Friday, September 4, 2015

The Fed, Interest Rates and Stock Prices: Fighting the Fear Factor

If it feels like you are reading last year’s business stories in today's paper, there is a simple reason. The Federal Reserve's Open Markets Committee (FOMC) meeting date is approaching, and in a replay of what we have seen ahead of previous meetings, we are being told that this is the one where the Fed will lower the boom on stock markets, by raising interest rates. While this navel gazing may keep market oracles, Fed watchers and CNBC pundits occupied, I think that the Fed’s role in setting interest rates is vastly overstated, and that this fiction is maintained because it is convenient both for the Fed and for the rest of us. I think that there are multiple myths about the Fed’s powers that have taken hold of our collective consciousness, and led us into an investing netherworld. So at the risk of provoking the wrath of Fed watchers everywhere, and repeating what I have said in earlier posts, here are my top four myths about central banks.

1. The Fed sets interest rates
Myth: The Federal Reserve (or the Central Bank of whichever country you are in) sets interest rates, short term as well as long term. In my last post on this topic, I mentioned my tour of the Federal Reserve Building, with my wife and children, and how sorely tempted I was to ask the tour guide whether I could see the interest rate room, the one where Janet Yellen sits, with levers that she can move up or down to change our mortgage rates, the rate at which companies borrow from banks and the market and the rates on US treasuries. 
Reality: There is only one rate that the Federal Reserve sets, and it is the Fed Funds rate. It is the rate at which banks trade funds, that they hold at the Federal Reserve, with each other. Needless to say, not only is this an overnight rate, but it is of little relevance to most of us who don't have access to the Fed windows. While there is a tenuous link of Fed Funds rate to short term market interest rates,  that link becomes much weaker when we look at long term rates and their derivatives.
Why preserve the myth: Giving the Fed the power to set interest rates gives us all a false sense of control over our economic destinies. Thus, if rates are high, we assume that the Fed can lower them by edict and if rates are too low, it can raise it by dictate. If only..

2. Low interest rates are the Fed’s doing
Myth: Interest rates are at historic lows not just in the United States but in much of the developed world, and it is central banking policy that has kept them there, through a policy of quantitative easing The myth acquires additional sheen when accompanied by acronyms such as QE1 and QE2, which bring ocean liners to my mind and a nagging fear that the next Fed move will be titled the Titanic!
Reality: The Fed has had a bond-buying program that is unprecedented and large, but only relative to the Fed's own history. Relative to the size of the US treasury bond market (about $500 billion a day in 2014), the Fed bond-buying (about $60-$85 billion a month) is modest and unlikely to have the influence on interest rates that is attributed to it. So, what has kept rates low? At the risk of rehashing a graph that I have used multiple times, it is far simpler and more fundamental, and it lies in the Fisher equation, which decomposes the nominal interest rate into its expected inflation and real interest rate components:
Nominal Interest Rate = Expected Inflation + Expected Real Interest Rate
If you make the assumption that in the long term, the real interest rate in an economy converges on real growth rate, you have an equation for what I call an intrinsic risk free rate.  In the graph below, I graph out the actual US 10-year treasury bond rate against this intrinsic risk free rate and you can make your own judgment on why rates have been low for the last five years.'

To me, the answer seems self evident. Interest rates in the US (and Europe) have been low because inflation has been non-existent and real growth has been anemic, and it is my guess that rates would have been low, with or without the Fed’s exertions. In fact, the cumulative effect of the Fed's exertions can be measured as the difference between the intrinsic risk free rate and the US treasury bond rate, and during the entire quantitative easing period of 2008-2014, it amounted to about 0.13%. It is true that the jump in US GDP in the most recent quarter  has widened the difference between the treasury bond rate and the intrinsic interest rate, but it remains to be seen whether this increase is a precursor to more healthy growth in the future, or just an one-quarter aberration. 
Why preserve the myth: I think it is much more comforting for developed market investors to think of low interest rates as an unmitigated good, pushing up stock and bond prices, rather than as a depressing signal of future growth and low inflation (perhaps even deflation) in much of the developed world. That problem will not be fixed by Fed meetings and is symptomatic of shifts in global economic power and a re-apportioning of the world economic pie.

3. The reason stock prices are so high is because rates are low
Myth: Stock prices are high today because interest rates are at historic lows. If interest rates revert back to normal levels, stock prices will collapse. 
Reality: Low interest rates have been a mixed blessing for stocks. The low rates, by themselves, make stocks more attractive relative to the alternative of investing in bonds. But if the low rates are symptomatic of low inflation and low real growth, they do have effects on the cash flows that can partially or completely offset the effect of low rates. One way to decompose the effects is to compute forward-looking expected returns on stocks, given stock prices today and expected cash flows from dividends and buybacks in the future to see how much of the stock price effect is fueled by interest rates and how much by cash flow changes. If this bull market has been entirely or mostly driven by the drop in interest rates, the expected return on stocks should have declined in line with the drop in interest rates. In my most recent update on this number at close of trading on August 31, 2015, I estimated an expected return of 8.50%, almost unchanged from the level in 2009 and higher than the expected return in 2007. 
At least based on my estimates, the primary driver of stock prices has been the extraordinary fountain of cash that companies have been able to return in the last few years, combined with a capacity to grow earnings over the same period. By the same token, if you are concerned about cash flows, it should be with the sustainability of these cash flows, for two reasons. The first is that earnings will be under pressure, given the strength of the dollar and the weakness in China, and this is starting to show up already, with 2015 earnings about 5-10% below 2014 levels.  The second is that companies will not be able to keep returning as much as they are in cash flows; in 2015, the cash returned to stockholders stood at 91% of earnings, a number well above historic norms. In the table below, I check to see how much the index, which was at 1951.13 at the close of trading on September 3, would be affected by an increase in interest rates (increasing the US 10-year T.Bond rate from the 2.27% on September 3, to 5%) as contrasted with a drop in cash flows (with a maximum drop of 25%, coming from a combination of earnings decline and reduced cash payout):
Base: S&P 500 on September 3= 1951.13, T.Bond rate = 2.27%; ERP = 6.34%, g=6.30%
If you hold cash flows constant, an increase in interest rates has a relatively small effect on stock prices, with stock prices dropping 8.76%, even if the US T.Bond rate rises to 5%.  In contrast, if cash flows drop, the index drops proportionately, even if interest rates remain unchanged. You are welcome to make your own "bad news" assumptions and check out the effect on value in this spreadsheet.
Why preserve the myth: For perpetual bears, wrong time and again in the last five years about stocks, the Fed (and low interest rates) have become a convenient bogeyman for why their market bets have gone wrong. If only the Fed had behaved sensibly and if only interest rates were at normal levels (though normal is theirs to define), they bemoan, their market timing forecasts would have been vindicated. 

4. The biggest danger to the Fed is that the market will react violently to a change in its interest rate policy
Myth: The biggest danger to the Fed is that, if it reverses its policy of zero interest rates and stops its bond buying, stock and bond markets will drop dramatically.
Reality: While no central bank wants to be blamed for a market meltdown, the bigger danger, in my view, is that the Fed does what it has been promising to for so long, and nothing happens. That is a good thing, you might say, and while I agree with you in the short term, the long-term consequences for Fed credibility are damaging and here is why. The best analogy that I can offer for the Fed and its role on interest rates is the story of Chanticleer, a rooster that is the strutting master of the barnyard that he lives in, revered by the other farm animals because he is the one who causes the sun to rise every morning with his crowing (or so they think). In the story, Chanticleer’s hubris leads him to abandon his post one morning, and when the sun comes up anyway, the rooster loses his exalted standing. Given the build up we have had over the last few years to the momentous decision to change interest rate policy, think of how much our perceptions of Fed power will change, if stock and bond markets respond with yawns to an interest rate policy shift.
Why we hold on to the myth: If you buy into the first three myths, this one follows. After all, if you believe that the Fed sets interest rates, that it has deliberately kept interest rates low for the last five years and that stock prices are high because interest rates are low, you should fear a change in that policy. Coupled with China, you have the excuses for your underperformance this year, thus absolving yourself of all responsibility for your choices. How convenient?

What next?
Over the last five years, we have developed an unhealthy obsession with the Federal Reserve, in particular, and central banks, in general, and I think that there is plenty of blame to go around. Investors have abdicated their responsibilities for assessing growth, cash flows and value, and taken to watching the Fed and wondering what it is going to do next, as if that were the primary driver of stock prices. The Fed has happily accepted the role of market puppet master, with Federal Bank governors seeking celebrity status, and piping up about inflation, the level of stock prices and interest rate policy. Market watchers, journalists and economists have found stories about the Fed to be great fillers that they can use to fill financial TV shows, newspaper and opinion columns.

I don't know what will happen at the FOMC meeting, but I hope that it announces an end to it's "interest rate magic show". I think that there is enough pent up fear in markets that the initial reaction will be negative, but I am hoping that investors move on to healthier, and more real, concerns about economic growth and earnings sustainability. If the Fed does make its move, the best news will be that we will not have to go through more rounds of obsessive Fed watching, second-guessing and punditry.

YouTube Video

  1. The Fed did it!
  2. Slides to accompany video

Past Posts
  1. The Fed and Interest Rates: Lessons from Oz (June 21, 2013)
  2. Dealing with Low Interest Rates: Investing and Corporate Finance Lessons (April 2015)
  1. Interest Rates, Stock Prices and Expected Returns


Kevin Erdmann said...

I wonder...stock options are basically the pairing of two transactions: 1) a subsidy to workers based on changes in the share price, which are an expense, and (2) an arbitrary stock transaction that happens as part of the compensation, which creates an accounting shadow of financial cash inflows and outflows. If we imagine a risk-free world where all options are exercised, and firms sterilize financial cash flows by buying shares when they issue stock options, we would see that this would cause gross cash distributions to rise, even though there would be no net effect on firm capitalization.

I wonder if this is causing cash distributions to be inflated, although it would be difficult to adjust for precisely, because we don't live in a risk free world, and the net effect on individual firm capitalization might be hard to pin down.

John Honovich said...

"the primary driver of stock prices has been the extraordinary fountain of cash that companies have been able to return in the last few years, combined with a capacity to grow earnings over the same period."

Why have stock prices been able to generate such an extraordinary fountain of cash in the last few years, especially if overall economic growth is slow?

Samir Sadek said...

Thank you professor.

Before reading this post, I though there were the contrarians -- against QE -- vs the mainstreams -- in favor of QE. But now, I see that here is also you.

I have seen nobody ever comparing the size of US Treasury bond with the QE. Basically, if the US Treasury Bond market is equivalent to the US Budget then we can say that the Fed is financing 0.04% of the US budget every year.

If we ask what would be the rate without the Fed intervention then we could have a look at the table about the difference between the T bond rate and the intrinsic rate. There, you suggest that the intrinsic rate has always been higher than the nominal T Bond rate.

Then, later on, you show that even 5% increase in the T Bond will not affect the market as much as a reduction on the cash flow.

Note however that, according to certain pundits:
- The strength of the dollars has to do with the same factor that influences the investors, that this interest rate hike.
- And the sell off in China could have been triggered by the same reason.

As a result, the psychological effect of the Fed the Chanticleer on the global economy might be complex to grasp by indirectly affecting the dollars and the cash flow of the economy.

The difference between the nominal and the intrinsic rate is the cornerstone of your demonstration. But maybe the nominal interest rate will affect the intrinsic rate: it seems that it is not impossible that investors influenced by the Fed policy will invest in certain markets providing liquidity and eventually increasing the growth rate and the inflation and a result the intrinsic rate.

Da Piit! said...

While monetary policy can and should help manage downturns for minimum damage, the real question is, can it actually trigger growth by itself?

Many think so and seem to be waiting for central banks to "get it right", making everything go back to normal.

However, the key factor is lack of political vision and commitment to competitiveness, to increasing productivity, to addressing problems in public sector and structural inefficiencies, while investing in innovation policy etc. The political society seems to have abdicated, expecting the banks to fix it. When was the last time one heard a politician talking about growth inducing policies? About how to make the country even more competitive as a home for global business?

Interest hikes should come in response to undesired levels of inflation increases, not to fill-in where real politics is failing. Attempting to kick-start things by mimicing a situation with growth is not the answer. Focus and accountability needs to shift to where it belongs.

at6 said...

Professor, some time ago I found this graph from GS:
They write that about 44%-47% of cash, now is returning to investors (it is near historical normal value). You write that it is 91% and this number well above historic norms.
Why such a difference may occur in the estimates?

PM said...

Thanks for the thoughtful article. How does the argument that "profit margins of US companies are at all time high and have to revert to mean" come into play in your forecast of expected returns? Cash flows will reduce quite substantially in that scenario.

Aswath Damodaran said...

John and PM,
I think that there are two reasons why companies have been able to grow earnings and return as much in cash flows over the last few years. The first is that they have honed the cost cutting knife, reflective in lower wage increases, layoffs and better margins in some businesses. The second is that they have used emerging markets as their growth engines, with relatively little investment in them. With the cost cutting close to hitting limits in many businesses and the slowing of China/emerging markets, both are under assault. Next year will tell the resulting tale. If earnings drop and cash flows decline from their current levels, you will see the results in the table that I have in the post and it can be ugly.
As for the GS number, I have no idea. I can tell you having spent more time with these numbers than I really should be that there is no way that companies are returning only 44-47%. Perhaps, they are living in a world where only dividends are counted as cash return.

Aswath Damodaran said...

John and PM,
I think that there are two reasons why companies have been able to grow earnings and return as much in cash flows over the last few years. The first is that they have honed the cost cutting knife, reflective in lower wage increases, layoffs and better margins in some businesses. The second is that they have used emerging markets as their growth engines, with relatively little investment in them. With the cost cutting close to hitting limits in many businesses and the slowing of China/emerging markets, both are under assault. Next year will tell the resulting tale. If earnings drop and cash flows decline from their current levels, you will see the results in the table that I have in the post and it can be ugly.
As for the GS number, I have no idea. I can tell you having spent more time with these numbers than I really should be that there is no way that companies are returning only 44-47%. Perhaps, they are living in a world where only dividends are counted as cash return.

Michel said...

Your data about the relative importance of the Fed's purchases of Treasuries and therefore its impact seems at odd with for example:

Would you care to explain ?

Also I fear that your conclusion is wishful thinking. Too many people make a living out of "Fed Watching" for that "noise" to disappear once we see the first rate increase.

Anonymous said...

This is a great post as always. But wouldn't the lending rate fo down and thereby cost of debt which would ultimately lead to reduction in WACC having impact on the value of the business and thereby value of equity? If Banks can raise cheap money (With lower Feds funds Rate) and lend at a lower rate - shouldn't this impact be felt?

Requesting if you could share some light on this.

Thank you.

PM said...

Professor, I have a question about the following line from your post: "In my most recent update on this number at close of trading on August 31, 2015, I estimated an expected return of 8.50%, almost unchanged from the level in 2009 and higher than the expected return in 2007."

It is counter-intuitive to believe that expected returns in 2009 were the same as they were in Aug 2015. Earnings in 2009 were at a trough and would be expected to revert to a higher level, whereas now earnings are at all time highs and may revert to a lower number. Why not use some sort of earnings smoothing / normalized earning measure which would likely result in much higher expected return in 2009 vs. 2007 or 2015?

Rick Raphael said...

Janet Yellen and the rest of the members of the Fed don't need levers to raise interest rates, they have a megaphone. Recent speeches have indicated that several members of the FED feel that interest rates should rise to constrain the possible threat of inflation. Paul Krugman emphatically disagrees and so do I:

What the Fed says about interest rates is as or more important than what it does about rates because, as you point out, in ordinary circumstances there is little they can do beyond the Federal Funds rate. But part of the Fed's strategy for the past few years has been to broadcast it's intentions and the data on which they are based. This had the effect of holding down rates because the Fed has emphasized the low levels of inflation and unemployment in the sluggish economy. While the 2d estimate of GDP shows a healthy 3.7% rise, that is coming on the heels of a -0.2% 1st quarter. The Chicago FED's National Activity Index "suggests that growth in national economic activity was at its historical trend. The economic growth reflected in this level of the CFNAI-MA3 suggests limited inflationary pressure from economic activity over the coming year." That doesn't sound to me like a wave of inflation is imminent.

Personally I see nothing to indicate the onset of inflation above the 2% level, but what do I know? And while a 0.25% uptick in the Federal Funds rate will have little to no impact on the economy, it is the threat of continued increases that can depress markets and the wealth effect.

You may get your wish for a rate increase Dr. Damodaran but markets never fight the FED so they'll sell off.

Anonymous said...

Is it strictly true that the Fed only sets one interest rate, the Fed Funds rate? I thought I had recently learned that they also set another rate, perhaps more than one, the "discount window" rate, which is also a very-short-term rate.

Anonymous said...


Thanks for your article,

1 Everyone aware centra bank sets only fund rate directly but have very minimal impact on long end curve. Point is when market see largest single buyer on daily basis enter market with objective of bringing long end curve , what would expect other participant to do take position against them or front run them, follow them ? Will this be captured as part of the equation you mentioned by rate Tylor equation ? Question is how long they can hide the real effect of economy on rate..

2 What they did with operation twist 1 & 2 ?

3 how much bank deposit earn in US banks ? Who decided ?

4 when USA, Europe, japan were down with high structural deflation where would emerging economy got their growth out when they are primarily export oriented economy ? What is the percentage of corporate earnings come from emerging country in relation to developed economy ? Can corporate get record cash flow with labor restructuring and 3rd world economic growth ?

5 what is the size of dollar carry trade due to FED liquidity pump into financial world ? Have we learned anything from japan experiment of least rate financing fueled carry trade and its impact of it in other market and their currencies ?

6 who had access to free money from FED ? What did they do with that money ?

7 how much is capex spending by record high cash flow corporate ? What is the rate of change of debt to equity ratio during this period of record low rate ? How much of eps expansion is supported by corporate buyback program and real earning growth ?

8 what is the deficit USA was running during this period ? What is the relative size of FED asset purchase to it ?

9 who is the largest holder of USA debt today pls consider FED too in this ?

10 Alan Greenspan or Paul Volcker or Ben didn't lower or raise rate ? Can we see the Treasury rate chart during their times ?

11 you mean market determined all time low rate without influence of FED sensing purely based on forth coming deflation ? When was we had this lowest rate in USA history ? When was bank deposit earned this lowest rate ? Great depression ?

12 recent yield inching high is the recognition of market about FED limited power in suppressing it in absence of big ticket asset purchase ? Emerging economy selling Treasury to meet their end ? Unwinding of dollar carry trade ? Or US growth ?

13 what would be the impact of US growth on other economies and vice versa in your understanding in current scenario ?

14 was 2008 credit crisis a liquidity issue or insolvency ?

15 what would be increase of interest amount & it's impact on tax, deficit due to rate normalization ? What would be impact of the same on corporate bottom line with renewed deflation across globe ?

16 what is the size of USA debt today ? Rate of change of it post 2009 ?

17 what is the impact of BOJ, BOE, ECB, PBOC stimulus balance sheet expansion on financial market ?

And many more factor , questions have which may not fit in mathematical equation to define situation for interpretation.

Thanks and Regards
Udayakumar D

Jon said...

Technically, the fed does not even set the Fed Funds rate, it buys and sells securities---typically short term treasuries---to get the Fed Funds overnight rate towards its target. The true "Fed Funds" effective rate is determined by the market for interbank lending.

The Fed does set the rate it pays on excess reserves "Interest on Overnight Excess Reserves" (IOER) which is now 25 bp. It also sets the rate at which it lends through its discount windos.

Aswath Damodaran said...

Jon (and Anonymous),
You are right, technically, on the Fed actually setting the rate at which banks borrow from its window, rather than the Fed Funds rate, but the Fed Funds rate is too static to be a market-set rate. So, the Fed implicitly must set that rate too.

Aswath Damodaran said...

Finding yourself in agreement with Paul Krugman on anything to do with financial markets is usually a bad sign, since he is almost invariably wrong on that front. (I know that he has a Nobel prize, but even Nobel prizewinners can have blind spots.) Second, you are right that the Fed's power can come from its signals, but for those signals to actually matter, it has to be credible, and to be credible, it has to behave like an independent central bank. In other words, if the economy is actually strengthening but the Fed acts as if it is not, it is weakening its credibility to send future signals to markets.

Jon said...

Actually if you graph the effective fed-funds rate on FRED you can see the effective rate, the average obtained from loans reported by Fed-Funds brokers, varying day-to-day.

Erikwim During said...

Great food for thought, so after some digesting, here are my musings:

I find the reasoning on stock valuations odd. Following your logic of cash-flow returns and looking at your figure 2, stocks were overvalued in 2003 and 2009, and undervalued in 2007 and 2008. It is anyway advice for disastrous investment performance. It follows the prudent investor should see the high pay-out % and high 'cash-flow' -return as a warning sign and liquidate partly.

Comparing fed bond-buying to the daily trade in the bond market is also questionable. The fed is buying to hold, and will turn around next day or hour or second or millisecond or picosecond, to put the bond on the market again. In contrast that is exactly what is happening in bond markets. So the correct comparison should be QE volume relative to total US govt debt outstanding and/or QE volume compared to new govt bonds issues in the same time period.

Finally your claim that interest rates follow fundamentals seems to be at odds with your figure 1. What that figure brilliantly shows (and i realized a long time ago) is bond rates more or less act as if current rates will prevail in the future. Long-term bond rates did not 'see' the run up in inflation coming in the 1960-1980 period, nor did they 'see' the steady decline in inflation coming from 1980-today. Far less then reflecting true fundamentals they seem to reflect yesterday, today and tomorrow.

Ok, not finally, another one: it is correct that lower future real and inflation growth affects company's cash-flows, but not so much valuations. Lower inflation in free cashflows is mostly compensated by the same lower inflation in the discount rate, and the same holds for long term real growth expectations. And anyway these cash-flows have to be discounted way past the 10 year horizon, at which point the best assumption is probably to take a historic average for both.

Anonymous said...

If the point of my post was to argue that stocks were under valued today, your point about the cash flows would be a reasonable one. In fact, you are making exactly the point that I was too, which is that the bigger danger to stocks is not a rise in rates, per se, but a drop in cash flows. As for what to scale the bond buying to, you are welcome to try another denominator, but the basic question remains: does the Fed bond buying significantly affect interest rates and my gut tells me that the effect is far more marginal than the Fed (and those who obsess about QE make it out to be). On the question of whether bond markets are slow to adjust to changes in fundamentals, I tend to agree with you that there is a lag between shifts in fundamentals and changes in bond rates. So, as an investor, you should factor that into your decision making. Again, that is not the focus of this post but perhaps deserves one of its own.

Aswath Damodaran said...

You cannot be serious!



Is that the reply for those queries ? Am serious.

So you believe market determined Zero or lowest rate for last 6 years post 2008 crisis.Fed has no or negligible influence on it.

Fed asset purchase has no impact on financial asset price inflation especially bonds & stocks.

Record cash flow during the period of great recession (post 2007) for the corporate comes from emerging economy earnings growth and workforce layoffs.What was the position of dollar against emerging currencies during the record cash flow ?

Stock market is up due to business cycle fundamental, earnings growth and record cash flow.

Can you share the chart on Fed asset purchase vs Bond yields, Corporate yields, Stock prices, GDP for these years (2009-2014) Also share dollar index chart during this period.

Credit cycle started uptick now ? money velocity started uptick now US economy started showing growth uptick now ?

Am completely in agreement with regards to your conclusion part about market, it cannot be overrun by central bankers in long run through all those short term smoke and screen attempt, gimmicks. central bankers are over hyped entities and misplaced confidence on their ability to save the day. Market will revert to its sense one way or other.

But disagree with you on Fed asset purchase, zero rate influence on financial market and its asset prices, I mean in short or medium term central bankers rule market participants with awash of unlimited liquidity as false hope of stability and confidence .

Thanks and Regards
Udayakumar D

Aswath Damodaran said...

The point about seriousness had nothing to do with the questions but about the forum for those questions. A comment section in a blog is not a good place for an extended Q&A. It is where you pick the one or two points that you disagree with (or agree with) and make your point, not seventeen. That has to wait for another time and another day!

derMensch said...


I would argue that cost costing is not nearly finished yet. From my experience most manufacturing companies still have enormous opportunities to cut costs and increase production (after initial capex) by adopting robotic platforms (fanuc, abb, kuka, etc.). These robots are also continuously getting much cheaper. On the IT front most companies, even those in high-tech, still have huge run-ways in reducing cost and improving efficiency (discounting time spent by employees on social media) by leveraging cloud solutions and software systems. For example most companies have moved onto the Salesforce CRM platform but from my personal experience I would say most of the large tech companies I have worked with are leveraging those "common" technologies very poorly. They are using those systems are a fraction of their potential; this should change as more tech-savy workers start to dominate the work force and with a lot of help from outsourcing.


Unknown said...

I wouldn't argue with the Taylor Rule, but that's a really, really long run relationship that doesn't appear overnight. You can't seriously call the QE actions "modest" when the % of Federal Debt held by the Fed has increased from 6% to 16%. All of those risk free assets suddenly no longer in the market has an impact.

Maybe, at the least, the Fed made the descent in interest rates faster than the long run expectations of growth and inflation would have, but that's hardly the picture of impotence you seem to be painting.

Anonymous said...

Dear Professor

How do you think the Fed action or inaction will affect emerging markets. Will Fed action on increasing rates entice FII's to move away from an emerging market say india.?

Avisek sarkar

Anonymous said...

Hello Professor,

I think there are a few fallacies and inaccuracies with respect to your explanation of the realities of the first myth. There are many types of interest rates for different purposes and maturities.

For one think the federal reserve doesn't directly set the Fed funds rate. It controls the rate by using temporary open market operations (TOMOs) called repurchase agreements (repos) but it doesn't directly set the overnight interbank lending rate. A Repo is where the federal reserve buys short term treasuries (3 month maturity) from the primary dealers (e.g The main American banks) which adds liquidity to the reserves of the banks and this reduces the need for them to borrow against each other. However like the interbank lending the repo is a very short term loan (1 day) so the banks need to pay back the fed with interest. The interest is usually really small (0.05%) though as it is such a short term.

The Fed Funds rate is effectively 0 to 0.25%. I don't think the primary deal banks even lend to each other now because they all have way too much reserves at this current time.

Unlike the federal funds rate which the fed does not directly set the federal reserve does set the discount window rate which is a liquidity buffer incase of bank runs and the likes. That rate is set at 0.75%.

The Federal Reserve also sets another interest rate which has been around since 2008 as far as I am aware called the interest on excess reserves. Because of QE (1,2,3) banks are awash with reserves and have excesses of about $2.6 trillion as far as I am aware. The federal reserve is actually paying interest on the excess reserves of the main banks. This rate is about 0.25% so it accounts to about 6 billion dollars a year of risk free money for the banking sector. ;).

I am not an economist myself but I do like the Austrian school as it seems very logical to me. For one thing when you saw "To me, the answer seems self evident. Interest rates in the US (and Europe) have been low because inflation has been non-existent" what does inflation even mean to you. I would love to get a clear definition of what inflation is and logically what is the causation between your definition of inflation and interest rates.

It is interesting to speculate on what will happen in the future with respect to what the Federal Reserve will do and how it will affect the economy. So we are in a strange situation where banks are sitting on $2.6 trillion of excess reserves. I am assuming that the Federal Reserve does not want that money to flow into the economy because I am pretty sure that would cause increased consumer prices and that is why it is currently paying $6billion dollars to the banking system every year. So if the federal reserve increases its targeted federal funds rate to 50 basis points then I wonder what will happen?

Currently the IOER 0.25% is higher than the fed funds rate (0.00) so they don't really have any incentive to lend to each other but what will happen if the fed funds rate goes up to 0.50%. Will it even matter because there is currently too much money in reserves? I don't know to be honest. I suppose if banks can find a way to make a risk adjusted return that is higher than the IOER return on its excess return they will find away.


Luis Espejo said...

Dear Professor,

As regards your point 2- Low interest rates are the Fed’s doing- I just find these interesting Speech ( by Stanley Fischer who says "Fed's balance sheet programs are currently depressing 10-year Treasury yields by about 110 basis points. What do you think about it? I mean, it's pretty obvious that you are on the opposite side but how can you sustain that FED actions has actually little or no consequences on Interest rates ? It sounds really strange to me.


Anonymous said...

Dear Professor,

How would you explain the drastic drop in interest rates in PIGS following the "whatever it takes" comment? To me, it shows the power ECB and FED have in dictating interest rates.

John said...

Prof. - What about the thought that maybe cash flows (dividends + stock buybacks, as you define them) are so high because stock buybacks are at all time highs - which in turn have been fueled by ultra-low interest rates themselves. Take Apple, for example, who's issued $20+ billion in debt this year just for stock buybacks (even though they have $200 billion in cash). See this article here:

Raj Raina said...

I thought to revisit this blog to un-cloud my thinking on the role of fed. It seems we are back to the guessing game of whether fed will increase rates or decrease or keep it the same. I just find the fascination with the rate mind boggling and hard to reconcile with your post.

While reading, I was also wondering if there is any link between historical low rates hence companies being able to borrow cheaply and " the primary driver of stock prices" as mentioned in your post?
I.e. if companies can borrow cheaply would it make sense to increase leverage and return shareholder capital (given it is more expensive)

Lucas Sena Molero said...

Maybe No reinvestiment due to low expected growth?

Ian said...

New academic research suggests that PE ratios should be viewed in relation to the after-tax yield on corporate bonds, as I explain in the article below.