This is the headline that hit me right in the face this morning as I eased into the day's review of the early news.
"Just six months ago, money market traders expected the Federal Reserve to raise interest rates by the end of 2013. Now, they see borrowing costs staying at record lows for about three more years as the economic outlook worsens.
Bond market measures from overnight index swaps, which indicate no increase in the federal funds rate until mid-2015, to a 62 percent decline in a measure of volatility in government bonds signal that rates will stay near zero for longer. The gap between two- and five-year Treasury yields, which decreases when traders expect benchmark rates to remain subdued, is more than 50 percent narrower than its average since 2008."
What kind of economic climate does this forecast imply?
Recession…or worse…in Europe? Recession…or worse in China? Recession…or worse…in the United States? Recession…or worse…in the rest of the world? All of the above?
Let's see, that means that if President Obama is re-elected this fall that we will have worldwide recession and zero short-term interest rates for at least three-fourths of his second term.
Or, since the Federal Reserve's current target Fed Funds rate was initiated December 26, 2008 and President Obama was inaugurated on January 20, 2009, that means that the Federal Funds rate will have been right around zero for almost 90 percent of his presidency!
The only way I can see short-term interest rates remaining this low for this amount of time is for the world…or, at least, most of it…to be in recession…or worse.
I have argued that short-term interest rates have remained low because there has been no demand pressure on interest rates. (I noted this in my September 4th post on Federal Reserve activity.)
And, there is no demand pressure because there is little or no demand for bank loans and there is little economic growth.
The monetary and fiscal stimulus that has been applied to the United States economy has helped the economy to grow again, but the growth has been extremely tepid. Seems as if there are other, structural, problems that are limiting economic growth at this time.
Three of the most important structural problems that are mentioned at this time have to deal with the amount of debt outstanding and deleveraging that needs to take place; the changing nature of the labor market and the need for long-run education and training in order to re-structure employment; and the unused physical capacity that exist in the manufacturing industries and the need to re-structure industry for the 21st century.
Given these re-structuring needs in the United States economy and the fact that the fiscal policy of the government is running trillion dollar deficits and monetary policy has created over $1.5 trillion in excess reserves in the banking system…and seems to be on the verge of cramming even more reserves into the banking system…I just don't see much happening in the way of raising US economic growth and lowering US unemployment.
We thought we had stagflation in the 1980s. Well, stick around.
There is no reason why businesses have to put people back to work as a result of a new round of credit inflation!
One thing we should have learned from the past fifty years is that long periods of credit inflation result in people taking on more risk, using more debt, and increasing the amount of financial innovation that goes on. I have left off this list a fourth result of credit inflation and that is the increase in financial institutions mis-matching maturities. With a term structure of interest rates like that mentioned in the quote from Bloomberg above, there is little or no possibility of gain at this time from financial institutions mis-matching maturities.
But, my point is, if we have all this money around, why do we need to put people back to work. Money is information and information can be "sliced and diced" all over the place within an environment of credit inflation using the electronic means that we have available today. Why did General Motors and General Electric move more and more into finance during the 1980s and 1990s and earn, at one time, more than one-half of their profits from their financial subsidiaries?
In fact, employment in the financial industry has been declining, but the ability to move money around has increased over the past five years. Rules and regulations will stop this? I don't think so. More rules and regulations just mean that financial institutions have to be more creative.
So, this line of thinking leads us to believe that we can have more monetary and fiscal stimulus, little or no economic growth, little or no improvement in the under-employment (not unemployment) situation…and rising credit inflation.
But, rising inflation is not consistent with zero interest rates! And, we have the money markets indicating that we will have zero short-term interest rates out until the middle of 2015 and a flat yield curve. I still cannot believe that we will have zero short-term rates for this long.
Do you believe in efficient markets? Do you believe that financial markets incorporate all the information available to them in setting prices?
Have you seen the recent TV ad put on by Ally Bank. The ad has Nobel prize winning economist Tom Sargent sitting on a stage with a moderator asking him if he can forecast interest rates out for two years.
If you think the financial markets are efficient I would suggest that you read Jack Schwager's book "Hedge Fund Market Wizards" published by John Wiley.
The problem, as always, is one of timing. One can't be "too early". John Maynard Keynes argued that a market can always hold onto a position longer than you have capital to outlast it.
We will have rising inflation, we will have rising interest rates, and we will have slow rates of economic growth and high rates of unemployment. How do use this scenario to our advantage?