In a CNBC interview last Friday, Minneapolis Fed President Neel Kashkari said that interest rates have fallen “over the last thirty or forty years” for natural reasons, including “technological reasons, demographic reasons, productivity …”. Kashkari implies that the Fed, in cutting rates for thirty or forty years, has just been riding the wave. He seems a bit confused though, because he then says the main reason for low interest rates is “central bank independence”.
He’s much closer to the mark with that last comment. Looked at in terms of stimulus, low interest rates are like a drug. The first few hits of cocaine or amphetamine make the user feel good. But as use continues, ever higher doses of the drug are required to attain the same high. Eventually administration of the drug is required just to make the user feel normal. In fact the core reason near zero interest rates have been needed for some semblance of economic normality for most of the past decade is that the pattern of ratcheting rates lower with each cycle over these last thirty or forty years has induced a financial market high that has come to be mistakenly viewed as normal.
In particular ever high asset prices have become thought of as normal. But no reason has even been given why asset prices need to go higher forever. It hasn’t always been this way … prior to the 1920s, stock returns came mostly in the form of dividends. You didn’t buy a stock so much because you were speculating on price increases, but because you were buying a stream of income. Stocks yielded more than bonds to compensate the investor for the higher risk. But the Fed was formed in 1913, and by the 1920s, stock prices began to rise such that they became the primary source of returns and objects of speculation. This bubble resulted in the Great Depression. By the 1950s, it had become clear that inflation was going to be a permanent fixture of the economy and markets, and because of the ability of stock dividends to rise with inflation, prices rose such that stocks yielded less than bonds. Ever since, the Fed has been chasing that inflationary high.
Since the 1980s, this has resulted in rising economic volatility as asset prices careened from boom to bust. The Crash of 1987 was met with monetary easing. We had a stock market bubble in the 1990s. When that deflated, it was replaced with a housing bubble. When that imploded, it was replaced with a credit and asset bubble that some call the “everything bubble”. The drug user gets high, then crashes, then attempts to regain the high.
The mechanism behind this is debt. The Fed via the banking system creates money by lending it into existence. While net lending is going on, the effect is inflationary. But as the debt builds up, the pressure to repay gradually catches up to and overtakes the desirability of borrowing. At this point, interest rates have to be cut in order to entice borrowers deeper into debt. So as we’ve outlined before, it is inflation itself that sows the seeds of deflation.
And so suppressing interest rates leads to the need for more of the same.
Mr Kashkari’s defense of “central bank independence” appears to be little but a thinly veiled bid for power, as if to say, just give us the power, and we’ll use it responsibly. The problem is that Mr Kashkari either has no inkling of how the monetary system he is charged with helping to oversee works, or has interests other than the general welfare in mind. Asset owners – by definition the wealthy – for example obviously like the high of increasing asset prices. The latter amount effectively to a reverse Robin Hood wealth transfer and have been blowing up the wealth gap. This wealth gap has been increasing since around 1980 … and it also just happens that’s how long the Fed has been cutting rates.
Fortunately there are those at the Fed who do not share Kashkari’s view. Chairman Powell has been working to return interest rates towards some semblance of normality. Just as lowering rates raised asset prices, raising rates puts downward pressure on them. And this means that this wealthy constituency of asset owners isn’t going to like it. The pressure on Powell and company to abandon the rate normalization program has become intense as asset prices have begun to fall in 2018. Screams of “Fed error” are all over the place. But the Fed error isn’t in what it’s doing now, it was in what it did before. No more than is the drug user’s attempt to go clean versus escalating the drug in the first place. Reasonable people can differ about the pace and timing of rate normalization, but those who don’t acknowledge the connection between debt and deflation or between interest rates and the wealth gap are part of the problem, not of the solution. For the drug addict, more drug only postpones the discomfort. The only path back to health involves eventually stopping the drug.