MAKING CENTS OUT OF THE NEWS
(May 15th, 2018)
Interest Rates To Go Higher
By Tom McAllister, CFP®
Historically low interest rates, both short term and long term, which we have experienced for the past nine years, have indeed stimulated the U.S. economy as our central bank, the Federal Reserve, intended. But most investors appear to be misled about these interest rates, where they come from, and how they are determined, and what they mean.
Much of the confusion has to do with the role of central banks. Most people think the Fed controls all interest rates. Not so! They are only able to control short term rates, which can and does influence longer rates. But the Fed has no direct control of the longer term rates.
Actually an interest rate is simply the cost of transferring consumption over time. If one wants to spend less than they earn (save) in order to consume more in the future, they must find someone who wants to spend more today than they have coming in, and repay it at a later date. Most of the time, except when tax money floods into the treasury, our U.S. government is ready and eager to do this.
Savers, of course, want to be compensated to maintain or improve their future purchasing power. Thus, they need to be paid for three things, credit risk (the chance the loan will be repaid), taxes on their earnings which this same government demands, and inflation. Alas, nowadays this later factor is mostly underfunded. Of course, after paying taxes investors deserve a positive return. In a competitive market all three of these should be included, but too often inflation is not fully covered. Why not?
Right now 90 day U.S. Treasury bills pay about 3%. Inflation is approximately 2%. If a saver is in the 33% tax bracket he or she owes 1% in taxes, leaving no compensation to the saver for loaning these funds. Something is wrong with this picture.
Of course, the real reason interest rates have remained so low these past nine years is because savers believed the Fed would keep holding short term rates down below their fundamentals. Fed policy influences, but does not control, longer term yields on U.S. debt. Zero percent interest rates artificially held down longer term Treasury yields, not the much discussed Quantitative Easing (QE). That is why longer term yields have risen as the Fed has slowly raised interest rates.
They will almost certainly continue rising because the Fed has held short term rates too low for too long. Interest rates are below inflation and well below current Gross National Product growth. The Fed has gotten away with this by over-regulating banks, making it harder for them to lend and grow. At the same time they have allowed them to earn a modest amount (.25%) on their mandatory reserves, thus producing record high earnings.
Interest rates are going up and will continue to do so because the economy is telling savers they can demand higher rates.
Tom McAllister, CFP