fall back time and again, as he always had, on the cliché of “jobs saved.” There is never a failed monetary policy in the minds of any central banker; there can’t be. After all, their complex, elegant econometric models all uniformly calculate nothing but benefits from “stimulus.” Serious benefits.

And since the programs are designed from what the models calculate, if the policy didn’t make anything better, then they must have kept the situation from being worse. Impregnable logic, just circular.

In no time, the Congressman would zero in on the crux of the issue. It’s called “stimulus” over and over, yet there wasn’t any discernable evidence the economy had been stimulated. Quite the contrary; all the data agreed the “recovery” had been the slowest (worst) in history, which, following the biggest contraction (to that point) since the 1930’s, had made it the worst of every possible world.

This despite what Fed reports showed had been $1.7 trillion in so-called excess liquidity in the form of bank reserves. These had been created and maintained as an accounting byproduct of quantitative easing (QE) as well as Twist. With the economy already betrayed by its curious lack of recovery up to the middle of 2012, there were the added prospects for it to suffer another setback (which it did later in the year).

Indeed, by that time talk of QE3 was everywhere. Federal Reserve officials including Bernanke were no longer denying the possibility (QE3 was announced just two months later). You could at least understand Congressman Hensarling’s indignation in this context.

“MR. HENSARLING. And so I am trying to figure out, what is it that--on the Federal Reserve menu, what would two more Operation Twists and two more QEs, even if you supersized them, achieved that haven't already been achieved?”

That’s what science is; you try something and if it doesn’t produce the desired results you know it didn’t work. You stop doing it. In terms of QE, a third go-round would’ve at least proved it couldn’t have been “quantitative.”

Bank reserves at any level, Bernanke replied, “are not the issue.”

“CHAIRMAN BERNANKE. The issue is the state of financial conditions. And we are still able to lower interest rates, improve, broadly speaking, asset prices, and that provides some [stimulus] incentive.”

In the textbook everyone uses, lower is always better where interest rates are concerned. It is the central basis by which all of this madness continues. We hear it over and over, the lie repeated ceaselessly by officials and then regurgitated by the financial media which betrays the decency of its audience swallowing it and repackaging it for them wholesale.

The reason this doesn’t fall under more badly needed scrutiny is a combination of fear and apathy; fear, in that no one wants to challenge Economists and central bankers who, when faced with data and evidence, immediately fall back on their mathematics which they know no one else does. Competency in creating regressions and checking for heteroskedasticity in them is substituted as useful knowledge of the subject matter - which is money and the economy, not this other stuff.

Apathy is the real substitute; lower interest rates intuitively sound like they should be helpful, therefore, given all that math no layperson can make heads nor tails from, a generous benefit of the doubt is applied by the general public. I mean, they sound really smart.

No one really stops to think about it in detail. Are lower interest rates really much of a help? Before even getting to that, does the Fed or any central bank actually control them?

The answer to both questions is a surprising, but no less hard, NO! History has shown, conclusively, that low interest rate environments become that way first because of major central bank failures - such as gross monetary panics that spread worldwide despite central bankers claiming no such thing should be possible in the first place under their skillful guidance.

Second, and more importantly, low rate environments persist because monetary policies do nothing to dislodge the underlying problem. And if you don’t fix it, that’s how you end up with angry Congressmen correctly citing (for once) economic statistics which conclusively demonstrate how repeated policy efforts only ever come up way short.

We are all taught from the very beginning that low interest rates are equivalent to stimulus; that the cost to borrowing is what ultimately matters. Thus, reduce the interest companies or even banks pay for credit and funding, ipso facto, more borrowing and therefore economic activity.

While it is true that low rates mean lower costs for borrowing, what’s left out of that proposition is everything that’s important.

To begin with, what do we mean when we say interest rates are low? Short term rates? Long term? Risk-free? Risky? Bonds? Loans? Monetary equivalents?

Credit markets are no single monolith; they are merely assumed to be by, again, the same Economists who are proficient in statistical modeling rather than the subject those models purport to study. I’ll give you a specific example of what I mean.

In June 2003, Alan Greenspan’s FOMC debated the prospects for the zero lower bound after having witnessed what they all regarded as QE’s failure in Japan. Committee members would eventually “reason” the Bank of Japan was at fault in its execution rather than admitting the idea was fatally flawed from the very beginning.

And the reason it had been fatally flawed is that no monetary official anywhere can honestly claim to be able to define let alone measure the money supply. Bank reserves are, instead, an article of faith that not even central bankers are willing to support; as Bernanke inadvertently admitted to Congressman Hensarling.

In lieu of technical skills about the money supply, central banks have since the seventies instead created complex theories (and, more to the point, the equations for them) for the behavior of interest rates out of whole cloth.

The “maestro” in June 2003 had said:

“CHAIRMAN GREENSPAN. It’s really quite important to make a judgment as to whether, in fact, yield spreads off riskless instruments—which is what we have essentially been talking about—are independent of the level of the riskless rates themselves. The answer, I’m certain, is that they are not independent.”

In other words, the Fed sets one riskless rate at the short end which then gets repriced throughout the entire yield curve (the mythical series of one-year forwards) in the same way. From there, the broader credit markets take these cues and set the rest of the interest rate complex depending upon that single input. In theory, it all can be reduced to a sole rate which just so happens to be under the central bank’s control.

It sounds so easy; for the most breathtakingly complex and far-reaching global financial system and the incomprehensibly large global economy it is meant to serve.

Quantitative easing is nothing more than applying the same theory once confronted with the zero lower bound; how a monetary authority gets around the nominal constraint imposed by positive rates. They increase inflation expectations by allowing people to think monetary policy is being overly aggressive and “stimulative” however people think they may be doing it (especially if the public believes it amounts to “money printing”, which not even central bankers believe).

Thus, while nominal rates stop at zero, real rates can go negative – which is what monetary policy aims to achieve. Because, again, it holds to the theory that rates are not independent of it and lower is always better.

There is, however, no empirical basis for this fiction. Instead, starting in 2004, Alan Greenspan was caught testifying before Congress in early 2005 about the interest rate “conundrum” which had already defied it. The Fed was hiking its short-term policy rate, the one for federal funds, but that’s as far as it went; not even getting to Step 2 of the theory, the rest of the yield curve wasn’t moving the same way at all.

Ever since, bond and credit markets have been making a mockery out of every central banker around the world. Just because it wasn’t reported like that in Bloomberg or the Wall Street Journal doesn’t make it any less true (and verifiable).

Take, for example, a period from history in which no sane person would ever confuse with overly aggressive monetary stimulus leading to a credit bubble. An age when interest rates were low but economic and financial activity remained profoundly suppressed throughout.

I’m referring, of course, to the Great Depression. Contrary to popular perception, interest rates moved down and kept going lower throughout it. Not just those for riskless assets, as I can get some people to understand at times, but also those for risky assets, too!

Yep, corporate bond yields on even junk-rated issues declined throughout the thirties. They had spiked in the initial crash, and again in 1937, but each time to lower highs and in general rates kept to their overall downward trajectory. By the end of the decade, published junk yields were substantially lower than they had been during the peak of the twenties credit bubble.


I wrote about this at our webpage earlier last month:

“During times of systemic illiquidity, like the thirties or today, though they may be low-rated bonds they are still bonds. That means there must be, to some degree, a dependably liquid market for them (which is aided by the survivor bias)…Alongside falling yields on the safest instruments, the fact that these things are still liquid instruments gives them a leg up on other forms that you don’t see because they don’t have a market – and therefore shrank even more than the bond market.”

Overwhelming demand for liquid assets of any kind; the key word is “liquid”, which reveals the whole game for that is what we are taught to associate with central banks.

This makes sense during the 1930’s because we know very well about the Great Depression and the monetary shortfall which made it – both in kicking the thing off and then maintaining it for so long. There was a high level of liquidity preference which is how we explain, along with credit risk at times, the actual behavior of interest rates. Central banks only factor for their repeated missteps.

In other words, while low yields on riskless assets, the safest and most liquid instruments, make perfect sense at times like that so, too, do low yields on risky instruments so long as they are also liquid.  When comparing possible investment choices, does a bank make an illiquid loan to a questionable borrower, or buy and hold the marketable bond of a potentially even more uncertain issuer?

The bond, every time. Liquid, liquid, liquid.

And those are just the interest rates we see; what we often miss, and what can never be printed in the paper or on a financial website, is all the possible credit availability that just vanishes, disappears without a trace. While big companies enjoy the privilege of issuing as much debt as they might want, particularly in bonds, and during liquidity-starved times they want to issue as much as possible, what about mid-sized and small companies who don’t make it into any interest rate index?

The yield on Corporate America’s bonds tumble while increasingly any mid-level company gets shut out of the credit market entirely. Liquidity bias also towards the bigger issuers at the expense of everything else; investors will buy every last bond at higher and higher prices offered by Big Inc. while completely avoiding Middle LLC in every credit format. “The” interest rate falls but for all the “wrong” reasons. Liquidity bias in the marketplace, not monetary policy, is what drives them downward.

The interest rate fallacy in its details.

When that happens, sorry Chairman Bernanke, it means nothing good. And if you think this is nothing more than an isolated case with America’s Great Depression experience, there are innumerable other examples (cough, Japan). Including, yes, the US in…2020.

From Bloomberg just yesterday:

“Unprecedented government stimulus has allowed more companies to borrow at lower rates than ever before. Yet amid the credit boom, smaller firms that power America’s economic engine are often being shut out, hamstringing the recovery just as it begins. [emphasis added]”

Is it a credit boom if most of what makes the economy work hasn’t participated in it because it can’t? That’s not a boom! There is everything wrong in just this one paragraph, starting with the myth of “government stimulus”; and there’s more:

“Banks are tightening conditions on loans to smaller firms at a pace not seen since the financial crisis, while many direct lenders that have traditionally focused on the middle market are pulling back or turning to bigger deals instead.”

Dear Lord, it is the textbook liquidity preferences which I’ve just laid out that, ironically, don’t appear in any Economics textbook; thus, why there is this unbelievably confused Bloomberg article desperately trying to report on real news which to its writer seems to be a contradiction.  There is none; Economics gets it all wrong on money and interest rates.

The very fact that big companies are borrowing dizzying sums isn’t a good thing, either; they are, like their forerunners did during the thirties, building up as big of a liquidity cushion as they possibly can get away with. Not because they intend on splurging on productive investment (or hiring) in the near future, rather because they are battening down the hatches while they still can.

As airtight of a practical indictment of monetary policy as there ever can be. The credit markets are being fragmented and severely pared back, perfectly consistent with what corrupt Economics calls “stimulus.”

Low interest rates aren’t a central bank providing accommodation, they are instead its worst nightmare being shoved right back in their face. Well, our worst nightmare because for one thing despite repeated failures, rates that never rise testifying to that failure, central bankers are never held to account.

There is not a single thing about monetary policy that is consistent with the real world; and it is playing out, again, right now before our eyes.

This isn’t very complicated at all, and there are no jobs to be “saved” by getting it backward yet again. For the millionth time, low rates are not stimulus! Fire them all. Now.

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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