Rate Watch #774 Does the Economy Need Higher Interest Rates?

May 6, 2011
by Dick Lepre
dicklepre@rpm-mtg.com
www.loanmine.com

Analysis

I started writing this piece early this week and after Thursday's commodity selloff and doubt about recovery the suggestion that the Fed needs to start increasing rates seemed inappropriate. The point of the following is that there is a perspective from which we need higher rather than lower Fed rates in order to grow. This cannot be done until there is greater confidence from business and consumers. What is discussed and suggested below must be implemented but not at present.

Fearing deflation, the Federal Reserve launched QEII. Now we have low rates, stagnant GDP, inflation (CPI-U) higher than GDP growth and the jobs market going nowhere. The deflation which never happened was to be avoided because deflation would cause investors to sit on their liquid assets. Still we have almost $1.5 trillion in excess banking reserves parked at the Fed which is, in effect, the one of the things they were trying to avoid. It may be time for the Fed to rethink what rate policy will lead to economic growth.

Elasticity of Supply & Demand

Interest rates are at rock bottom but yet there is not enough borrowing/lending. Such a situation is indicative of inelasticity of supply and demand. Let's look at supply, demand, and elasticity in general and then see how these pertain to money. Money has supply (created by the central bank), demand created by borrowers and restrained by federal and international banking regulations, and price (interest rate.)

Demand, Supply, and Elasticity.

"Demand" is the amount of stuff that consumers are willing and able to buy at a given price. Many folks would like a 6 bedroom home with a great kitchen, a pool, a wine cellar, and entertainment center with a 6 foot HDTV and a 6 car garage. The prices of such homes being what they are, few people are willing and able to buy at current prices.

"Utility" is the satisfaction people get from consuming (using) a good or a service. Utility varies from person to person. It varies by taste. It also varies by circumstances. Some people get more satisfaction from wine than others. Unless I am trying to impress someone, it is unlikely that I will spend $100 on a bottle of wine unless I can appreciate its value. The same person may get less satisfaction by drinking a bottle of Chateau Lafitte Rothschild once he is too drunk to distinguish it from Ripple.

The amount of a stuff demanded depends on:

- the price of the good
- the income of the would-be buyer
- whether the buyer likes it (consumer taste)
- the demand for alternative goods which could be used (substitutes)
- the demand for goods used at the same time (complements)

Complements are like pickles. If McDonalds sells fewer quarter-pounders the demand for pickles goes down. If people eat fewer hot dogs they will buy fewer hot dog buns. As an extreme, people are unlikely to buy hot dog buns for hamburgers (substitutes) even if the price of hot dog buns is halved. They may buy more hot dog buns if the price of hot dogs is halved. (And I don't want to hear any stories about how your mom made you eat your hot dog on a slice of Wonder Bread. Moms understand substitutes.)

Supply

Supply is the amount of a good producers are willing and able to sell at a given price. The amount of stuff supplied depends on:

- the market price of the good
- the cost of producing the good
- the supply of alternative goods the producer could make with the same raw materials, plants, equipment and labor force
- the supply of goods produced at the same time (joint supply)
- unexpected events (i.e. "disasters") that affect supply.

The Law of Supply & Demand

In 1776 Adam Smith in "The Wealth of Nations" explained the law of supply and demand as: "The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market and the demand of those who are willing to pay the natural price of the commodity, or the whole value of the rent, labor, and profit, which must be paid in order to bring it thither."

And Then What?

So the "law of supply and demand" tends to set a "natural price" for stuff. The problem is that none of us are ever happy with the way things are. Companies want to do more business and, thus, are willing to "diddle" with the price of things in order to seek a greater market share and (perhaps) greater profits.

Elasticity

The price elasticity of demand measures how much the quantity demanded responds to a change in price.

Elasticity can be defined numerically as the change in demand divided by the change in price. (Since demand goes up as price goes down this number is actually negative and elasticity is more correctly mathematically defined as the absolute value of this number.)

Elasticity greater than one means demand is elastic. When the elasticity is greater than one, the percentage change in quantity demanded exceeds the percentage change in price. When the elasticity equals zero, demand is perfectly inelastic. There’s no change in quantity demanded when there’s a change in price.

Supply also has elasticity. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by percentage change in price. It measures how much the quantity supplied responds to changes in the price.

By the differences in nature between supply and demand (by that I mean that demand can change in a very short period of time) the price elasticity of supply is usually larger in the long run than it is in the short run. Over short periods of time, firms cannot easily change the size of their factories to make more or less of a good, so the quantity supplied is not very responsive to price. Over longer periods, firms can build new factories or close old ones, so the quantity supplied is more responsive to price - in the long run.

One thing that we have seen lately is that some commodities, such as crude oil, have relatively inelastic supplies. The lack of supply elasticity translates into too small an increase in supply with rising price which has sent prices spiraling upwards.

For an economy to function well elasticity or inelasticity is not a neutral proposition. Elasticity is better than inelasticity because it allows a means to stimulate production, GDP, jobs, taxes when the economy is languishing. Elasticity is good; inelasticity is bad.

Money Also Has a Price - Its Name is Interest Rate

While these rules pertain to most all commodities, I want to note that they also pertain to our favorite commodity - money. Money has a price. The price is the interest rate. The discussion about supply, demand and elasticity pertain to money and interest rates as well as they do to oil, precious metals or agricultural commodities.

Interest elasticity of supply represents a change in the quantity of loanable funds supplied in response to a change in interest rates. Interest elasticity of demand represents a change in the quantity of loanable funds demanded in response to a change in interest rates.

Lurking behind interest elasticity is the willingness of banks to lend. They may, in fact, have a ton of loanable funds but are in fear of losing it to bad loans. Ultimately there is a loan to be made. The risk must be factored in and the borrower and lender strike a deal which they each feels to be beneficial to them. Tighter banking regulations (Basel II) discourage lending. Continued dissing of banks by politicians and the regulatory consequence of Dodd-Frank provide reasons for banks to not lend.

So What's Wrong?

Rate lowering alone does not lead to significant long-term economic growth. It merely helps to create an environment in which it can happen. Existing businesses and entrepreneurs will make investments and create jobs when the reward from those investments outweighs the risks.

The are other actions that the Fed might undertake to jump-start business activity. The problem may be in the yield curve itself. The Fed dictates the short end (the overnight rate) and, to the extent that the short end dictates Prime it also dictates the Prime rate. But this is still short-term money. In terms of our mortgage world, businesses that get Prime based loan are getting volatile ARMs If I am a businessman wanting to make a capital investment I would be much more interested in what I could borrow money for at a fixed rate for 10 or more years. This is the corporate bond market.

The "Liquidity Trap"

An extreme case of interest inelasticity could be a prelude the "liquidity trap." The expression "liquidity trap" is one of those things that economists like to argue about - as in "does it really exist?" Keynes used the expression to describe a situation where interest rates were so low that wealth holders chose to hold cash i.e. remain liquid rather than invest it or even put it in the bank.

The present situation is perhaps best described as "a zero interest rate trap." With interest rates so low, interbank lending may be stalled. Bank operate by making loan commitments and, if they do not have the cash they can borrow it on the interbank market now and increase savings rates to draw in deposits later. The interbank market may not be functioning because the reward (interest rate) is so low compared with the risk. Yes, the Federal Reserve acts as the lender of last resort and will always provide the cash needed but we may be seeing the effects of the interbank market still not functioning smoothly.

The implication is that the Fed keeping short term rates too low may be hurting rather than helping the economy. The most recent H.3 report from the Federal Reserve indicates that there are $1.474 trillion in excess banking reserves parked at the Fed doing nothing for the economy. The question is this: would higher rates help a good chunk of that $1.474 trillion to get out of bed and encourage GDP and job growth?

Since I am someone who thrives when interest rates are low this suggestion that we need higher interest rates is not in my interest but sometimes what is good for the economy and what is good for me are not the same.

It is also worth noting that Fed rates are so low that even a 2% increase in the Fed funds rate would still leave rates low.

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Dick Lepre
RPM - SF
1400 Van Ness Avenue
San Francisco, CA 94109
DRE License # 01143973
NMLS Individual ID 302379
California Department of Real Estate - real estate broker license #01201643
dicklepre@rpm-mtg.com
Web site: www.loanmine.com
Blog: economy.typepad.com
(415) 244-9383
(866) 488-2051 fax

 

Comments

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