The Federal Reserve’s special power is convoluted…
As history shows us, the Fed’s interest-rate hikes almost always precede financial calamity.
And yes, we all know how much rates have risen since the central bank started using this weapon to attack out-of-control inflation last year.
The benchmark federal-funds rate now sits in a targeted range between 4.25% and 4.5%. It’s the highest level since 2007.
Still, despite what the Fed has done in recent months, interest rates are not too high.
Today, we’ll discuss the near-zero interest rates the Fed forced on the economy in the past. As I’ll explain, they were more than a little “communist.”
And now, the Fed is trying to fix that problem…
Let’s start exploring this idea with a simple definition…
Interest rates guide the prices paid to folks who supply debt capital.
When these folks supply debt capital, they take on the risk that borrowers won’t be able to repay the loans as promised. They also give up opportunities to use the capital for their own ventures. In turn, they should receive fair compensation.
About 15 years ago, the housing crash and ensuing financial crisis knocked everything out of whack. Plenty of capital got destroyed as borrowers defaulted on loans.
The Fed wanted to keep capital flowing through the economy. (This is like blood flowing through a person’s circulatory system. If it stops flowing… well, you know.)
So that’s why the Fed held rates as close to zero as it could. It essentially punished suppliers for hoarding capital to ensure that the economy survived.
But that was a special emergency. Over the long term, expecting creditors to supply debt capital without much interest is a communist mindset.
And the thing is… we’re not communists.
It was absurd for the Fed to suggest that we shouldn’t allow creditors to fairly profit from the value of what they supply. Negative, zero, or even near-zero rates have no place in our capitalistic society.
This era of low interest rates was like financial martial law. The Fed effectively nationalized capital to ward off a non-economic calamity. And then, it did it again when COVID-19 hit…
In March 2020, the Fed once again slashed the federal-funds rate to near zero. It hoped to keep the economy running despite the world coming to a standstill – this time due to a global pandemic.
But it had nasty consequences, like out-of-control inflation. As we all know, by last summer, the Consumer Price Index had soared to its highest level since the early 1980s.
As I said at the outset, the Fed’s special power of interest-rate manipulation is convoluted. And it brings us to an important question…
What is the correct price of debt capital?
The truth is, we don’t know the correct answer. No one does. We’ll all watch and see.
In supply-demand economies like ours, we use the market as a price-discovery mechanism. We judge whether the price of debt capital is too expensive or too cheap by observing marketplace behavior.
I know what it looks like when money is too expensive (when interest rates are too high)…
I started covering stocks for Value Line in December 1979. At the time, the federal-funds rate was around 15%. It topped out at about 20% a year later.
When talking to companies’ management teams, I kept hearing the same thing over and over. They were canceling or postponing plans because the cost of capital was too high.
Here’s the deal, though…
That isn’t happening today among large, publicly traded companies (as opposed to small businesses, which have little leeway for any kinds of cost increases). I haven’t seen or heard the cost-of-capital story happening for ages.
In fact, that script vanished by the 1990s. Then, companies complained about inadequate revenue visibility. And today, the uber-complaint is supply-chain inadequacy.
My point is…
Interest rates will only be too high when they inhibit large numbers of folks from borrowing. And even with the Fed’s latest rate-hiking cycle, we’re nowhere near that point right now.
What’s the right match between sustainable economic activity and non-damaging inflation? We’re all finding that out together again for the first time in roughly 15 years.
In the end, today’s higher rates aren’t out of the ordinary. They’re a more “normal” cost of capital.
After the financial crisis and again following the COVID-19 crash, the Fed tricked the markets. It made many folks think a “communist” monetary policy was normal.
Now, it’s trying to undo that damage.
Good investing,
Marc Gerstein
