When I was 12 years old, I had saved $600 from my paper route. I met a kid at school who also had a paper route and told me about a Certificate of Deposit (CD) he opened up at his bank with his savings from his route.
This was 1990 and interest rates were quite high. I got excited, I recall, about the prospect of my money making money.
In the newspaper, on Thursdays, in the business section, they always listed the rates of interest offered at all the banks in Long Island and showed the banks that were offering the highest yields and the various CD maturity times, 3 months - 5 years.
A bank called Green Point had the highest yield on a 1-year CD. So I rode my bike to the local Green Point and inquired about opening an account.
I opened up a 1-year CD and I remember it paid 8.56%. I calculated what I would earn in interest over that one year's time: $51.36
It was that experience that got me hooked on the concept of investing.
CDs paid a higher rate of interest vs. simply leaving your money in the savings account because you agreed to give up your money to them for a certain period of time. The longer you gave up your money to them, the higher rate of interest they gave you generally.
The Normal Trade-Off
I gave my savings to the local bank to use. The deal was, they would use my deposit and would make loans to businesses and home owners and charge them a rate of interest higher than the rate of interest they would offer to me.
In return for my savings, I received a rate of return that would be higher than the rate of inflation.
Thus, in 1 year, my investment would provide me with greater purchasing power than I had the year before.
Here is a chart that shows 3 things:
- The Fed Funds rate - The rate that is set by the Federal Reserve Bank
- The yield on a 3-month CD
- The rate of inflation (shown as the personal consumption price index)
The rate of interest that you would earn in a 3-month CD is generally just slightly higher than what the Fed Funds rate is.
The red line is the rate of inflation. So long that the rate of interest that you earn is higher than the rate of inflation, you will earn enough to provide you with a higher rate of purchasing power. The point of investing money.
Note: Notice the difference in the Fed Funds rate and the rate of inflation in 1990.
In the majority of the time, the Fed Funds rate is set at a higher rate than the rate of inflation. This was considered normal to this author.
When the Fed lowers the Fed Funds rate below inflation, savers and investors then are subsidizing debtors and risk takers.
Pension funds, in particular, have been a huge subsidizer of the low Fed Funds rate as their investments in fixed income have provided lower rates of return than what they need.
When The Economy Is Sick
When your spouse or kids get sick, you have to take time off work or leisure to take care of them.
When the economy gets sick, the Fed will lower the Fed Funds rate, even below the rate of inflation, as you can see in the late 1970s, early-mid-2000s and substantially, from 2009-2015 when the Fed took rates to zero and kept them there.
It's a shared sacrifice.
The entire point of lowering interest rates is two-fold:
1. Alleviate the pain for debtors by lowering the rate of interest they have to pay on their debts and mortgages.
2. Entice more borrowing.
Starting October of 2015, rates began to rise and we are finally reaching the point where savers can put their money in the bank and in a 3-month CD, and earn a rate of interest that will provide them with a real rate of return.
Real Rate of Return: The Magic That Makes it All Work
The noble and honest way as to what makes this work are the gains in productivity.
Investments in new capital that is more efficient and provides better economy are one component of increasing productivity. The other is gains in labor utilization know-how. Industrial engineers figure out the best way to allocate employee labor time and the tasks that they do that will produce the greatest output of work per hour from them.
There are other ways to reduce the cost of goods and services that are also very beneficial and can too be noble. We can import goods and services at far lower prices than if we were to produce or provide them in the States. However, these methods can also be abused and lead to unintended bad consequences: Trade deficits and an impaired net international investment position.
The other factor is debt growth. We have a debt-based money system and each and every year, massive amounts of new debts are created in aggregate.
This has stalled in the last 9 years or so.
Road Block In the Magic
We have a massive road block in this magic that makes it all work.
For one thing, productivity has stalled. Our manufacturing productivity is near dead in the water for the past 8 years still.
Bureau of Labor Statistics has this chart of manufacturing productivity:
Productivity is not helping the saver earn a rate of interest at the bank over the rate of inflation as it once did. This is contributing to the lack of a real rate of return for savers for the past 8+ years now.
Net Domestic Investment
Net domestic investment is the difference between the total domestic investment, which includes tools and equipment, infrastructure and inventories, minus the depreciation of these assets.
The best way to appreciate net domestic investment is to look at it as a percent of GDP:
It has seen a nice boost and is holding up in the 5% range. This might help contribute to slightly better gains in productivity.
We're still well below the rate of domestic investment that we saw in the past.
This I believe is a major reason why productivity rates are not going to be coming back to the 2-3% rate we saw in the '80s and '90s.
This is also a major reason why it's going to be difficult to get the Fed Funds rate comfortably above the rate of inflation anytime soon.
That we are already hearing lots of complaints about the Fed raising rates too high, when all they did was get them back to about the same rate as inflation, is quite telling. If you look again at the first chart in this article, the Fed Funds rate was frequently well above the rate of inflation.
Lack of Aggregate Debt Growth
The other factor is simply aggregate debt growth has stalled quite a lot over the past 8 years.
It's the rate of new money growth, which is debt, that provides the money that becomes the inflation, profit on the borrowers investment and profit the saver who is earning a rate of interest in the bank.
Allow me to run through this concept of aggregate debt growth.
As of the end of 2017, there was a total of $68.950 trillion in debt in the US.
This debt is all relative to both GDP as well as the number of people in the US.
This next chart shows the percent of new debt issued per year relative to GDP.
This is why the banking system is so important to the US economy.
What this chart shows in this case, is post the 2008/2009 recession, the levels of debt growth have been lower than historical norm.
This has been a major reason for both rates being kept at 0% by the Fed and why inflation as a whole has been low: Lack of new debt.
What About All The Federal Deficits?
The Federal Government has been running large deficits post the last recession and these deficits have been critical to aggregate debt growth.
Hear is a chart showing the rate of change in total debt vs. the rate of change in gross Federal debt:
Throughout the 1980s, 1990s and 2000s, most of the aggregate debt growth came from the financial business sector and private business sector.
Post the last recession, private sector and financial sector debt growth collapsed, leaving mostly the Federal Government having to run deficits that would provide most and in some years, all, credit growth.
The US economy is in the midst of a change at hand. The tree has been cut and now we have to see which way it falls.
What comes ahead is either a re-birth of a US economy 2.0 that is going to provide solid 2-3% gains in productivity per annum, or, an economy that continues to de-leverage and not invest enough in new assets that improve productivity.
The Fed Funds rate and the 3-month CD rate are to the point where the saver is able to earn a higher rate of interest than the rate of inflation. It appears we are heading in the right direction.
Whether or not this can last will be the question.
My logic suggests that lack of domestic investment will reduce productivity and take away the magic that brings about real rates of return on savings.
The consequences of this are that the Fed could very well have to revert back to bringing down the Fed Funds rate below the rate of inflation creating conditions again where saver and investor subsidize debtors.
At some point, the market will no longer tolerate negative real rates of return and rates will rise. That's when defaults will begin to soar and a panic will set in creating the next crisis.
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.