Fed interest-rate manipulation should concern us all

Fed interest-rate manipulation should concern us all
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On June 27, the American Enterprise Institute (AEI) held a program on reforming the Federal Reserve where numerous reform proposals were discussed, including the manner in which the Fed formulates and executes monetary policy. 

No one at the conference, though, posed this fundamental question: Should the Federal Reserve, a government bureaucracy, manipulate interest rates? That this question was not posed is hardly surprising since there is widespread agreement that, of course, the Fed, and other central banks, too, should actively engage in interest-rate manipulation, or to put it more bluntly, fixing the price of credit.

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Since its founding in 1913, the manner in which the Fed implements monetary policy has evolved. In recent decades, the essence of monetary policy, until the aftermath of the 2008 financial crisis, was Fed manipulation of short-term interest rates (generally less than one year to maturity) through its open-market operations — the buying and selling of Treasury securities. 

 

Fed manipulation of short-term rates, in turn, had some impact on longer-term rates, although that impact was not always readily evident. Importantly, since World War II, the Fed did not try to directly influence longer-term interest rates by buying and selling longer-term Treasury securities. 

That changed dramatically after the financial crisis hit, when the Fed ballooned its balance sheet by buying longer-term Treasury securities as well as securities issued or guaranteed by the three housing-finance government-sponsored enterprises (GSEs) — Fannie Mae, Freddie Mac and the Federal Home Loan Banks.

The Fed’s increased investment in longer-term Treasuries substantially reduced the quantity of longer-term Treasuries other investors in fixed-income securities could purchase. The increased competition to own these Treasuries naturally drove down interest rates at the long end of the yield curve on all debt securities, which was the Fed’s intent.

Fed investment in Treasuries with a remaining time to maturity of more than 10 years increased from $89 billion at the end of 2007 to $145 billion at the end of 2009 and then to a peak of $658 billion at the end of 2014 before beginning a slight tapering to $623 billion at the end of 2017.

Magnifying the Fed’s downward impact on longer-term rates was its incursion into the ownership of housing finance-related debt. At the end of 2007, the Fed owned no debt issued by the housing-finance GSEs, nor did it own any mortgage-backed securities (MBS) guaranteed by Fannie or Freddie. 

Two years later, at the end of 2009, the Fed owned $1.07 trillion of GSE debt, including $908 billion of MBS with a remaining maturity of more than 10 years. In normal times, that debt would have been owned by other investors. Fed-owned MBS with a remaining maturity of more than 10 years grew to $1.74 trillion at the end of 2017.

Despite all the talk of shrinking the Fed’s balance sheet, the Fed’s depressing impact on longer-term rates continues to this day. On June 27, the Fed owned $619 billion of Treasury debt with a remaining maturity of more than 10 years, down just $4 billion from the end of last year. 

The Fed’s MBS portfolio with a remaining maturity of more than 10 years shrank at a slightly faster rate during the first half of 2018 — just 3.6 percent — to $1.68 trillion on June 27.

While there has been extensive discussion of two negative impacts of a prolonged period of excessively low interest rates — inflated asset values and increased leverage as businesses and individuals load up on cheap debt — there has been very little discussion of a third impact — the negative effect depressed interest rates are having on long-term investors, notably insurance companies and pension funds. The hangover they will suffer will be long and painful.

Insurance companies, especially life insurers, and pension funds have substantial long-term liabilities with fixed payouts, such as whole-life and long-term-care policies, annuities and defined-benefit pensions. 

The actuarial calculations on which those payouts are based include assumptions about the interest rate the investments funding those obligations will earn over the long term. Those interest-rate assumptions have been torpedoed by the Fed’s interest-rate manipulations, especially at the long end of the yield curve.

Insurers fully understand the challenge posed by a prolonged period of low interest rates, as noted in a New York Times article two years ago, but are limited in how they can respond. For some types of policies, insurers can increase premium rates to offset the interest-rate drought, but often that is not possible.

Pension funds may have to reduce their payments to pensioners or seek higher contributions from employers.

The long-term consequences of the Fed’s manipulation of interest rates across the entire yield curve will not be fully felt for some time, but based on what we know today and can reasonably foresee, the rationale for central bank interest-rate manipulation needs to be challenged.

Economic history has taught repeatedly that government price fixing, especially of basic commodities, such as oil and credit, creates distortions with long-term, painful consequences. Like any other commodity, financial markets are fully capable of setting interest rates — pricing credit — if given the chance to do so.

As with other goods and services, market interest rates will decline when the economy slows and rise when economic activity accelerates.

This would be comparable to what the Fed tries to do through its interest-rate manipulations, but without the distorting effects of the Fed's misjudgments as to the direction and magnitude of economic activity.  Markets can do it better.

Because lenders and borrowers have opposite perspectives on inflation – lenders are hurt by inflation while borrowers benefit from it – ongoing marketplace bargaining over interest rates will produce rates that minimize price inflation over time.

Even though the consequences of the last decade of interest-rate distortions have yet to be fully felt, now is the time to begin assessing the wisdom of government-sponsored interest-rate manipulation. Just because the Fed has demonstrated that it can manipulate rates across the entire yield curve does not mean that it should.

Bert Ely is the principal of Ely & Company, Inc., where he monitors conditions in the banking industry, monetary policy, the payments system, and the growing federalization of credit risk. Prior articles by Ely on banking issues and cryptocurrencies can be found here.  Follow Ely on Twitter: @BertEly.