The Fed And Easy Money: The Party Will Go On Because The Party Must Go On

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Includes: DIA, IWM, QQQ, SPY
by: Louis Kokernak, CFA

Summary

Federal Reserve actions to depress interest rates have become an essential tool to control the budget deficit.

The federal government will save trillions of dollars on debt service costs as a result of near zero rates.

With no inflation and no sign of entitlement reform, ultra low interest rates are the only alternative.

Many young Americans have no memory of interest rates above zero on their bank deposits. It seems strange to us financial advisors. At one time, I tracked money market account yields in case clients needed to invest for some near term purchase. It's been over 7 years since it's been worthwhile to shop time interest rates.

The extraordinary measures that the world's central banks have taken since the subprime crisis have reduced interest rates worldwide. The US is not even the most extreme case. 30% of the developed world's sovereign debt now offers a negative rate of interest.

We have veered into uncharted territory with, as yet, no obvious adverse economic repercussions. Many economists rightfully fret that these artificially low rate will cause severe misallocation of investment resources. No one is really sure where though. Given how short-sighted our own executive and legislative branches are, it's fair to say that other, more definitive, consequences of ultralow interest rates are of more concern to lawmakers.

And the most obvious consequence is pretty good. Budget wonks have known for years that the first order effect of low interest rates is smaller deficits. Lower debt service costs are having an increasing salutary effect on our fiscal balance.

In March 2013, the Congressional Budget Office (CBO) issued a forecast of federal budget deficits through 2023 under various interest rate scenarios. A key comparison was the CBO's own forecast of the ten year treasury bond (5.2%) against a return to interest levels that prevailed between 1991 and 2000 (6.7%). A gradual return to the "normal" yield curve of the Clinton years increased the federal deficit $1.4 trillion when contrasted with the lower long term baseline forecast by the CBO. That's real money ... roughly equal to the annual output of Spain!

The following simplified chart shows the varying forecasts of the 10 year treasury rate over time. Note the green line represents the actual prevailing 10 year rate during the first three years of the CBO's forecast window. The Treasury stands to save even more money than forecast if these ultra low interest rates persist.

Click to enlarge

As federal spending expands in the next few years under the weight of Medicare and Social Security, the sensitivity of budget deficits to interest rates increases. The CBO updated its budget and economic outlook just last month. The stakes are even higher as a mere 1% change in the market interest rate impacts the deficit by $1.6 trillion!

If interest rates were 1 percentage point higher or lower each year from 2017 through 2026 and if all other economic variables were unchanged, cumulative deficits projected for the 10-year period would be about $1.6 trillion higher or lower, mostly as a result of changes in interest payments on Treasury debt.

During the first few years following the subprime crisis, many economists feared that the exceptionally accommodative monetary policy would rekindle inflation. That has proven to be false. General price increases have been below trend while commodity prices have collapsed. The developed world has been mired in a low growth trajectory that has been highly resistant to the infusion of money supply.

American inflation rates have been below the Fed's target rate of 2.0%. Moreover, every other central banking authority is hell-bent on printing money in a frantic effort to keep foreign economies growing. Mario Draghi of the ECB famously said in 2012 he was prepared to do "whatever it takes". Today, the ECB and its national central banks are buying about $60 billion in assets every month. The Bank of Japan announced a few weeks ago that it would move short term rates below zero.

Since the financial emergency in 2008, the US President and Congress have failed to implement pro-growth labor or entitlement reforms. There is no cavalry coming to the rescue on the fiscal side of the equation. A demographic tsunami is about to wash over America's fiscal house. And, as Mohamed El-Erian said in his recent book, the Fed is "the Only Game in Town".

As the only player willing to act, what does the Janet Yellen of the Fed see?

She sees a world that has fallen in love with the dollar. Every time there is a hint of a crisis, foreign investors pile into treasurys. The other major currencies are implementing their own version of quantitative easing.

She would be hard pressed to find price inflation. It's been missing for over a decade and doesn't appear on the horizon. The latest Survey of Professional Forecasters (SPF) indicates a five year forward inflation rate of 2.04%. The market based forecast of 5 year inflation based on TIPs is only 0.95%.

She see a labor participation rate in this country has fallen to its lowest levels since the 1970s. Real wages have been stagnant for years.

And she knows that trillions of dollars are at stake with a federal budget deficit that is about to explode. That's not speculation or theory ... that's a fact. Uncle Sam would like to keep borrowing at rock bottom rates

There really is only one course of action. It's easy money and ultra low interest rates. Like any responsible official, Yellen and company need to talk a good game. They will continue to promise "data driven" decisions on future interest rate action. But the vast majority of data out there today tells the same story. There is no inflation in the US and everyone loves the dollar. Easy money can delay our reckoning with an unfunded entitlement liability of $60 trillion. The party will go on! The party must go on!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.