C’mon Fed – Stop Calling Negative Real Rates Tightening

The FOMC (Federal Reserve Open Market Committee) is all wrapped up in their short-term interest rate management: how fast or slow to raise, how high to go and when to begin lowering. They need to do what all their predecessors did when the capital markets were healthy: Disappear.

Here’s the problem: They have forgotten that interest rate determination is NOT their job. Yes, they can raise rates to cool an overwrought financial system. And they can lower rates to support a troubled one. However – Once they have rectified the problem, they are supposed to step away.

But, then, who will set the interest rates?

The answer is easy because it’s how interest rates had always been set prior to Ben Bernanke’s wholesale takeover. It’s the capital (money) market where participants (lenders and borrowers, buyers and sellers) come together and bid or ask, creating a fluid, open, fair and equitable determination of the cost of money – the price of capital – that supports capitalism’s tenets, goals and systems. Not only is it more robust, the capital market’s rate setting operates steadily for long hours every week – not just once every six weeks or so.

The “fair and equitable” bit has been sorely missing for fourteen years and counting. The providers of capital (from savers on up) have been forced to take a large, negative real (inflation-adjusted) rate, as well as forgoing any positive real return that could have occurred. The Fed-caused loss of purchasing power since 2008 has been well over 20%.

Think about that. It’s as if the Fed taxed all the owners of those multiple $trillions in short-term assets about 2% per year – and for what? So borrowers could get bargain-priced capital to ____ (fill in the blank). Originally, Ben Bernanke said organizations would borrow to make capital investments, hire more employees and produce more, making the U.S. GDP increase. It never happened. Instead, gluts were created, much borrowing focused on producing financial gains, and GDP growth ran at a historically mediocre rate.

Wall Street brings back false “inverted yield curve = recession” fear

The current recession-is-coming lists include the inverted yield curve. However, the “traditional” cause, when the Fed tightens money to cool a hot economy, is absent. Moreover, the link is tenuous. Sometimes it works, although many times it is delayed. Other times the inversion simply comes and goes. It all depends on why short-term rates are higher than long-term ones. Today’s situation is all about inflation expectations – not a recession forecast.

The Fed is reversing its easy money policies to lessen inflationary pressures. As short-term rates rise from their abnormally low levels, longer-term inflation forecasts have declined, causing longer-term interest rates to ease. The two, opposite movements caused short and long rates to cross – hence, an inversion on paper, but not in effect.

But won’t the Fed’s tightening cause a growth slowdown?

Not yet. Until Ben Bernanke introduced 0% interest rates in a 2% inflation environment, short rates naturally equaled – and more often exceeded – the inflation rate. Why? Because investors demanded an appropriate real return on their money. Therefore, when the Fed tightened historically it reduced money supply, causing rates to rise higher than those normal levels.

Now consider this Fed’s rising rates. The short-term rate has moved closer to the inflation rate, but it is still in negative real rate territory. In other words, short-term rates are still below normal – an easy money status, not a tightening.

The bottom line – The “truth” will come out eventually

So, why hasn’t this policy been called out as wrong-headed? Because the abnormally low rates benefitted those who could make use of the abnormally low borrowing rates – think major corporations, hedge funds, private equity funds, leveraged organizations and wealthy individuals. Then there is the biggest borrower beneficiary: The U.S. Government.

The harsh reality is that the Federal Reserve has stiffed the holders of the multiple $trillions of short-term assets for 14 years: Savers, retirees, conservative investors, companies (especially those dependent on interest income, like insurance carriers), and nonprofit organizations.

Additionally, they forced many of these to take on unwanted risk to earn what should have been a safe return. Those that went into long-term bonds benefitted for a while as long-term rates slowly ground down, causing prices to rise. Then, suddenly in 2022, the Fed began its interest rate rising , causing longer-term bond yields to rise and prices to fall. Many of the losses were greater than multiple years of the bonds’ low interest payments.

There have been various articles about the Fed’s flawed actions, but nothing has stuck yet. However, the truth will out. It always does – eventually.