The yields on the 10-Year Treasury Note are currently below 2 percent, a level that is both unusual and concerning. Such low interest rates signal a weakness in credit markets. Furthermore, despite the Federal Reserve’s attempts to maintain low interest rates, these historically low yields might actually be detrimental to the economy rather than acting as a stimulus.
How did we arrive at this situation? Let’s delve into it.
In his latest Investment Outlook, renowned investor Bill Gross asks, “Where does credit go when it dies?”
He explains, “It deleverages, slows, and inhibits economic growth, ultimately turning economic theory upside down and challenging the wisdom of policymakers.”
The crucial point Gross emphasizes is that when policy drives interest rates to the zero-bound threshold, low rates cease to encourage growth; instead, they suppress it. Essentially, if credit markets do not provide a satisfactory risk-reward ratio, lenders are inclined to invest their funds elsewhere.
This scenario undoubtedly leads to negative repercussions for the economy…
Monetary Policy Redux
The Federal Reserve’s manipulation of money prices creates distortions across various markets and the broader economy. During periods of economic boom driven by cheap credit, the perceived growth misleads businesses and lenders. Ventures that seem profitable may not necessarily be so, and demand that appears strong may actually be an illusion.
Eventually, businesses overextend themselves, relying on unrealistic expectations of continuous growth to manage their debts and sustain operations. When the unsustainable boom collapses, businesses face bankruptcy, and lenders endure defaults.
In response, the Federal Reserve typically reduces the federal funds rate to make credit cheaper and ease the transition during economic downturns. This approach has been the standard monetary policy for the past three decades.
While the Fed believes it has successfully fostered continuous economic growth during this period, the reality is complex. From 1980 to 2007, the U.S. experienced multiple booms with few notable busts. Even the bursting of the dot-com bubble was swiftly addressed through low interest rates.
However, alongside this apparent success, several peculiar trends have emerged. Public and private debt levels have surged, the dollar has lost value, and with each cycle of interest rates, the booms yield diminishing returns. Genuine growth, derived from capital investment and production, has been overshadowed by asset price inflation and credit-based consumption.
Credit Market Killing Machine
Since the 2008 credit crisis, the Fed’s strategies have seemingly failed to spur economic recovery. The federal funds rate has lingered near zero since December 16, 2008. According to policymakers and economists, such conditions should have prompted substantial economic growth, but this has not materialized.
Instead, the Fed has lowered the cost of borrowing so dramatically that even in the presence of profitable business opportunities, lenders hesitate to lend due to minimal risk premiums. Consequently, the credit market’s ability to bolster economic growth has been severely compromised.
Clearly, the Federal Reserve’s approach of providing inexpensive credit to stimulate growth has lost its efficacy. Moreover, this policy encourages speculation. Faced with negligible real returns on CDs or government bonds, some investors opt for riskier investments.
Gross notes, “It may induce inflationary distortions that lead to increased demand for commodities and gold as alternative stores of value when paper currency loses significance.” In addition, the stock market joins the roster of speculative investments where investors chase inflated returns. Notably, the stock market is experiencing its best start in 25 years, possibly influenced by the Fed’s policies.
In conclusion, as we navigate these complex economic waters, it is evident that the strategies designed to stimulate growth may need a comprehensive reassessment. The long-term effects of persistently low interest rates warrant scrutiny to ensure a stable and thriving economy in the future.
Sincerely,
MN Gordon
for Economic Prism