Fed Meeting On 7-8 November 2018: Impact Of A Rate Rise

|
Includes: BIL, DDM, DFVL, DFVS, DIA, DLBS, DOG, DTUL, DTUS, DTYL, DTYS, DXD, EDV, EEH, EGF, EPS, EQL, FEX, FIBR, FWDD, GBIL, GOVT, GSY, HUSV, HYDD, IEF, IEI, ITE, IVV, IWL, IWM, JHML, JKD, OTPIX, PLW, PSQ, PST, QID, QLD, QQEW, QQQ, QQQE, QQXT, RISE, RSP, RWM, RYARX, RYRSX, SCAP, SCHO, SCHR, SCHX, SDOW, SDS, SFLA, SH, SHV, SHY, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TAPR, TBF, TBT, TBX, TLH, TLT, TMF, TMV, TNA, TQQQ, TTT, TUZ, TWM, TYBS, TYD, TYNS, TYO, TZA, UBT, UDOW, UDPIX, UPRO, URTY, UST, UWM, VFINX, VGIT, VGLT, VGSH, VOO, VTWO, VUSTX, VV, ZROZ
by: Alan Longbon

Summary

A Fed rate rise adds to the private sector debt interest burden.

A Fed rate rise adds to Treasury bond interest income.

A larger share of GDP goes to bankers' profits and less to household and business with each rate rise.

An interest rate rise means that an inversion of the yield curve and subsequent recession move ever closer.

This article provides an impact assessment of the FOMC 7-8 November 2018 meeting and a possible rise in the Federal Funds Rate [FFR] to 2.5%.

The Federal Reserve raised the target range for the Federal Funds rate by 25bps to 2 percent to 2.25 percent during its September 2018 meeting.

The current FFR situation is shown in the chart below.

What Happens When The Fed Changes Rates?

A movement of the FFR has three broad impacts:

  1. Bank lending costs on borrowed reserves.
  2. Interest burden on private debt.
  3. Interest on newly issued Treasury deposits.

These three impacts will be looked at in turn.

Bank Lending Costs

The stock of private debt is shown in the chart below in terms of a percentage of GDP.

One sees the most current level of private debt to GDP is 202.8% for 2017.

The table below shows the impact of the rate rise on bank reserves advanced by the Fed, via the discount window, when a bank makes a loan.

(Source: Author calculations based on Trading Economics GDP measure)

When a bank creates a loan, it creates a deposit in the recipient's bank account and borrows funds from the Fed to cover the loan amount, if it cannot source them more cheaply in the interbank market to meet any reserve requirements. Loans create deposits and generate reserves at the Fed. The Fed creates the reserves on demand as part of the federal payments system.

Every 0.25% rate movement changes the cost of loan funds by $10 billion. The private banks then pass on this rate change to the customer.

A Fed Funds rate increase can be seen as a giant, economy-wide tax on borrowers and lenders. Each time the Fed raises the rate 0.25%, it moves $10 billion from the private sector to the government sector.

The Fed is the national government's bank and remits its profits to the national government in the same way that taxes are remitted from the private sector to the government. Because the national government is the issuer of the dollar, it has as many dollars as it wishes to create and does not need to get them from an outside source. The $10 billion income stream to the government from a Fed rate rise is simply deleted from existence in the same way as national taxes are. It is a net reduction in the money supply. It exists on no measure of any money supply after remittance, not M1, M2 or M3. This is a contractionary and deflationary impact at the macro level.

Interest Burden On Private Debt

The following table shows the impact of the rate on the stock of private debt in absolute terms and as a percentage of GDP. The likely new Fed Funds rate is highlighted in green.

The chart shows that with each 0.25% FFR rise, $98B or 0.53% of GDP is transferred from the household and business sector to the finance sector in a macro intersectoral income transfer.

At present, over 5% of GDP goes to banks as interest on private loans. Money that could have been spent on real goods and services.

If rates go up, an additional $98 billion per annum will move from the household and business sector to the banking sector.

At the macro level, this has no impact on the net money supply as it stays the same. The biggest income is the transfer of income from businesses and households to the banking sector.

This transfer of income causes what Professor Michael Hudson terms debt deflation and is also known as secular stagnation. It is the draining of aggregate demand for real goods and services by the shifting of income from households and business (productive sectors producing real goods and services) to the banking sector (unproductive sector that produces no real goods or services while extracting income from the other sectors).

A spiral develops whereby aggregate demand falls, business inventories build, businesses wind back production resulting in unemployment and thus a further drop in aggregate demand.

The stock of private debt and its Fed-driven rising servicing cost expands faster than the real economy's capacity to pay and eventually an economic contraction occurs and resets the economy at a lower level.

Treasury Deposits

Another impact of a rate change is on Treasuries (also known as government debt). If there is a general rate rise, then the yield on Treasuries will also rise as new Treasuries are issued at the new higher rate, and existing ones trade on secondary markets for lower face values.

The following table shows the generalized impact of the rate rise on the stock of Treasuries in absolute terms and as a percentage of GDP. (Treasuries do not have to be issued at all, and that is covered in this article.)

Government Debt in the United States increased to $21516058 Million in September from $21458850 Million in August of 2018.

(Source: Author calculations based on Trading Economics Government Debt measure)

The table above shows that with each 0.25% rate rise, some $54 billion of new money enters the private sector from the government sector. This is the positive side of the equation in that more dollars in the economy grow the economy.

The government credits the bank accounts of coupon recipients to pay interest on issued Treasuries. The number in the bank account of the recipient increases upon direction from the Treasury. At that point, new money ("State Money") enters the private sector and adds to the money supply. The money is "keyboarded" into existence by the Treasury. Money is similarly "keyboarded" into existence when the Fed buys and sells bonds to maintain its Federal Funds target rate.

These famous words come to mind:

Ben Bernanke: The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”

Alan Greenspan: A government cannot become insolvent with respect to obligations in its own currency.”

St. Louis Federal Reserve: As the sole manufacturer of dollars, whose debt is denominated in dollars, the U.S. government can never become insolvent, i.e., unable to pay its bills.”

The same keyboard powers could be used to provide for the public purpose such things as first-class education, healthcare, and infrastructure for every citizen. Given these things would lift productivity and efficiency, such spending would not be inflationary.

This also runs in reverse when rates go down.

If all the Treasury deposits were at the new rate of 2.5%, then the government would add $538 billion to the economy each year from treasury interest payments alone. The actual figure is lower, as the chart below shows. This is because most of the deposits are earning a lower rate of return than the new ones will do.

This gives the banks more income. As part of the Fed's monetary operations, it is required to swap bank reserves for Treasury deposits until it hits its target rate of 2.5%. The Fed swaps bank reserves for Treasuries at the new higher rate, and the income stream from the Treasuries flows to the banks and is higher than interest on reserves of 0.25%.

Treasuries are bought and sold as part of interest rate maintenance, and one can say that the so-called "national debt" is equal to the net money supply, and for as long as the Fed carries out interest rate maintenance in this way, the national debt can never be paid off. As an alternative, the Fed could simply set a support rate of 2.5% on reserves and desist with the open market bond buying and selling operations. Treasuries could be dispensed with altogether, then there could be no more "scaremongering" with the national debt.

An interest rate may lift the demand for Treasury deposits. While domestically this is only a portfolio shift, it might improve the current account balance when foreigners buy more Treasuries which in turn drives demand for the US dollar.

On Balance, What does This All Mean?

There are winners and losers from a Fed rate rise.

Banks: On the one hand, banks must pay more for their borrowed reserves from the Fed when they make a loan. This is bad news for those that hold a lot of fixed-rate loans, as their margin gets squeezed. On the other hand, those banks that hold a lot of Adjusting Rate Mortgage (ARM) loans are anticipating or enjoying the triggering of exploding rates that are much more than the actual Fed Funds rate rise. Banks will now be able to swap their excess reserves for Treasuries at the new higher rate and enjoy more income. On balance, the banks come out ahead thanks to the rate rise. This means they can make more profit and expand their capital base and lend even more if there are creditworthy households and businesses that want a loan.

Banks slowly devour a larger and larger share of GDP with each rate rise for no additional effort and no actual production of a good or service.

Borrowers: Suffer when rates rise and benefit when they fall.

Borrowers in the household and business sector get slowly squeezed with each rate rise. More and more income is devoted to debt service, and the appetite for more debt is reduced.

The macro-economy: The impact on the macro-economy is dependent on the relative size of the two debt stocks.

Taken to extremes, interest rates can rise so high that so much private sector income is allocated to debt service that the aggregate demand for real goods and services is weakened to recessionary levels.

The chart below shows the stock of private debt and the stock of Treasuries.

(Source: Professor Steve Keen)

When the stock of private debt is larger than the stock of government debt, the impact of a rate rise is a larger removal of dollars from the economy.

The overall impact of this has to be weighed against the impact of dollar creation by banks, fiscal policy and also the current account balance. This can be summarised in the sectoral balances after the work of British economist Professor Wynne Godley.

GDP = Federal Spending [G]+ Non-Federal spending [P] + Net Exports [X].

GDP = GDI = G+P+X

As a percentage of GDP, all three sectors sum to zero and balance each other out.

A chart of the sectoral balance flows is presented below:

(Source: Professor William Mitchell)

At present, the private sector balance is positive, but only weakly so at about 1-2%. This means that:

  1. Businesses and households are saving overall, and net financial assets in the private sector such as stocks, bonds, and real estate can grow in value.
  2. Overall, there is more currency added to the money supply than removed and additional dollars grow the economy.
  3. Most of the newly minted dollars flow overseas to the external sector in return for the real benefit of goods and services by way of the current account. These tend to be held as US Treasury deposits. The size of the money supply remains the same, and it is the ownership of the money supply that changes. Taken to an extreme, if the USA exported its total GDP for the year, foreigners would have $19T of USDs and Americans would have lots of real resources and no money.
  4. Recessions normally occur when the private sector balance is zero or negative. This has not happened yet. The table below shows how the sectoral balances looked at the peaks and troughs of the last two recessions. Strong private credit growth can cover the private sector deficit and sustain aggregate demand where:

Aggregate Demand = GDP + Credit.

(Source: Trading Economics, FRED and Author calculations based on same)

* Estimate to be updated when the end-of-year numbers are known.

# Forecast based on existing flow rates

Recessions normally occur after the interest rate inverts; this means the FFR is more than the 10-year bond rate. This too has not happened yet but is on a collision course to do so. The most likely scenario is that the long end of the yield curve moves down into and through the low end.

The current state of credit creation and sectoral flows are shown in the table below and more detail can be read here in this recent article focusing on this subject.

(Source: Trading Economics, FRED and Author calculations based on same)

* Estimate to be updated when the end-of-year numbers are known.

# Forecast based on existing flow rates

Summary, Conclusion, And Recommendation

Each movement of the FFR upwards moves the economy towards the greatly feared yield curve inversion where the short end of the curve is greater than the long end. Historically, a recession has followed each time this has happened after twelve to eighteen months after the inversion.

The important point with the yield curve inversion is that the damage to the economy is being done in the lead up to the inversion. That means right now. The inversion itself is the final stage of a growing problem like cancer that finally destroys something vital in the body.

The concept is based on the following economic relationships developed by Professor Steve Keen:

  1. Employment rate - Employment will rise if economic growth exceeds the sum of population and labor productivity growth.

  2. Wages' share of GDP: The wages' share of output will rise if the wage rise exceeds the growth in labor productivity.

  3. Private debt to GDP ratio: The debt ratio will rise if the rate of growth of debt exceeds the rate of growth of GDP.

What is happening as rates rise is that a higher share of GDP goes to bankers and a lower share to wages and business. The wages' share of GDP is particularly hard hit as more and more income is devoted to debt service instead of the purchase of real goods and services.

The following chart shows this process visually.

The bottom line is that the compounding rate of growth of the private debt goes beyond the capacity of the real economy to carry it which then triggers Professor Hudson's golden rule that debts that cannot be paid will not be paid.

This is a symptom of our finance-dominated economy where the economy has been made to serve finance instead of finance serving the economy.

The Fed is said to be independent of the national government, but it is not independent of the finance sector that controls it.

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.