Federal Reserve Vice-Chairman Stanley Fischer made a couple of
controversial statements this week regarding negative interest rates.
Fisher stated negative rates “seem to work” while admitting they are bad
for savers but they “typically they go along with quite decent equity
prices.”
There are two problems in play. The first is an explicit admission that
the Fed sponsors wealth inequality. The second problem is Fisher does not understand
how markets even work.
Failed Transmission
John Hussman takes Fisher to task on how markets work Failed
Transmission – Evidence on the Futility of Activist Fed Policy.
Any economist with even a vague understanding of how securities are priced
should understand that elevating the price that investors pay for financial
securities doesn’t increase aggregate wealth. A financial security is nothing
but a claim to some future set of cash flows. The actual “wealth” is embodied
in those future cash flows and the value-added production that generates
them. Every security that is issued has to be held by someone until
that security is retired. So elevating the current price that
investors pay for a given set of future cash flows simply brings
forward investment returns that would have otherwise been earned later,
leaving little but poorly-compensated risk on the table for the
future (see QE and the Iron Laws for an illustration of this
process).
In this context, the following statement last week by Federal Reserve
Vice-Chairman Stanley Fischer last week (Bloomberg) displayed a strikingly
narrow understanding of the investment process:
“Well, clearly there are different responses to negative rates. If you’re
a saver, they’re very difficult to deal with and to accept, although
typically they go along with quite decent equity prices. But we consider all
that and we have to make trade-offs in economics all the time, and the idea
is the lower the interest rate, the better it is for investors.”
To be fair, there’s a kernel of truth in Fischer’s view that lower
interest rates are “better” for investors. In recent years, low interest
rates have certainly encouraged speculation, stretching reliable measures of
equity market valuation to the third most offensive level in U.S. history
next to 1929 and 2000. But Fischer’s statement is also incomplete. A clear
understanding of how financial securities are priced suddenly turns Fed
policy from something that seems quite generous to investors into something
that’s actually terrifically hostile. See, the lower the interest rate, the
better it is for investors, but only provided that investors wholly
ignore the future.
In reality, depressed interest rates ultimately benefit only those
investors actually cash out at the speculative pre-crash
extremes that the Fed seems so fond of producing. From here, for example, we
estimate that the prospective 12-year nominal total return on a conventional
portfolio mix (60% stocks, 30% bonds, 10% cash equivalents) is likely to
average just 1.5% annually. As for the S&P 500 Index itself, we presently
estimate annual total returns of just 1.4% annually over that horizon, with a
strong likelihood of cyclical losses on the order of 40-55% in the interim
(which would be a rather run-of-the-mill outcome from present extremes). Real
prospective long-term returns are already likely to be negative on both fronts
after inflation. The blue line on the following chart brings the future of
conventional investing up-to-date.
The foregoing chart estimates 12-year prospective S&P 500 total
returns using the log ratio of nonfinancial market capitalization to
corporate gross value-added. The two have a -93% correlation on that horizon
in post-war data (negative, because higher valuations imply lower subsequent
returns).
Reflections on Wealth Inequality
The US does not have negative rates, but it certainly has had amazingly
low rates. What Fisher said about negative rates applies equally well to low
rates.
By holding rates too low too long the Greenspan Fed created a huge
property bubble.
Who benefited?
It certainly was not the saver. The beneficiary of the bubble was the
equity holders and bank CEOs. Not only did financial insiders make a fortune
in stock options in the runup, the Fed bailed out the banks after the crash
as well.
Negative Rates “Seem” to Work
In his speech Fisher said Negative Rates Seem to Work in Today’s World.
Negative rates “seem to work” for whom?
Mike “Mish” Shedlock
