This is gonna be a long post. I’m going to build a blog and put these long posts there and do links to FB. Idk if that’s is going to help if you still have to read them from your device but it might.
A couple of weeks ago I promised to make a couple of comments on why the timing of the Fed’s interest rate drop was not necessarily good and why the Fed was playing to trump and not necessarily for the benefit of the country. I gotta do a little setup before I get into it. The first disclaimer is that this is my opinion. My opinion is not without foundation but still, it’s my opinion.
The other thing I should do is apologize to the other finance/economic people that might stumble on this post. For those folks it will clearly come across as an oversimplification but, that’s intentional. Not everybody is as geeky as I am or you if you think I’m oversimplifying this.
In addition to making it simple, it’s going to be kind of abbreviated but hopefully not choppy. There’s a lot to economic policy and you can’t do it in a single post but that’s what imma try to do.
There are three things, four if you count the actual conversation on interest rates. Imma hit fiscal policy (taxation), monetary policy (fed policy), treasury and interest rates. Imma mix in some nerdy stuff on economics just to glue it all together.
First, let’s put up an umbrella for the US economy. I’ll hit the rest of the discussion points under that umbrella.
Our economy is represented by goods and services bought and sold in the US. The buyers and sellers in many cases include people; that’s you and me, businesses; that includes foreign and domestic companies, and governments, and includes foreign and domestic governments. If it’s made then sold or if it’s a service provided that someone or company pays to have, its party of the pie known as our economy.
Here is a really important point to put a nail in. Generally, the more money that is spent on all the goods and services everybody and every company buy, the healthier the economy is thought to be. There is a bit of a caveat to that but I’ll get to that later.
There are several ways to measure the health of the economy. You’ve heard them, like, GDP (gross domestic product), new jobs reporting housing starts, inflation, etc. There are a lot of them. I’m not going to spend time defining or explaining them. There are two that I want to hit cause they well help when I wrap this up.
GDP or gross domestic product. This is the value of goods produced in the country. So, the dollar amount is never really published in places for the general population to ready. Only the geekiest of the geeks know or keep track of the absolute number. What is talked about in the news, and in the WH when it is favorable, is the change in GDP from quarter to quarter.
The GDP touted to support the tax cuts was to get to 4% and be consistently at 4%. All I’m going to say about that is that a market of say 3.2 to 3.7 would be a really good GDP number, the average, is just not that high. Our economy moves or swings up and down; it always has and always will for one or more reasons.
Gotta move on
Inflation is the other indicator that I will mention. It may be the most important indicator for me to make my point.
The definition of inflation is pretty simple, it’s just the rise in prices of goods and services. It’s not more complicated than that. The cause, simply put, ‘is too much money chasing too few goods’ as one of my economics professors explained. Kind of a word salad? The point he was trying to make in basic terms is when there is a lot of money in the company and the goods (ignoring services on purpose) available to be purchased are limited, then the sellers can raise the prices because there is money to pay the higher price.
Take a basic example of a pencil. Let’s say a pencil cost $.025. There is one lady with $.025 and she wants to by a pencil. She buys the pencil the seller sells it deal done. Change it up. Let’s add a guy as a pencil buyer looking for a pencil and he’s got $.50. The lady has $.50 as well. The selling price of the pencil is still $.25 unless the two buyers bid-up the price, they want to pay more just to get the pencil. The seller can charge anywhere from $.25 to $.50 because there is money in the ‘market (economy)’ to support the increased price.
Oversimplified? Kinda, probably but you get the point. You can think about that in broader terms, like the economy or in more narrower terms like home prices.
Let’s move on. A couple more things to mention before I put a bow on this.
There are a number of things that keep our economy moving, or that hinder the economy from moving. Don’t lose sight of the fact that the economy can also contract or shrink. Contraction is also part of an economic cycle. Growing should probably be substituted for moving. I use them interchangeably. From what I’ve mentioned above, money is the lubricant that greases the skids, which keeps the economy moving. Remember what I said earlier, its everybody’s money, yours, mine, your company’s, the governments, foreign and domestic. By contrast, the lack of money or a reduction of money in the economy can lead to an economic contraction.
When we, people, work we can do a couple of things with our money, save it or spend it. The more we spend the better the economy works the fewer taxes we pay the more money we have to spend (or save). Better for the economy when we spend it. Companies are the same but with a bit of a twist. When they buy stuff or pay us, they’re spending the money they have made. Greasing the skids. When they don’t spend or buy back stock or buy other companies or hold earnings (save) for whatever reason, that’s not spending in the economy. When they get a tax cut and don’t spend the ‘savings,’ well, you get the point?
Finally getting to the point.
Fiscal policy refers to taxation, what taxes are we going to pay and who is going to pay the tax and how much. Tax policy is legislatively driven, i.e. Congress decides tax policy. Basically, from a fiscal perspective, Congress decides who is going to have more money to grease the skids resulting from tax policy. Let me stick a little dig I hear, rich people and rich companies don’t spend their money, like the middle class and working families. Their ‘tax savings’ don’t ‘trickle down.’
I’m leaving that right there and moving again.
The Federal Reserve has a lot of tasks, responsibilities but I’m only going to address the two that are related to the point I’m trying to make.
The Fed, short for Federal Reserve, uses monetary policy to ensure a strong economy and to keep a lid on inflation. Interest rates are one of two tools Fed uses to accomplish their responsibility, relative to economic stability.
Let’s talk about monetary policy and the come to interest rates. If all the things I’ve discussed so far, these are the most complex. Let me explain.
Monetary policy is putting money into or taking money out of the economy. In my greasing the skids analog, its exactly as it seems. More money helps to ‘stimulate’ the economy and money out slow economic growth down. I talked about measuring growth by measuring GDP and inflation. Why would you want to slow economic growth? To prevent inflation.
Let me insert this for clarification. Monetary policy is not the Fed printing money per se, although one of the Federal Reserve’s actual cash in circulation. It’s kinda confusing but I’m not going to try to explain that here.
How does the Fed ‘put money into the economy?’ The Fed buys government securities from banks, giving the banks money. The theory being that a is will take the money and lend it to, well, everybody and anybody that can qualify for a loan.
An obvious question, I guess would be, how does the Fed know that banks have these securities to sell. Well, banks are permitted to only have certain kinds of investments on their books. Treasury securities are the safest assets a bank can own. A bank would have to work really hard to not have treasury bonds and that would not be a good thing the bank.
On the converse, when the Fed wants to shrink the economy the will sell treasury bonds to banks.
Here’s the deal with interest rates, finally. Banks borrow money from the Fed. These are overnight loans, primarily, that the banks can use for investments. There’s a little more to it than that but to keep it simple, let’s stick with that.
One more thing to insert, quickly. The Treasury Department has many functions. None of the Treasury’s functions really relate to economic policy. Relative to this discussion, the Treasury issues debt, the Treasury bonds/notes to pay for the obligations of the federal government, including interest. These bonds/notes are the securities that the banks hold as investments.
The lower the rate, the higher the spread between what it costs to borrow and the return on the investment. How about a simple example? If I were to lend you money at 0% and you buy a CD paying 2%, you have a 2% spread or profit margin. That’s oversimplified but I hope you get the point.
The theory with the rate spread the banks make is that they will use those profits to make more loans, loans at low rates.
Let me reiterate something, the Fed lends to banks. The Fed, in the US, is the banks, bank.
In my opinion, the Feds lowering or raising of their rate to banks is more symbolic than the impact it has on the economy. I’m not saying this activity doesn’t have an impact, financially, I’m saying it also has a psychological impact as well, that extends beyond the banking system.
Now I’m going to bring this home, I hope.
The Fed looks at the economic activity for the last year and particularly the last 2-3 quarters to determine if the economy is growing and if so, how fast. Is it at risk for inflation, a recession? They attempt to forecast economic activity for the immediate next couple of quarters and the next year. With all this data, the Fed then decides about interest rates in particular. The buying and selling of securities/treasures are ongoing but the volume may be driven by the economic forecast.
This post was prompted by the Fed’s recent decrease in the Fed rate. With the Fed’s change in rate Trump made a statement indicating that he was dissatisfied with the Fed and the Fed chair because they didn’t commit to continued decreases in the Fed rate.
Here is the crux of why I wanted to write this post. Even though the Federal Reserve Board members are appointed by the president, the intent is that the Fed will act independently of the executive branch. That’s why the terms of the members extend beyond the term of the president. The United States is not an authoritarian country, the president doesn’t control, manage or oversee the central bank.
Just a couple of things more.
When the economy is slowing or we are in a recession, the Fed initiates measures to stimulate the economy, lowering rates or increasing the buying of securities. If rates are already too low, there will be little impact the Fed can have on the economy. We would be in an extended recession because of mismanagement of monetary policy by the Fed.
Trump lobbied for the Fed to lower rates, to prop up the economy going into an election year. The economy is slowing and there is probably nothing we can do to prevent a slowdown. Our, US economy, is cyclical. We are the largest economy in the world but we don’t operate in a vacuum. We are impacted by other economies. We don’t drive economic activity around the world, we manage our economy relative to other economies. Global leadership from us is absent at the moment. We are catering to the whims of one person.
The risks of lowering rates too early or committing to lowering rates too soon could put us in an extended recession. That would eliminate one of the tools available to lift the economy out of a recession. Low rates and the Fed’s monetary policy helped to create the economy that we now enjoy. Rates were lowered in 2008 and stayed low for years. This spurred job creation and the growth that we have experienced for over a decade. The recession started at the end of the Bush administration with the collapse of the mortgage/housing industry. The recovered started at the beginning of the Obama administration and thrived throughout his second administration. Economic growth and job growth didn’t’ start in 2017!
In my opinion, and the opinion of others who are paid to have an opinion, we are entering an economic downturn. There is no consensus as to when the downturn will begin but the general feeling is that it will happen. Historically, we have experienced one of the longest economic upticks in the country’s history. A downturn is not a surprise. The strategy should be how we make the downturn as short as possible.
This was a long post, hopefully not too choppy. I hope it is helpful.