How did the Fed act in 2008? In exact opposition to Bagehot’s rule. They sprayed money in all directions, charged practically nothing for it, and accepted almost anything as collateral. Not surprisingly, the banks took to this largesse like bees to honey. Taking it away from them has proved very difficult. We now find ourselves in an era of speculation about what will happen when interest rates are raised.
(By the way, thanks to reader Richard Field for pointing me to the above Keynes quote. It’s amazing how much help you can get from complete strangers on Twitter. I will admit that I ignored Twitter for a long time, but now I find myself roaming it when I’m sitting around with nothing else to do and my iPad in hand. You should consider following me on Twitter, right here.
NIRP Problem #3: Policy Paralysis
What would Keynes and Bagehot say about today’s interest rates, or lack thereof? Their beloved Bank of England last week cut its benchmark rate to a record-low 0.25%. That is not what anyone would call a “heavy fine on unreasonable timidity.”
The problem is how to correct this policy error without causing yet more turmoil in the markets. On that, I’m stumped, and so are the central bankers. If they could wave a magic wand and get short-term rates back to, say, the 3% region where they were at the end of 2007, I’m sure they would be delighted. And we might see some positive effects. Savers would receive more income, for sure. However, this magic trick would also crater the stock market. The one thing we know is that the Federal Reserve is now in the thrall of the stock market.
The S&P 500 dividend yield is currently around 2%. To earn it, you have to accept the principal risk and volatility inherent in stocks. No one would do this if they could earn the same or even more in Treasury bills or bank savings accounts. An unexpected rate normalization by the Fed would jar the stock market downward to restore balance to the equation of risk and reward.
So we are stuck. The Fed can’t use the only available exit without slamming the markets. The only alternative is to stay in the trap and walk around in circles, hoping something will change. Someday it will, but I expect that it won’t be a pleasant change – but rather one that, in the minds of the central bankers, requires an even more unusual monetary policy. We will examine that potential in depth and detail next week. Until then, the room will get increasingly uncomfortable.
NIRP Problem #4: Killing Insurance Companies And Pension Funds Softly
Insurance funds make a profit by taking your money and turning it into long-term loans. They use the money they make, along with your premiums, to cover your insurance risk in the event of need. Pension funds generate profits from long-term loans to grow the money they need, along with your contributions, in order to pay for your retirement. They have built into their models a reasonable long-term return – at least from a historical perspective – on bonds and the stock market.