Why do interest rates matter?
You may be wondering after last week’s dramatic fall in the stock market, why do interest rates have such a profound effect on the value of stocks?
And why is it that seemingly small changes in interest rates have such outsized effects on the value of stocks?
The reason has to do with two things, that can each be though as interest rates:
- The Risk-Free Rate, and…
- Return on Investment above and beyond the risk-free rate
The risk free rate is the rate of return on US Treasury bills.
The term “risk-free” implies that there is no risk in owning/investing in US Treasury Bills. Could this be possible, that there is no risk in US Treasury Bills?
Yes, and no.
The US government has never defaulted on its debt. If we use just this fact, it would imply there is no risk in owning US government debt. The US government sells US Treasury Bills and US Treasury Bonds to fund its debt and day to day operations. US Treasury Bills are different from US Treasury Bonds, which are also different from US Treasury Notes.
- US Treasury Bills are short-term loans taken out by the US government. There are several durations of loans that are considered Treasury Bills.
- 1 month
- 3 Month
- 6 month
- 12 month
- US Treasury Notes are medium term loans taken out by the US government. There are several durations of loans that are considered Treasury Notes.
- 2 Years
- 3 Years
- 5 Years
- 7 Years
- 10 Years
- US Treasury Bonds are long term loans taken out by the US Government. There is one duration
- 30 Years
When the government takes out a loan, it becomes a debtor. The counterparty, the creditor, is the investor. A metaphor for the government in this scenario is a homebuyer who takes out a mortgage, from a bank, the creditor. The market for US government debt is an international market; foreign and domestic investors borrow money to the US government via the debt markets.
War Bonds were issued during World War II to help the government finance the war. Average US citizens bought war bonds, thereby investing in the war effort. In return, the government paid back its investors after 10 years, plus interest. That interest rate was 2.89%.
World War II was a time of economic prosperity. The war unleashed America’s industrial might, and created the military industrial complex that is still responsible for a large portion of America’s economic output.
The below visual aid from OurWorldInData.org shows exactly how much military spending occurred during World War II. The US spent over $700 Billion [in constant year 2000 USD value] fighting World War II, almost double the amount spent by Nazi Germany. In constant year 2011 US Dollars, the US spent $4.1 Trillion, according to a piece by the Federation of American Scientists. In World War II era Dollars, the US spent $296 Billion. Notice that at the peak of World War II, the US was spending 37.5% of GDP on defense! In comparison, peak defense spending in the post-9/11 world was 4.3% of GDP. World War II truly stands alone in this regard, and will hopefully never be exceeded.
The table below, with data from the US government budget office (OMB), shows how much each of the wars fought by the United States cost, in both actual dollars, and adjusted 2011 US Dollars.
|Total Cost of War, in Billions USD||Inflation Adjusted Cost, in FY 2011 Billions USD||% of GDP @ Peak War Cost|
|War of 1812||0.09||1.55||2.2%|
|Civil War: Union||3.18||59.63||11.3%|
|Civil War: Confederacy||1.0||20.11||N/A|
|Spanish American War||0.28||9.03||1.1%|
|World War I||20.0||334.0||13.6%|
|World War II||296.0||4104.0||35.8%|
|Persian Gulf War||61.0||102.0||0.3%|
|Total Post-9/11, Iraq,Afghanistan,Other||1046.0||1147.0||1.2%|
Another interesting graphic, also from OurWorldInData.org, shows that as a % of GDP, US military spending has been declining rapidly, ever since the end of the Cold War, despite an increase post-9/11.
That increase in spending ended in 2010. In 2016, military spending was 3.29% of GDP. It’s possible, and likely, that President Trump’s budget will increase defense spending, as is usually the case on Republican administrations, but we don’t have the data yet.
Notice that Russia, led by Vladimir Putin, has dramatically increased defense spending, relative to GDP.
One explanation for that may be that Russian GDP is contracting. Turns out, this is exactly the case, as we can see below. Starting in Q4 2014, Russian GDP contracted for 8 straight quarters! Interestingly enough, Russian intervention in the Syrian Civil War began in September 2015 (Q3 2015).
Notice from the above that Russian intervention began when the Russian economy was contracting most severely, at a rate of -2.5% year over year.
We know from political and military history that autocrats will often start wars when their economies are in bad shape, as a way of deflecting popular attention from the economic hardship, to patriotic duty to support nation over self. It’s called the Diversionary Theory of War.
The annexation of Crimea in March 2014, and the Russian involvement in the Ukrainian Civil War in February 2014, both coincide to the same period of severe economic contraction in Russia.
The total amount of war bonds sold (by the US government) and bought (by Americans) during the second world war was $187.5 Billion! That number is clear evidence of the strong commitment the US public had toward the war. Recall the total cost of the war in actual dollars was $287 Billion. That means 65% of the war was financed by either the personal savings of US citizens, or the earnings of US business.
Very impressive to say the least.
If the US had not won the war, an investment in War Bonds would have most likely been a total loss. The reason being much of the cost of the war was loans to US allies. If Nazi Germany had won the war, those loans would have never been repaid, and the US government would have most likely defaulted on its debt.
War bonds were sold to the public at a 25% discount to face value. This means that if someone wanted to buy $1,000 worth of war bonds, they would pay up-front $750 to the government. After 10 Years, which was the duration of the war bonds, the investor received the $1,000 face value of the bond, amounting to a profit of $250.
At face value, one would think the RIO (return on investment) of a World War II war bond was 3.3% per year, since a $750 investment yielded $250 after 10 years. In actuality, we have to convert the yield into an annual yield, in order to compare it to other bond investments. We have to discover the Yield to Maturity on the War Bond. We do this by taking into consideration, the compounding effect of interest.
The formula for calculating the Yield to Maturity of a zero-coupon bond is below. A zero coupon bond is one that does not make interest payments. It simply sells for a discount, and then pays out a full face value sometime in the future. War Bonds were Zero Coupon Bonds.
The yield on War Bonds was pegged at 2.89%. Pegged means the government artificially determined the price of interest on the loans, without consideration for the market for interest rates.
The reason why the government pegged the interest rate at 2.89%, despite the fact that inflation and GDP growth was much higher than that, is because the US government wanted to limit the amount of interest it would have to pay once the bond came due. This was done because the war had an uncertain outcome, which meant the fate of the country was at stake. Interest debt on the loans was the last thing the government wanted to worry about.
Cost was a large factor in the decision to drop the Atomic Bombs on Hiroshima and Nagasaki. Government debt had already soared during World War II, and the deficit was at 26.8% of GDP in 1943. You can see from the chart below, not even today, with the national debt at $22 Trillion, is the deficit that large (relative to GDP).
As we will see in a bit, inflation was a worry in the US during the war. So much of production and supplies was being diverted to the military. Everything from food and clothing to cars and stoves became scarce. The US government was forced to put price controls on stuff, to keep prices down, artificially.
A side-effect of this was to make investing in War Bonds more desirable. Why you ask? Because when prices are kept down artificially, the free market can’t work. Consumers and producers can’t determine supply and demand, and at what price the two meet. Investing is stifled when prices are controlled by the government; think Communism. As a result, money was further diverted, even forced, into War Bonds.
“To keep the costs of the war reasonable, the Treasury asked the Federal Reserve to peg interest rates at low levels. The Reserve Banks agreed to purchase Treasury bills at an interest rate of three-eighths of a percent per year, substantially below the typical peacetime rate of 2 to 4 percent. The interest-rate peg became effective in July 1942 and lasted through June 1947. The Reserve Banks reduced their discount rate to 1 percent and created a preferential rate of one-half percent for loans secured by short-term government obligations, substantially below the 3 to 7 percent that had been common during the 1920s. All of the Reserve Banks implemented these rates in the spring of 1942. The rates remained in effect until January 1948.”
Pegging interest rates should sound familiar to anyone who knows anything about the post Great Recession US economy. The Federal Reserve has artificially controlled interest rates ever since 2009. It did this via its Quantitative Easing program.
Quantitative Easing essentially put a ceiling on how high interest rates could go. The Federal Reserve was given the authority by the US Government to print US Dollars, and use those US Dollars to buy US Treasury bonds from the market. Notice the Federal Reserve also did this during World War II. In exchange, holders of those bonds would get cash. By buying these US Treasury bonds (and also government backed mortgage bonds), the Federal Reserve kept interest rates low along the desired part of the yield curve, specifically the part it had least control over via its traditional interest rate tool: the Federal Funds Target Rate.
The Federal Funds Target rate has the most influence on US Treasury Bills, and other short term maturities of US Treasury Notes (2, 3, 5 year). In order to bring down long term interest rates, to make it cheap to invest money in risky long-term assets (real estate, business investment, infrastructure investments, etc..), Quantitative Easing was put in place.
In the case of War Bonds, the US government pegged rates for a slightly different reason; they wanted to actually prohibit investment, not encourage it. The reason why it worked to prohibit investment is because REAL interest rates were much higher than 2.89%.
We know this because inflation data, and GDP growth data, shows that nobody in their right mind would have normally invested in something yielding 2.89% if the inflation rate was closer to 8% and economic growth was booming at 6.9%.
|Inflation Indicator||Avg Yearly % Change, 1939-1948|
|Implicit Price Deflator||+6.5%|
|Economic Growth Indicator||Avg Yearly % Change, 1939-1948|
|Growth Domestic Product (GDP)||+6.9%|
An investment yielding 2.89% would actually have a negative real yield if inflation is greater than 2.89%. To understand this concept, think of your savings account, where you’re probably getting an interest rate of 0.1%. If inflation is 2%, every dollar you have in your savings account is buying you 1.9% less stuff every year you leave it there.
You might ask, why didn’t people buy stocks instead of War Bonds, if economic growth and inflation were so high? The stock market reflects inflation and growth. There technically was an alternative over War Bonds. This is true, but recall, the US had just emerged from the Great Depression. Americans suffered from PTSD as a result of the Great Depression. Many lost everything in the stock market. That psychology, that trauma, combined with a lack of trust in the capital markets, was a powerful force that drove more Americans to buy even more War Bonds.
The National Bureau of Economic Research put out a book on the New Deal and World War II inflation, published in 1980. You can find a chapter of that book titled, World War II Inflation, September 1939-August 1949, here. It is a great discussion of how price controls affected the US economy during World War II. A comparison to the time period before and after price controls is also made.
First of all, the author points out that.
“…our [US] entry into active war [World War II] was rather surprisingly accompanied by a slowing down of the rate of rise in the available price indexes, while the termination of wartime deficits was accompanied by a sharp speeding up…wholesale price index rose at the rate of 4% a year during the period of wartime deficits, compared with 9 % in the prior period, and 16% in the succeeding period.”
Basically, the translation of the above is that while the US government was running large deficits to pay for the war, inflation remained relatively tame at 4% a year. This period of wartime deficits started in 1941 and ended in 1946. Normally, deficits lead to inflation, because government deficits are a sign that the government is buying and paying for things [the war] with money it doesn’t have. But inflation had actually gone down during the deficit years; inflation was 9% before the deficit years, and 16% in the period after [post-war].
Continued from NBER,
“General price control was instituted in early 1942 and suspended in mid-1946. During the period of price control, there was a strong tendency for price increases to take a concealed form, such as change in quality or in services rendered along with the sale of a commodity or the elimination of discounts on sales or the concentration of production on lines that happened to have relatively favorable price ceilings…where price controls were effective, “shortages: developed, in some cases-such as gasoline, meats, and a few other foods-accompanied by explicit government rationing. The resulting pressure on consumers to substitute less desirable but available qualities and items for more desirable but unavailable qualities and items was equivalent to a price increase not recorded in the indexes.”
Basically, the above can be summarized simply: price controls don’t work. Price controls are a communist and socialist concept, not a capitalist construct. Capitalism depends on the free flow of money and capital, allowing the market to determine the most efficient price of things, based on supply and demand. The market got around price controls, in ways that the government did not anticipate, such as trade in the black market. Furthermore, because price controls were not placed on everything (just items the government deemed essential to the war effort and the war economy were price controlled), shortages of goods from gasoline to good became commonplace. This led people to seek out less desirable, but available alternatives, which led to price inflation in things that normally should not have been expensive.
For example, price controls on new automobiles intended to force factories into not producing cars, and instead producing guns, led to price inflation in the used car market. The government did not measure the price of used cars when it calculated inflation. Therefore, inflation existed, even though it wasn’t being measured.
As the NBER put it,
“The result [of price controls] was that “prices”, in an economically meaningful sense, rose by decidedly more than the price index during the period of price control. The jump in the price index on the elimination of price control in 1946 did not involve any corresponding jump in “prices”; rather, it reelected largely the unveiling of price increases that had occurred earlier.”
So basically, actual prices of things people were able to buy, alternatives to things they couldn’t get their hands on, were skyrocketing in price, even though that inflation was not reflected in the wholesale price index (measuring the price of goods that were price controlled, and scarce).
Do you see the ridiculousness of price controls? The government was measuring the price of things that it controlled the price over, and then telling everyone, prices were under control.
When price controls were removed, and the free market returned, actual measured inflation soared, because it had been there all along. For example, since the price of a used car had soared under price controls, when new cars came back back on the market, they were priced above used car prices, which were above where new car prices used to be before the war.
For prices, the removal of government control meant it was time to play catch-up.
What we need to understand is that during World War II, price controls, whether it be the price of money [interest rate], or the price of gasoline, were intended to transform the economy from a consumer economy, to a war economy.
In this context, it becomes clear that capitalism can’t function in a war economy, because governments wage war, and when a government monopolizes production, the economy is no longer capitalist. It becomes a planned economy, where the government determines how resources are used. In instituting price controls, the main goal of the government was to prevent the scarcity of goods from driving up the price of those goods; in other words, the government did not want a shrinking supply of goods, to drive up the price of those goods.
Even if consumer demand went down during the war simply because of a reduction in the civilian population (as a result of a dramatic rise in the military population), the reduction of supply was far greater. As a result, the price of gasoline in the US did not go up during the war, but unfortunately, the supply of it (for civilian consumption) almost completely disappeared.
Going back to the example of automobiles, price controls on durable goods, such as automobiles, made it so that Ford and General Motors found it no longer profitable to manufacture cars that were price controlled. The price controls were set so that it would be less profitable to manufacture cars, as opposed to military equipment. As a result, GM and Ford turned to manufacturing tanks, exactly the effect the US government was going for. The intention of the US government was to indirectly prohibit investment by the private sector in anything other than that which was needed to fight the war. And it worked.
World War II saw the savings rate in the United States soar. Why was this?
After the imposition of price controls, Americans found that, for example, automobiles, an American infatuation at the time, were nowhere to be found. Dealerships had nothing on their lots except for used cars, and the price for a used cars soared. Rather than pay those prices, Americans simply didn’t buy cars. The same was the case with dishwashers, stoves, and all things known as “durable goods”. At the same time this was going on, Americans were flush with cash; wages were high, jobs were plentiful, and the war economy was leading to a historic post-Depression wealth accumulation. Price controls, and scarcity combined to make it so consumers had nowhere to put their money except into savings accounts, or War Bonds. And due to the patriotism and nationalism of the day, consumers made it their duty to invest in War Bonds.
The demand for War Bonds served to keep the interest rates on those bonds low. The US government didn’t have to entice the public to buy them; they were selling out at 2.89%, because of all the above reasons. Interestingly enough, prior to entering the war, the United States government became a massive owner of Gold.
As Nazi Germany militarized and began its conquest of Europe, it paid for American made goods, services, and loans, with Gold. The French and the British, upon declaration of war on Nazi Germany, sold off much of their Gold holdings to pay for their own military build-up. In addition, in 1933, President Franklin D. Roosevelt issued Executive Order 6102, which basically made it illegal to hoard gold, or own anymore than a small amount of Gold, either in personal or corporate possession.
The reason behind the Executive Order 6102 was to put more Gold in the hands of the Federal Reserve so that it could print more US Dollar currency. The Depression led US citizens and companies to shun US Dollars and hoard physical Gold, and that alone was causing the Depression to linger.
Under threat of imprisonment, people began to turn over their Gold to the Federal Reserve, at the price of $20.67 per ounce. In 1934, after seizing Gold from the public, Roosevelt declared that the new price of Gold was $35 per ounce, a price that was more reflective of the true value of Gold.
Do you see what happened there? FDR ordered the public to hand over their Gold for $20.67 per ounce. He then said, anyone who wants to buy Gold from here on out, needs to pay $35 an ounce. Incredible! The new gold, and its higher declared value, also allowed the Federal Reserve to print US Dollar paper currency, which was injected into American business via New Deal loans.
Roosevelt used the money to pay for the New Deal, and later to pay for World War II. The $35 price per ounce also created a new Gold Rush, worldwide. It suddenly became far more profitable to mine Gold. Newly mined Gold was overwhelmingly bought by the US Government, via Treasury, since it was illegal for US citizens to own more than $100 worth of Gold. The more Gold the Treasury owned, the more US Dollar currency it printed, and this loop financed the economic boom that lasted in the US throughout the late 1930s and 1940s.
By 1940, the US owned 19,543 metric tons of Gold, 51% of all the Government/Central Bank-owned Gold in the world. By the end of the war in 1945, the war had barely dented its holdings (then at 17,848 metric tons), which was 63% of Government/Central Bank owned Gold in the world. The following table from World Gold Council shows the details.
Notice how the 1934 devaluation of the US Dollar, taking the price of Gold from $20.67/ounce to $35/ounce, led to a near doubling of Gold owned by Central Banks. US ownership more than doubled. Again, this was caused by the Gold Rush triggered by the US Dollar devaluation.
The National Bureau of Economic Research published research on the topic of US inflation during World War II. From NBER,
“The outbreak of war in Europe in September 1939 ushered in a period of inflation comparable to the inflations which accompanied the Civil War and World War I, though more protracted than either. By the postwar price peak nine years later (August 1948), wholesale prices had more than doubled, the implicit price deflator had somewhat less than doubled, the stock of money had nearly tripled, and money income had multiplied more than 2.5x.”
NBER goes on further to talk about how at the same time as the above, the velocity of money plummeted. From NBER,
“As this comparison indicates, velocity on net fell over the period. After an initial rise to 1942, it fell sharply to 1946 and then rose mildly to 1948.”
The following table lists the important statistics that show just how far below market levels interest rates were being held during World War II.
|Indicator||Average Annual Change, 1939-1948|
|Implicit Price Deflator||+6.5%|
Wholesale prices are a measure of inflation. Wholesale prices are a measure of the change in commodity prices, year over year. In the US, the Wholesale Prices indicator is defunct; today, it is called the Producer Price Index. It is a measure of prices for goods that producers acquire in the manufacturing of products that will then be sold to consumers. Producer Prices eventually trickle down to consumer prices, and so the Producer Price Index sometimes can predict a move in the Consumer Price Index.
The Implicit Price Deflator is also known as the GDP Price Deflator. It is the difference between Real and Nominal GDP. The difference between Real and Nominal GDP is the inflation rate. For example, if Nominal GDP is +7%, and the Implicit Price Deflator is +2%, then Real GDP is 5%.
Money Stock, or more commonly known today, Money Supply, is the amount of currency in circulation in the economy. There are several measures of money supply; they are known as M0, M1, M2, and M3. For the purposes of this discussion, we will assume money stock is equivalent to the broad money supply. The Broad Money Supply is the amount of cash and cash equivalent and short-term easily convertible investment money, in the economy. This measure tries to quantify the amount of money that is circulating and usable today, as opposed to being tied up in long-term investments or in illiquid assets.
An example of an illiquid asset would be your house. If you have equity in your home, that money would not be included in the broad money supply. But, if you applied for a Home Equity Loan, or you refinanced, and received a credit line that is equivalent to the equity in your home, that credit line would be included in the Broad Money Supply since it is then accessible and liquid (easily convertible to cash).
Money Income is the equivalent of Gross National Income. It is the amount of money Americans make in total, before government taxes. From TheBalace,
“Gross National Income is a measurement of a country’s income. It includes all the income earned by a country’s residents and businesses, including any income earned abroad. Income is defined as all employee compensation plus investment profits. It includes earnings from foreign sources.”
Real income is Gross National Income adjusted for inflation. Change in real income can be thought of in the following way: if you get a 5% raise, from one year to the next, and during the same period, inflation was 3%, your change in real income was 2%. If you don’t get a raise, and inflation is 2%, then your change in real income was -2%.
Take that to your boss then next time your raise doesn’t come through!
Finally, Money Velocity is the pace at which money moves from one place to another, from one individual to another, or from one institution, private or public, to another. The velocity of money is a very cool concept because it measures how effectively, how productive, an economy is with its money supply.
Central Banks should only print as much money as is required for its economy to operate and grow in a stable and controlled manner. It’s a balancing act.
One of the reasons the US dropped the Gold Standard in the 1971 was because the supply of gold could not keep up with the money supply needed to grow the economy. Basically, US GDP was growing too fast for Gold supply to keep up. The only alternative was to devalue the US Dollar, so that more US Dollars could be printed without the need for more Gold. This is similar to what FDR did in 1933, what we talked about earlier.
The problem with that, of course, is inflation. Devaluing too much would trigger inflation, making it so US citizens would need far more money to buy basic goods. Devaluing too little would not have the intended effect of putting more Dollars into a growing economy. How much to devalue is very difficult to know, especially when by 1971, US Gold reserves had fallen dramatically from their peak in 1940. Between 1950 and 1971, US Gold reserves fell by over 50%.
In losing its Gold Reserves to the European countries it had rebuilt after World War II, the US had lost its ability to corner the Gold market, or de-facto determine the value of Gold in US Dollars.
On top of that, the US government budget, having been heavily mismanaged in the post World War II period, was running a larger and larger deficit. The below graph shows that the US government ran a deficit consistently throughout the 1960s and 1970s. In addition, the Corporate tax rate was nearly 50% throughout the 60s and 70s, which meant taxes were already high.
Not to mention the top tax bracket for Individual Income Tax was at its highest, 90%, and at its lowest, 70%!
The point being, the government was in a bind, between a rock and a hard place, running out of options to continue funding itself. As a result, President Nixon took the nuclear option: he abandoned the Gold Standard. He unpegged the US Dollar from Gold. It was now up to the Foreign Exchange markets to determine the value of the US Dollar. Not knowing how to respond, markets simply decided that the move was the first step toward unconstrained US dollar devaluation, which led to the inflation shocks that plagued the US during the 1970s.
The below graph shows that throughout the 1960s, the US experienced GDP growth consistently, with several prints of GDP in the +10% range.
That would put the recent +4.1% print of GDP growth that President Trump loves to talk about to shame. As a matter of fact, the US has not had a decade like the 60’s ever since the 60’s.
Recall that the 1960s were a turbulent time for the world and the US. The Vietnam War, and the Cold War, raged, and the military industrial complex powered the economy, as it had during World War II. The 1970’s saw the arrival of volatility and several recessions. Most importantly, it saw the arrival of inflation that broke the US economy for the entire decade, and into the 1980s.
The end of the Gold Standard brought upon the globalization that drove the Chinese Industrial Revolution, at the expense of US industry. How? Because Nixon realized that if he was going to devalue the US Dollar, and thereby proliferate the world with US Dollar paper currency, he needed to find a place where that money could go. He needed a place US Dollars could go, and yield a return. China was that place. Although Nixon failed in many ways, his “Opening of China” initiative, and the subsequent investment of now trillions of US Dollars in China, allowed the US to prolong its post-war domination.
Notice in the above graph that inflation (red line) used to trigger recessions. You can see the recessions in the graph by the gray shading. In 1960, the US experienced a recession accompanied by sub 2% inflation ( as indicated by the core PCE number). Once the Gold Standard was removed, and the US Dollar was no longer pegged to the price of Gold, recessions in 1971, 1974-1975, and 1980, were all accompanied by high inflation. In 1975, inflation reached 10%. Inflation again spiked in 1980, triggering another recession. These are all examples of inflation triggering recessions.
The reason why this is odd is because normally, recessions mean that prices go down, not up. The type of inflation that triggers prices to rise, and economic growth to fall, is called Stagflation. Stagflation is extremely hard to fight. The reason why stagflation is so hard to fight is because Central Banks, such as the US Federal Reserve, can’t fight the recession by reducing interest rates. That would only make the inflation problem worse. Inflation can only be tamed with higher rates.
When stagflation occurs, the Central Bank priority is to tackle inflation first. The Central Bank must raise interest rates, which means making the recession worse. This is why in the mid 1970s and the early 1980s, there were several quarters of negative GDP growth i.e. economic contraction.
The US was in peril during these days. Politically, the US was a disaster in the 1970s, after Watergate, and the Nixon impeachment, and the failed presidencies of Gerald Ford and Jimmy Carter. Even when Ronald Reagan arrived in the early 1980s, it took taking the top tax rate (rate paid by wealthiest Americans) from 70% to 33% to stabilize the economy. The below graph of the top tax rate shows that throughout the 1960’s, when inflation was tame and the economy roared, the top tax rate was between 70-90%! By that metric, one has to assume that inflation was a problem in the 60s, but somehow it wasn’t evident. Somehow it was hidden by the war economy.
Does that sound familiar? History repeated itself! As we wrote earlier, the same thing happened during World War II. The war economy, incentivized and directed the government, obscured inflation.
The dramatic decrease in taxes, both personal and corporate, shows how devastating the inflation of the 1970’s and 1980s proved to be to the US economy. It showed that policymakers thought the only thing that could save the economy was government financing, which is exactly what the Ronald Reagan Tax Cuts were. They simply took money that would normally be meant for funding the government (and reducing deficits), and gave it to wealthy individuals and corporations. The name given to this policy was Reaganomics, also known as Trickle Down Economics.
The above chart shows us something interesting. It shows the US budget deficit/surplus going back to 1960, as a % of GDP. Taking the government deficit as a percentage of GDP is a better way of analyzing it. As long as the deficit is not a large proportion of the country’s GDP, deficits are ok. This is because a large economy can easily finance a relatively small deficit by a combination of taxation and debt financing without hurting the economy.
When the deficit becomes a large portion of GDP, funding the deficit by way of taxes would have a negative effect on the economy. Notice that the US Budget had a surplus in 1969. In 1970, the surplus became a deficit, and grew larger until it was -5.3% of GDP in 1983. As this piece by the Brookings Institute tells us, President Reagan realized right away that they had overdone it on the tax cuts. From Brookings,
“The tax cut [Reagan Tax Cuts, 1981] didn’t pay for itself. According to later Treasury estimates, it reduced federal revenues by about 9 percent in the first couple of years. In fact, most of the top Reagan administration officials didn’t think the tax cut would pay for itself. They were counting on spending cuts to avoid blowing up the deficit. But they never materialized.”
After the 1981 Reagan Tax Cuts were passed, the White House Budget Office projected that the deficit would explode higher as a result. From Brookings again,
“As projections for the deficit worsened, it became clear that the 1981 tax cut was too big. So with Reagan’s signature, Congress undid a good chunk of the 1981 tax cut by raising taxes a lot in 1982, 1983, 1984 and 1987. George H.W. Bush signed another tax increase in 1990 and Bill Clinton did the same in 1993. One lesson from that history: When tax cuts are really too big to be sustainable, they’re often followed by tax increases.”
Raising taxes led to George H.W Bush being a one-term president, which led to a Democrat, President Bill Clinton, taking office, who also raised taxes, in a bipartisan manner, with then Republican congressmen John Kasich.
Bi-partisanship led to a budget surplus in the late 1990s. During the 2000s, before and after the 2008 Financial crisis, government spending surged. Today, the deficit is quite frankly, massive, and only expected to grow. The deficit today also has the added effect of adding to the National Debt, which is at ~$22 Trillion.
The below chart is worth pointing out. It’s the Federal Debt as a percentage of GDP. Notice how when the deficit became a surplus in the mid and late 1990s, the Federal debt dropped significantly, from a peak of 65% of GDP in 1995 to a low of 54% in 2001, right before the 9/11 terrorist attacks.
Also notice that the tax increases that Reagan put into effect when he realized he had gone too far with cuts in 1981, were ineffectual. The 1980’s saw the Federal debt as % of GDP go from 30% to 60%, a gigantic increase. This shows how difficult it is to reign in tax cuts, and the prolonged effects of both tax cuts and tax increases. This is why tax policy that is rushed through congress is a bad idea, as were the Trump Tax Cuts of 2017. Already, talks that the Trump Tax Cuts were a mistake are being heard, even among Republicans.
Some people say that Defense spending is a huge component of the deficit. The chart above, of Federal Debt as a % of GDP, shows otherwise. We know that the 2000s in the US were a time of massive defense spending. The US government built up a military complex to fight and survey that rivaled anything ever done before. Two wars in Iraq and Afghanistan and a housing boom sent the US economy skyrocketing. Therefore, GDP grew along with spending. Tax revenue increased and kept the debt in check.
The Great Recession of 2008 sent the ratio of debt to GDP soaring. Why? Because GDP crashed, the economy contracted, tax revenue plummeted, and spending on fiscal stimulus (programs like TARP, bailouts, and Obama’s Economic Recovery Act) skyrocketed.
The federal debt today is 104% of the total output of the US economy. Stunning.
Let’s go back to the concept of velocity of money. Recall, the velocity of money measures how many GDP dollars are generated by $1 of money supply. The Velocity of Money is therefore simply nominal GDP divided by M2 Money Supply. M2 money supply is the amount of money in the economy that is in cash (checking accounts) and cash equivalents (savings accounts, money markets, CDs, line of credit).
Ideally, the Velocity of Money should be as high as possible, meaning each dollar of Money Supply is generating multiple dollars of GDP (economic activity). For example, a machine in a factory that costs $1 Million, produces product that is valued at $3 Million dollars. The velocity of the money used to buy that machine is there 3.0.
The above chart shows the Velocity of Money in the US (blue line) versus the M2 Money Supply in the US. Pretty shocking chart!
What we see is that since the mid 1990’s, the velocity of money has crashed, and the most significant slow down occurred during and after the financial crisis.
What the above chart means is that we are doing less with more as a country. We have a productivity crisis. Somehow, money is very stagnant. It’s being held in long term investments, illiquid investments, such as real estate, or long term bonds, or stocks. Business investment is just not there.
The above chart explains somewhat the rally in financial assets, a rally that has NOT been accompanied by business investment and strong economic growth. How?
Money is simply not being invested in innovation, or new ways of increasing productivity. What’s even more shocking is that we are seeing this even with a technology boom in the US that has seen technology stocks soar in value since the financial crisis.
The weakness in velocity of money, not seen since at least the 1960s, is definitely a bad sign, and is reason to be concerned for overvaluation in financial assets. Recall the issue of stock buybacks; stock buybacks are when companies, rather than invest in their businesses, go out and buy back their own stock as a way of returning money to shareholders (driving up the value of their stock by buying their stock with profits generated by the business).
An uncharacteristically large amount of national income is coming from financial assets (stocks, bonds, real estate) and not from economic productivity (development of technology, machinery to make more with less).
The above graph expands a bit more on the conundrum of tumbling money velocity. The blue line is the the percentage of GDP that is paid out to people, in total. It is the total National Income as a percentage of GDP.
The red line is the total National Income paid out in wages and salaries, as a percentage of GDP. The red line is therefore the total of all wages and salaries paid to workers, as a percentage of GDP (economic output).
Notice that total National Income as a percentage of GDP has been fairly stable since 1950 (when this chart begins). It is hovering between 52.5% and 57.5%. Now, look at the Red Line. Notice how it has been on a downward trajectory since 1970.
Remember, 1970 saw the end of the Gold Standard. It saw the US Dollar become unhinged from Gold. It also saw the beginning of globalization caused by the removal of the Gold Standard, and, as we mentioned earlier, the Opening of China.
What the graph shows is that globalization has increased competition in labor, thereby lowering wages. Therefore, the only Americans who have seen their incomes rise are the ones who make money in other ways, not just by working. These are the Americans that own financial assets (stocks, bonds, real estate). An example would be Americans who own apartment buildings and make money on rental income. They have seen their incomes rise, and at the very least, stay stable. This line of thought conforms with the weakness in the velocity of money. Money is not being put to work in producing economic value. It is being put to work in financial assets, which is the only way income has been able to stay stable or increase since the 1970s.
If we return the conversation back to interest rates, we can make a few conclusions. First, the Federal Reserve, post Great Recession, reduced interest rates to fight deflation. They implemented Quantitative Easing to fight deflation, to encourage investment, to speed up the velocity of money. They accomplished none of those things. The only thing they did was accelerate the trend for Income to be generated from financial assets rather than from wages. Wages have gone nowhere, and yet financial assets have skyrocketed in value since the crisis. Housing prices, stock prices, and bond prices, have all skyrocketed.
Today, the Federal Reserve is fighting a bubble in financial assets, the same kind of bubble that led to the Great Recession of 2008. The Federal Reserve needs to divert money away from financial assets, and into increasing productivity, increasing the velocity of money.
The fact is, the psychology of crises and and bubbles dictates everything. We saw the same thing happen in the United States during World War II and during the drive to fund the war. At that time, the US government artificially held down interest rates, and did so by instituting price controls on everything that could potentially trigger measurable inflation.
The psychology of the crisis during the Great Depression meant that Americans were more liable to save anyway, and in a sense, there was a constant mindset of preparing for the next crisis. There was an expectation that a crisis would hit after the end of World War II, just as one had hit after World War I.
The difference between today and World War II is that the US now has a national debt that is beyond belief and requires servicing. Artificially holding down interest rates only encouraged people to seek out yield, and to take out more risk. People in World War II did not have that option, and so they either turned to War Bonds, or savings accounts.
Globalization combined with pegged interest rates, leads to financial asset bubbles; war bonds today would fail miserably, which is why US wars in Iraq and Afghanistan were fully paid for with debt.
The initial response by the Federal Reserve to hold down rates was ok, because that initial response was in-line with reality. Rates were low because inflation was non existent, and the economy was contracting (growth and inflation were negative). The problem is that the Fed’s initial response has become a prolonged response. They have continued to hold down rates even as GDP growth has picked up steam, and inflation has increased. The only thing this has done is divert capital to where it most easily can earn a return. Low interest rates in the stock market meant that valuations could be pumped higher and higher, simply on the account of cheap money.
And then companies bought back their own shares, simply because money was cheap, and they sometimes did so on debt, offering their shares as collateral to loans. What we have today is situation where equity and debt are tied together as one, which means just as bond prices and stock prices rose together when rates were low, they will also fall together when interest rates rise.
This will be a painful process, but a required one in order to divert capital back into business investment, things that will actually increase productivity, increase the velocity of money, and provide for sustainable GDP growth going forward.
In addition, taxes will have to go up. There is no way that monetary policy normalization can occur, at the same time fiscal policy is loosened. That is to say, normally, this would be the case. But unfortunately, the Great Recession of 2008 led to both fiscal policy and monetary policy being loosened (tax breaks, government spending, and cheap money, together). We had an environment where monetary policy and fiscal policy were loosened at the same time. We will then have an environment where they will both need to be tightened.
Budget deficits cannot rise infinitely.
Just like in World War II, the government wanted to keep interest rates low, to prevent debt servicing costs (interest payments) from going too high. The only difference is that low rates encourage more debt, from loan seekers, and loan makers. Banks (loan makers) depend on high rates, and specifically, a large interest rate spread between short term and long term interest rates. Why?
Because banks make money by taking in deposits, offering a short term rate on those deposits (savings accounts, CD’s, etc…) and then lending out money at a much higher rate, for the long term (15-30 year mortgages). Interest rates today are making that very hard for banks to do. Below is the interest rate differential between 5 year and 30 year interest rates:
Notice that the difference is effectively 0% today. To be exact, it’s 0.13%. That spread means banks cannot make money on their traditional business. This means that bank stocks, especially after the financial crisis, seriously lagged the rest of the market as the stock market recovered. We can see this below in the chart comparing the S&P 500 returns (purple line) to the XLF (large bank ETF) returns (turquoise line) to the KRE (regional bank ETF) returns (red/green candlestick line).
The S&P 500 has returned 117.17% since July of 2006, while large banks have returned 1.75%, and regional banks 16.75%. The divergence in returns is pretty shocking!
Some say that not all banks are created equal. This is true, but if we look at the different classifications of banks, specifically, regional banks versus large, integrated banks (commercial, investment, and asset management banking), the Yield Curve makes no distinction. From large banks like JP Morgan and Citibank, to smaller regional banks like Bank Of Hawaii and KeyBanc, the shrinking yield has had its effect on all of them, as the above shows.
With that said, since Donald Trump’s election, the possibility of further deregulation of banks and the Trump Tax Cuts, put a little fire in bank stocks. The below stocks hows the performance of both regional banks and large banks, compared to the performance of the S&P 500 (the general market).
For most of the past two years, starting in late 2016 to today, October 18, 2018, the above shows that both regional banks and large banks outperformed the market. Unfortunately the recent market sell-off has hit the bank stocks, and specifically the regional banks, much harder than the S&P 500 and large banks. It should come as no surprise that since Jan 1st, 2018, the yield curve has flattened by 0.30%, further depressing the ability for banks to make money on the spread between short and long-term interest rates.
The only thing that enabled banks to outperform the market recently is the anticipation (and enacted) deregulation, and the Trump Tax Cuts which allowed banks to pocket more profits.
The Wall Street Journal recently put out a piece titled, “Behind Market Turmoil, Potentially Good News”. If you own stocks, you want to read that piece, because at the core of the article, is an analysis of interest rates, and how they are misunderstood.
Interest rates need to reflect two things: economic growth (as measured by quarterly GDP, change over the previous year) and inflation (as measured by CPI – consumer price inflation, or PCE inflation rate – Personal Consumption Expenditures). Interest rates, specifically the interest rate on the 10 Year Treasury note, should roughly equal the sum of those 2 things.
Does it? Well, in the past, sometimes it does, sometimes it doesn’t. And when it doesn’t, bad things have happened. Specifically, recessions have happened, triggered by out of control inflation.
The Wall Street Journal notes the following:
“After the financial crisis, the economy struggled to grow more than 2%, and inflation repeatedly fell short of the Fed’s 2% target. In response, the Fed cut interest rates to close to zero and bought long-term bonds to bring down long-term interest rates.”
In examining our chart above, in the 4th Quarter of 2008, the combination of GDP growth and PCE Inflation totaled -6.8%. This was a massive contraction in the economy, and it was further accelerated by deflation. The Federal Reserve took the Effective Federal Funds rate (the Interest Rate it manipulates) down to 0%, and the 10 Year Treasury rate went down to 1.57% in August of 2012.
The Federal Reserve does not have control over the 10 Year treasury rate. On the contrary, it has direct control over the Federal Funds rate. Notice that the Federal Funds rate and the 10 Year treasury rate have been far below the blue line (inflation + growth). This was purposely done by the Federal Reserve to try and create inflation.
Notice how during the 1960s, the blue line (inflation + growth ) was also far above the interest rates, both the Federal Funds rate and the 10 year Treasury rate. It was the case also in early 1970s and the mid to late 1970s.
Recall that the 1970s were a devastating period for the US economy, because of inflation. The grey shaded areas on the chart show that between 1970 and 1982, 4 recessions took place! Four recessions in 12 years, all triggered by inflation, inflation that was only tamed by a dramatic rise in the Green Line in the above chart (the Federal Funds Rate). Since 1982, a 36 year period, we’ve had 3 recessions, and all (except 2008) were shorter and less painful than the 1970s and 1980s.
The point of all this is to realize that interest rates must reflect the state of growth and inflation, otherwise inflation will get out of control and subsequently destroy growth. When inflation gets out of control, and the Fed is forced to take the Federal Funds Rate aggressively higher, they only add to growth destruction. Recall, high inflation and economic contraction equals stagflation, the worst possible situation. This is what happens when interest rates don’t accurately reflect the state of the economy and inflation.
The below chart should make this even clearer.
The line in the above chart should ideally stay at or near zero. If this was the case, it would mean interest rates perfectly reflect inflation and growth. It’s not the end of the world if the spread between growth + inflation and Interest Rates goes above 0, but the longer and farther it stays there, the greater the danger for stagflation.
Notice during the 1960s, during a decade where the economy was booming and unemployment was at historic lows ( we are actually at those same historic lows today in 2018), the Federal Funds rate was consistently over 5% below where it should have been if it reflected growth and inflation correctly.
What happened in the 1960s is that the war economy (Vietnam and Cold War) launched the US economy into unprecedented growth. The housing market boomed, suburbs were growing, government spending was unprohibited, and everyone had a job. Does this sound familiar?? Here’s hint. We’re going through the same thing today.
The reason why the US experienced such growth in the 60s is the same reason why the 2010s have seen gradual to now explosive economic growth: the price of money (Interest Rates) does not reflect the realities of growth and inflation. Just as in the 1960s, there is a possibility that the economy is overheating, today in 2018. Throughout the 2010s, we have seen and continue to see undervaluation of interest rates by over 5%, just like the 1960s.
One final thing to notice in the above chart is the time period between 1985 and 2000. In those 15 years, not once were interest rates undervalued relative to growth and inflation by 5% or more. There were times when interest rates were actually too high, briefly in 1984, 1990, and 1995, but otherwise, interest rates were conducive, and reflective of gradual and stable economic growth.
It’s no wonder that the late 80’s and 90’s are considered goldilocks years for the US economy.
Jon Hilsenrath is a great reporter with the Wall Street Journal. He put together the following video report on the current state of interest rates. It’s a short and good watch if you’d like a bit more color.