Before COVID hit, a few family members and I were competing in our own version of Biggest Loser, trying to see who could lose the most weight over a set period of time. For the month of January, besides trying to exercise more, I took bread and cheese out of my diet entirely. By the time February had rolled around I had already shed 10 pounds and I was happy with that success.
However, I quickly realized repeating these results proved difficult in February, because the leaner we get, the harder it becomes to shed pounds. This can be said of many things, including most hobbies. Going from a terrible chess player, for example, to a halfway chess player can be easy, and sometimes your improvement can come quick. However, typically people will plateau, as it becomes more challenging to sustain the improvement over time. I have been reminded of our weight loss competition and my early success in it, as I listen to the Federal Reserve talk lately about the state of the economy and the Federal Reserve’s ability to support it. To me the message is clear: “We’ve done the easy part, now it will become more challenging.”
The Fed’s role in the economy
The Federal Reserve currently has a dual mandate: to create an economy in the US that achieves full employment and has stable prices. One of their most powerful tools is the Fed Funds Rate which (in layman’s terms) is the rate at which banks lend excess reserves to other banks. All else equal, when the Federal Reserve raises the Fed Funds rate, banks now have to pay more to borrow and they will pass that increased cost on to consumers and business by charging higher rates on mortgage, credit cards, and business loans. That new house, or new car, or a new business idea may not be economically feasible if the cost to borrow is too high.
Conversely, when the Federal Reserve lowers rates we get the opposite effect, whereby banks now find the hurdle to make a profit is lower and they will respond by passing the lower rates on to the consumer. Anyone looking to buy a house right now can thank the Federal Reserve for the record low mortgage rates: (https://www.marketwatch.com/story/mortgages-rates-fall-to-a-new-record-low-but-not-all-americans-will-be-able-to-access-them-2020-09-10)
Once COVID hit the US, the Federal Reserve jumped into action by lowering the Fed Funds rate to essentially 0%. I say essentially, because (and I am simplifying here), the Federal Reserve always gives a range of 0.25% for the Fed Funds Rate as a guide because they don’t legally have the authority to force banks to charge a specific rate. So if you go to the Federal Reserve’s webpage you will see the current Fed Funds rate right now is 0-0.25%
As with previous drops in the Fed Funds rate, our economy has benefited from these low rates. For example, we sold almost 9% more homes here in the US in July 2020 in the middle of a pandemic than we did in July of 2019 when we had record low unemployment. This seems illogical but speaks to the pent-up demand that Millennials must have to own their first home, because current data shows that Millennials are on pace to account for over 50% of every home purchase in 2020.
That is great news, but if you listen to Fed Chairman Powell this week in his speech, there is a growing sense that the economy (like my weight loss) is starting to plateau. The efficacy of record low Fed Funds rates starts to wear off as time passes.
With the Fed Funds rate stuck at zero, Powell has been asked about going into negative rates. Much like when Oil traded at negative $40 during the height of the pandemic, negative interest rates is an extremely complex situation and one which Powell has said publicly many times that he does not support the idea and he doesn’t believe it works in improving an economy.
What are negative rates and how would they work?
I imagine that everyone reading this blog has owned a Certificate of Deposit (CD) at some point in their lives, or they are familiar with the concept. You go to a bank with $1,000, tell them you want to buy a 1-year CD paying 1%. The bank will then say essentially, “Come back in 12 months and we will give you $1,010 for your $1000.”
However, if interest rates were to go negative, here is what the bank could potentially say:
“Come back in 12 months and we will give you $995 for your $1,000.”
The idea behind negative rates is that people would balk at this offer and start looking for other things to do with their money. The theory is that by making it costly to hold on to the safety that cash represents, people will be incentivized to spend their cash or invest it. Then the idea is that due to the increased spending, or investing, the economy would start to grow rather quickly. Remembering the Fed’s dual mandate, a stronger economy should lead to lower unemployment rates and higher inflation, all things equal.
The European Central Bank shifted to a negative interest rate policy in 2014. Japan’s Central Bank adopted a negative interest rate policy in 2016, and neither bank has had positive rates since they went negative. Since Japan embraced their negative rate policy, their largest GDP growth rate was 2.17% and the ECB’s topped out at 2.54%, not exactly robust growth. One may argue that both regions would have seen their economies shrink if they had not used such aggressive monetary policy, and there is certainly no way to prove those folks right or wrong. However, they cannot debate that in practice, negative rates are not the panacea that they had hoped they would be.
The box the Fed is in
The Federal reserve cannot make people spend money, and they cannot force people to borrow money. They can, however, make it unattractive to save with extremely low rates and they can make it attractive to borrow with those same low rates. The Fed is punishing savers with these low rates, at the expense of spenders. The issue is, much like my weight loss, there is a point where these low rates will lose their efficacy. Cutting out cheese and bread from my diet did work, but to lose more weight I was going to need to take more actions. Keeping those items out of my diet, would keep my weight down from where I originally started but it was not going to be enough to continue to shed pounds.
If this economy is going to continue to grow and recover, we are going to need to see additional stimulus. The Fed acknowledged that 40% of Americans making less than $40,000 a year lost their job. Low interest rates are not going to help these people. The same can be said for the 13 million Americans currently collecting unemployment: low rates are not going to help these folks get back on their feet. The Federal Reserve has made it crystal clear that they have no intentions of raising rates through the end of 2023. This means that the government can borrow at extremely low rates to raise the funds to pay for an additional stimulus package. It’s time for Congress to put politics aside and reach a deal, because with rates at 0% and with no evidence that negative interest rates work, the boost that our economy has received from the Federal Reserve’s initial response to COVID will most likely start to slow down.
Derek Amey serves as Partner and Portfolio Manager at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail him at damey@strategicpoint.com.
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