Alexander Hamilton, George Washington’s Treasury Secretary, in his first “Report on the Public Credit” in 1790, put forth the concepts of “assumption” and “redemption.” He argued that the federal government should assume the Revolutionary War debt of the states and pay those debts at “face value” in full to the bearers of such debt on demand. In order to redeem the $75 million of bonds, Hamilton promoted creation of a “sinking fund” that would pay off five percent of the bonds annually. Revenue to pay off the principle and interest should come from tariffs on imported goods and an excise tax on whiskey. Bondholders would be due 4% annual interest payments.
Today, the total value of US Treasury Bills, Notes, and Bonds is above $20 trillion and rising. US Treasuries are the global standard of debt, as is the US Dollar the standard for currency. A bond investor today would enthusiastically buy 4% US Treasuries, if he could buy them at “par value” or $1000 per bond. Today’s 10 Year Treasury Note Yield is 2.309%. In today’s bond market, a 4% bond is worth $1150, according to the Hewlett-Packard 12C calculator, a $150 “premium.” However, if a bond investor believes that market interest rates will rise over time, the price of that 4% bond should fall until the market rate, now 2.309% matched or rose above the bond’s “coupon rate” of 4%. The decision to buy, sell, or hold US Treasuries takes into account the “interest rate risk” just described.
US Treasuries today carry the lowest “default risk” among global government bonds, so investors need only consider interest rate risk. Bond prices determine not only what a bond investor will receive twice per year in interest payments, but also what a borrower pays monthly to finance a home purchase or start a business. That is where the rubber meets the road for the Fed’s influence on economic expansion or contraction. The driver of the vehicle to which those wheels are attached is the Federal Open Market Committee (FOMC). It directs the market operations of the Federal Reserve System (The Fed). Fed action affects the price, and thus the yield, of US Treasuries by buying and selling in the open market. When the Fed buys, it decreases the supply, increases prices, and lowers the yield. Selling increases supply, decreases prices, and raises the yield.
The Fed also sets the Fed Funds Rate, the interest rate at which banks may lend money to each other on an overnight basis. The rate at which banks can borrow also influences the rate at which they will lend to their customers via home mortgage and business loans. The higher the Fed Funds Rate, the higher the interest rates on loans. Most often, the effective Federal Funds Rate is lower than the yield on US Treasuries, but not always. If the Fed wants to slow the economy, it will raise the Fed Funds Rate and make it more expensive for banks to borrow. Paul Volker’s Fed, in June of 1981, raised the Fed Funds Rate to a peak of 20% in order to squelch the rampant inflation of the 1970’s. He succeeded. His Fed’s action was accompanied by the 1980-82 recession and its 10+% unemployment rate.
If the Fed wants to encourage lending by banks, it can lower the Fed Funds rate. If banks can borrow at a lower rate, their loans to homebuyers become more profitable, and they will tend to lend more, but not always. During the 1990-91 recession, which followed the Savings and Loan Crisis of the late 1980’s and the invasion of Kuwait by Iraq, Alan Greenspan’s Fed dropped the Fed Funds Rate from 9.75% in December of 1988 to 3.0% in September of 1992. Greenspan stated his frustration with the stubborn 7+% unemployment rate and banks’ unwillingness to lend by saying, “You can’t push on a string.”
Paul Volker’s Fed proved that rising interest rates will eventually slow the economy and stem inflation, but his successors—Alan Greenspan, Ben Bernanke and Janet Yellen—did not meet with equivalent success by lowering rates to stimulate the economy and reduce unemployment. It turns out that bankers will not lend unless they see a potential for profit. Loans to poor credit risks can end up as losses on the balance sheet and unemployment for loan officers. Bankers want to make money, but they also want to keep their jobs.
Confronted with what would later be known as “The Great Recession,” Ben Bernanke’s Fed dropped the Fed Funds rate from 5.25% in June of 2006 to 0.25% in December of 2008. Even though banks were able to borrow at an effective 0% interest rate, unemployment continued to rise. The unemployment rate was 10.0% in October of 2009 and did not drop below 9% until October of 2011. The Organization for Economic Co-operation and Development considers full employment to be an unemployment rate of between 4% and 6.4%.
For Ben Bernanke, author of Essays on The Great Depression, the worst economic event in US history was not the inflation of the 1970’s, but the deflation of the 1930’s. When, in 2008, a zero-percent Fed Funds rate had little effect on the unemployment rate, Bernanke’s Fed began buying bank debt, mortgage-backed securities, and treasury notes. The intent of this “quantitative easing” was to flood the banks with liquidity in order to bring down long-term interest rates. By the end of his second term, the Federal Reserve had transferred $4.5 trillion to the US Treasury from bank balance sheets. When Bernanke’s second term as Fed Chair ended in 2014, unemployment was still at an unacceptable rate 6.7%.
Janet Yellen, the first female Chair of the Federal Reserve, defended quantitative easing, but vowed to revert to traditional monetary policy when economic growth and unemployment returned an acceptable level. Her Fed targets a 2% growth rate for Gross Domestic Product (GDP) and is now close to achieving that goal. The US economy expanded at an annualized rate of 3.1% in the second fiscal quarter of 2017. Yellen’s Fed has increased the Fed Funds rate four times and projects continued gradual rate increases. On Tuesday, September 27th, Ms. Yellen told the National Association for Business Economics, “It would be imprudent to keep monetary policy on hold until inflation is back to 2 percent.” But she also admitted that the Fed’s understanding of inflation is “imperfect” and that the apparent lack of inflation in the current full-employment economy is “a mystery.” She said, “We recognize that something more persistent may be responsible for the current undershooting.”
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