A friend of mine sent me an email asking to leverage my MBA education to learn about government manipulation of interest rates. I decided to go ahead and respond to him through a blog post since I figured it might be interesting to some of my reader(s). Warning: an MBA doesn’t make someone actually that knowledgeable about any particular subject. Most of what is below is stuff I have accumulated over several decades of a somewhat relaxed study of business, economics and politics; I might be totally full of crap.
Hey,
I’m going to put your MBA to good use.
1) When the economy is doing bad, the government lowers interest rates.
If bad enough, almost to zero.
a) This makes sense, to spur the business and little people to lend money or growth, thus growing the economy and fixing the problem.
2) When the economy is doing good, the government raises interest rates.
a) Certainly, at first when the rates are at near zero (after extended bad economy) – I can buy this one. They generally wait till good growth is going anyway, before lowering the boom.
b) But once the rates get up to 3 to 4% (which is what it costs them and reasonable profit), why does the government keep raising rates, like up to 18% “to cool the economy”. If growing, let it grow? What’s bad about everything growing? They certainly get more taxes when the economy is growing.
Actually, the government manipulating rates was pretty much discredited back when it was tried in the late ’70s, early 80’s by Carter’s administration. The government has mostly learned that while it can attempt to bolster the economy by reducing interest rates (something that doesn’t have a lot of evidence is successful and instead tends to result in speculative bubbles), raising rates is highly problematic. Now (at least at present), the government tends to let the market set prices, even at when there is need for stimulus. For instance, the reason why US borrowing rates are at historical lows isn’t because of manipulations, it is because investors are afraid to invest and plow their money into what they consider safe assets (e.g., treasury bills). The market manipulation you are likely referring to (keeping the borrowing rates down) is a function of the Fed keeping the interbank lending rate down by acting as lender of last resort. The thought is that by lending to banks at ultra low (near zero) rates, the banks will then turn around and lend that money to consumers at low rates. That approach hasn’t been wildly successful because some of the companies that have access to those low rate are simply buying treasuries to get ‘risk free’ return on their investment and others are hoarding that money. Part of that latter behavior is also caused by government ‘decisions’ (interference) because deregulation allowed companies to become too highly leveraged and now the government is forcing them to deleverage which, naturally, results in the company holding on to profits (some will offer additional equity, but if the market doesn’t care for their equity the bank dilutes the current shareholders value without adding new value to compensate).
So, the government doesn’t attempt to influence rates directly, it relies on the Fed to do so (the Fed, contrary to popular knowledge, is NOT an arm of our government, but is a private, for profit company paid by our government to mange our money for us; think about that for a while!). The Fed does so primarily by setting lower intra bank lending rates (by offering those rates itself), but also by so-called quantitative easing…
‘Quantitative easing’ is where the Fed, rather than simply offering (nearly) interest-free loans, buys up large amounts of debt (in our particular case at present, lots of mortgage debt) thus depressing the price and making it economical to offer lower interest rates to borrowers and still operate profitably. For instance, say that a bank has money to lend (it has made regulators happy with the cash reserves it has on-hand and wants a better return than buying treasuries). If the bank lends that money as part of a mortgage it is making a 30 year gamble that inflation will be reasonable and that the borrower will be able to repay. When economic times are hard, lenders get skittish and tend to insist on higher qualifications, larger down payments and higher interest rates. That, naturally, depresses the number of borrowers which, naturally, depresses any economic recovery and if carried on past a certain point actually reinforces the economic bad times and can trigger (or exacerbate) a downward spiraling economy. Thus, the hope of the Fed is that by hoovering up certain types of debt that the original lenders will re-lend the same money under more favorable conditions, ideally stabilizing the economy or even triggering an upward, self-reinforcing spiral.
What caused huge run-ups in interest rates? Inflation! When inflation runs amok fixed-rate bonds become increasingly worthless (since they are paid back in non-inflation-adjusted dollars). Since any lender (think mortgages) is essentially buying a bond (the promise of fixed payments including interest), if the lender is expecting inflation to reduce the future ‘real’ value of the coming payments, the lender will want a higher rate to compensate. Only once inflation gets under control can interest rated come back down
As a side note, now that the subject of bonds has come up, if your financial adviser ever suggests you have less than 70% of your investments in equities, fire the guy! Even when retired and pulling money out for day-to-day living expense you should have no less than 60% of your assets in equities (stocks) simply because of the inflation protection (equities generally do no worse than track inflation and historically have substantially outpaced inflation). Unless you are retired, investing in bonds (unless you are gambling on the rates changing, you can buy bond options just like stock options) is a very poor way to grow your money. Yes, they pay back the principle, but what value is your same principle if inflation has cut its value in half? Immediate (6-8 month) needs should be held in cash or money markets, intermediate needs (1-2 years) in CDs or high quality short-term bonds and purt near everything else should be in equities (buy and hold is king! Don’t waste your money on funds!).
