Nov162015

Could rising interest rates stimulate the economy?

Rising interest rates would put money into the hands of savers, particularly seniors, who will spend it on goods and services and stimulate economic growth.

Janet-Yellen-in-Banker-Instinct-2Last week I wrote about interest rates. In the post Will Janet Yellen capitulate to greedy bankers and raise interest rates?, I lampooned a poorly reasoned heap of manure published by a Chase Bank lackey. The central thesis of the study was that rising interest rates could stimulate the economy.

Last Friday I met with a close friend who is a professional asset manager with 30+ years experience closely watching the economy and financial markets. I greatly value his opinion and the talks we have. He thought my post was too dismissive of the idea, and he challenged me to seriously consider the premise that rising interest rates could stimulate the economy.

In my post I noted that there was a good argument to be made that rising interest rates could stimulate the economy, but the Chase bank flunky failed to expound it. I plan to do that today.

How rising interest rates could stimulate the economy

The federal reserve manages interest rates on the basic premise that high interest rates deter borrowing and slow the economy while low interest rates encourage borrowing and speed the economy. Generally, this simple relationship holds true, but at the zero bound, strange things happen, and perhaps zero interest rates create an unusual stagnation that’s difficult to break out of.

interest rates and demand

Banks act as financial intermediaries. They make a profit on the spread between the rate at which they can loan money and the rate they must pay to obtain it. Banks can make money if rates are 2% or 12% as long as a margin exists between what money earns and what it costs.

Paul Krugman wrote back in February that Debt Is Money We Owe To Ourselves. He notes that one person’s debt is another person’s asset, so when a borrower makes a debt service payment, the interest expense for the borrower is interest income to the lender.

As long as interest rates are some number above zero, the flow of money from borrowers to lenders circulates throughout the economy, but when interest rates fall to zero, this flow of money stops — literally. The economy settles in to a stagnation equilibrium where borrowers don’t pay very much, but lenders — and in particular bank depositors — earn nothing at all.

federal_reserve_steals_from_retirees

When bank deposits earn nothing, the billions of dollars of risk-adverse savers like senior citizens earn nothing. When interest rates go up, the burden on borrowers increases, reducing their economic activity; however, the income to savers and bank depositors increases by equal measure, and many will spend it, particularly the seniors who need this money to make ends meet.

Thus, raising interest rates has the potential to stimulate consumer spending by putting money in the hands of bank depositors, many of who will withdraw with interest income and spend it.

Why haven’t rates gone up earlier?

yellen_raise_ratesIf raising interest rates has the potential to stimulate the economy, why hasn’t the federal reserve raised rates earlier?

First, millions of borrowers became insolvent during the Great Recession, and it’s taken time for them to find work and improve the family balance sheet through retiring debt (mostly through bank write-downs). The job market has improved enough that fewer borrowers are insolvent, and more are capable of supporting higher debt service payments.

Rising rates will will be painful as the higher borrowing costs will push many marginal borrowers back into insolvency, but the slow financial death of those borrowers unable to get back on their feet over the last seven years will not endanger the financial system.

Over the last seven years, banks wrote down much of the bad debt on their balance sheets. While their books still show the borrowers owe them large sums, their loss mitigation practices have allowed them to write down the value of these assets on their own books, preserving their own solvency. In short, banks can take the hit now that they couldn’t take before.

Rising rates will also wreak havoc on the values of financial assets. The value of any financial asset is loosely tethered to the discounted value of future cash flows, and when the discount rate rises, values invariably fall.

The practice of corporations floating bonds with cheap debt to buy back stocks will stop, so stock prices will be volatile.

The value of long-term bonds will suffer from the higher discount rate and the more attractive yields on short-term debt, so the bond market will also be volatile.Yellen_fed_reflation

Basically, those who hold financial assets will be in for a rough ride.

Asset values aren’t the economy

The inflation (and deflation) of numerous asset classes over the last several years is a direct response to cheap debt; however, these fluctuations have little to do with the functioning of the underlying economy.

In a normal economy, if investors drive up asset values of one sector of the economy, it spurs investment in property, plant, equipment, and labor to further exploit that resource. Over the last several years, that isn’t where this investment capital went. Instead, it merely flowed back into asset values and inflated them. If these asset values crash, it won’t have much of an influence on investment in goods and services actually producing something.

In short, even if the values of nearly everything declined, it won’t have a large impact on investments in productivity, so it won’t have much impact on the production of goods and services in the real economy.

What will happen to real estate?

Janet_Yellen_housing_bubbleI recently wrote that Rising mortgage rates will expose housing momentum myth because higher borrowing costs will cause sales volumes to crumble. Affordability will become a huge problem because the Housing inventory is abundant at prices buyers can’t afford. Back in January I stated that Affordability will be the major housing market issue of 2015. It was, and it will be an even larger issue in 2016.

What will a long-term rise in interest rates do to home prices? The main determinant of house prices is aggregate mortgage debt. It increased dramatically during the housing bubble, and it collapsed during the credit crunch. If mortgage balances fall due to higher borrowing costs, either house prices will fall, or sales volumes will dry up — or perhaps both with declining sales volumes first followed by falling house prices.

The feedback loop between real estate and the economy

I also stated my belief that housing will hold back the economy for the next decade. If the economy starts to heat up, the federal reserve will be under pressure to raise rates to combat inflation. If they then raise rates, it will cause housing to sputter or tank, and since homebuilding is a significant part of the economy, a decline in housing will drag down everything else and prompt the federal reserve to lower rates again.

I believe the economic drag caused by the impact higher interest rates will have on housing will be the biggest economic story of the next decade. Housing will be the laggard holding back the economy for the foreseeable future.

Of course, I expect realtors to spin it a bit differently….

Mortgage Rates Set to Rise, Adding Frenzy to Real Estate Market

Brian O’Connell, Nov 10, 2015realtor_know_nothing

… “We should see continuing strong demand for housing in the months ahead if today’s strong jobs report reflects a true return back to a strong growth trend we’ve seen over the last few years,” says Jonathan Smoke, chief economist at Realtor.com. “The healthy strong employment results for the past two years created an uptick in household formation, which has driven increased demand for home purchases and rentals.”

“The jobs report will influence the long-term bond market, so mortgage rates will increase in response,” he adds. …

The economy is getting better. It’s my anecdotal observation that we are only now recovering from the 2008 debacle. It feels like we are back to an economy dominated by earned income rather than Ponzi debt.

I spent most of the last year searching for a commercial space. When I started in earnest in January, there was plenty of supply and not much activity. Over the course of 2015, I watched these vacant spaces rent up, and very little new supply came to market. Commercial inventories are tight again, and rents are rising.

Perhaps these future merchants are foolish optimists betting on a brighter future that won’t come to pass, but there are plenty of people willing to make this bet, and the money they spend on tenant improvements and inventory is stimulating the economy today.BuyNowHurry

“This development [higher rates] is not good news for people looking to take out mortgage debt in the near future,” Johnson says. “Once the Fed starts raising rates, interest rates throughout the economy, including mortgage rates, auto loan rates and other loan rates will trend upward. I believe that anyone thinking about refinancing a mortgage or buying a home and taking out an initial mortgage should not wait, as rates will rise.”

Like Smoke, Johnson also believes the jobs number will boost home sales. “Many potential homebuyers may see an opportunity to buy a home and take advantage of current low mortgage rates,” he adds.

… John Wake, the so-called geek-in-chief at Real Estate Decoded and a realtor with HomeSmart in Scottsdale, Ariz. “Many people expected the increase to be the first of many so they became even were more desperate to buy a house right away.”

The false urgency of realtor bullshit never goes away, does it?

Affordability products are not the answer

In the past when interest rates went up or prices got too high, lenders responded by offering affordability products. Those days are gone as these products were effectively banned by Dodd-Frank in order to prevent future housing bubbles.

Future house prices and sales volumes will be dictated by the course of interest rates. Based on what we’ve seen over the last 3 years, we can expect sales volumes to plummet when interest rates rise, and if they rise high enough, price pressure will mount. We won’t see a crash without must-sell inventory, but we may see air pockets where prices drift lower as discretionary sellers decide they want to get out.


[dfads params=’groups=23&limit=1&orderby=random’]
[listing mls=”OC15246905″]