Is Lowering The Real Interest Rate The Solution For The U.S. Economy?

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Includes: TIP
by: Antonio Carradinha

During the 61st Annual Management Conference presented by the University of Chicago Booth School of Business, Minneapolis Fed chief Kocherlakota participated in a panel that discussed the future of central bank policies. He was asked an important question: "What are the key challenges facing central bankers around the world today?"

The theme is of particular interest to the United States because there are serious doubts about the sustainability of the zero percent interest rate policy. This policy, in conjunction with colossal monetary injections, raises genuine concerns about the soundness of the whole financial system. A major financial problem may arise unexpectedly jeopardizing the fragile balance achieved. But that does not seem to disturb Mr. Kocherlakota, quite the opposite. In fact, he thinks that the measures adopted so far are still very insufficient.

It is precisely his long and eloquent response to the question mentioned above that is the subject of this article.

Mr. Kocherlakota responded: "The demand for safe financial assets has grown greatly since 2007. This increased demand stems from many sources, but I'll mention what I see as the most obvious one… Workers and businesses want to hold more safe assets as a way to self-insure against this enhanced macroeconomic risk".

It is obvious that the demand for safe financial assets has grown greatly since 2007. After a financial collapse of immense magnitude such as what occurred in that year, what else could be expected?

As the Fed has been buying huge amounts of previously issued U.S. securities, the supply of money into the financial system has increased enormously. Banks can make low-interest loans even in the context of increased risk.

With this policy there is the invitation to excessive consumption intensified by the existence of a large amount of credit available for the purchase of assets in general. Several problematic situations are growing, and its resolution will become more difficult over time.

He also stated: "The supply of the assets perceived to be safe has shrunk over the past six years. The increase in asset demand, combined with the fall in asset supply implies that households and firms spend less at any level of the real interest rate - that is, the interest rate net of anticipated inflation."

I disagree with this statement because the increase in demand for shrinking assets always implies a climb in their prices and the creation of favorable conditions for rising inflation. Furthermore, households and firms are spending more, not less. To fight against the natural pace of the market, the Fed flooded the U.S. economy with money which is being invested in all kinds of assets.

The Federal Funds Rate continues to have a target of zero percent with very low interest rates across the yield curve by direct intervention of the Fed.

Moreover, there are no longer safe assets. Given the massive distortion of the market, investors do not have at their disposal adequate government bonds. Indeed, the longer-term Treasuries are at risk of suffering a sudden drop in prices, and likely to cause serious harm to their holders. The increase in yields may be a reality very soon and may be triggered abruptly due to any unsuspected reason.

And he also said: "The FOMC has responded to this challenge by providing a historically unprecedented amount of monetary accommodation… Despite its actions the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I've described. The passage of time will ameliorate these changes in the asset market, but only gradually. Indeed, the low real yields on long-term TIPS bonds suggest to me that these changes are likely to persist over a considerable period of time - possibly the next five to 10 years."

Perhaps there is something I do not understand here when Mr. Kocherlakota states that the FOCM has still not lowered the real interest rate sufficiently. There would be only two ways to achieve this outcome - by further decreasing the interest rate, which is practically impossible, or by increasing the rate of inflation which would conflict with the previous measure. Moreover, inflation depends more on market forces than on Fed policy.

With respect to TIPS like the iShares Barclays TIPS Bond Fund (NYSEARCA:TIP), it is also necessary to see the real situation. The yield on a TIPS bond is equal to the Treasury bond yield minus the expected rate of inflation. If Treasuries offer yields below the rate of expected inflation, TIPS will stay in negative territory. TIPS, despite being issued by the U.S. government, are not free of risk.

There are indeed other risks involved. One is related to the fact that the CPI does not reflect the exact measure of inflation in the economy. Another concerns the situation in which the investor does not hold TIPS until maturity. There is still risk in case of deflation or mere expectation of falling prices. That was the case in 2008 when the financial crisis and the possibility of deflation led to a decline in the TIP ETF's share price in August and September of that year. On the other hand, higher inflation generally leads to higher rates and falling share prices for TIPS mutual funds or ETFs.

Thus, it should be noted that it is not possible to build a financial policy with a horizon of five to 10 years based on TIPS. In fact, TIPS are highly sensitive to interest rate movements, and its value can fluctuate widely in a very short period.

Conclusion

There is a serious problem here given that interest rates will most likely begin to rise in the near future. Dangerous situations may materialize if the current intervention imposed on markets is not changed. In fact, long-term Treasuries present an unbelievable high risk given that its yields are extremely low. In addition, Mortgage-Backed Securities should no longer be purchased by the Fed, at least in the current amounts. The monetary and financial authorities should address the problem of excessive intervention, not postpone its resolution. Currently, the United States is completely dependent on what the Fed does or promises to do. I believe that a centralized economy is not in the best interest of this country.

Disclosure: I 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.

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