Theory and Practice
“In theory, there’s no difference between Theory and Practice, but in practice there is.” — Engineering saying
There has been a sea change in the forecast direction of interest rates over the last six months. Under pressure from the administration, the Federal Reserve has flipped from a policy of gradually increasing the Fed Funds Rate to talk of lowering it, as certain quarters insist that 2% rates are ruining the economy and cutting them back to 0% would provoke miraculous changes for the better.
Prevailing Economics 101 theory states that lower interest rates stimulate borrowing by businesses and individuals. As interest costs decrease, the cost of financing debt decreases and thus makes new investment and purchases more attractive. This new debt is spent, goosing the economy and leading to better times. There’s only one thing wrong with this theory—it hasn’t held true in practice for the last twenty-five years.
It seems to me the graph shows that interest rates and debt growth are positively correlated—that is, households and businesses borrow more money when rates are higher, not less. In my opinion, this is because one of the primary factors that leads people to borrow money is confidence. Their perception of future business and employment prospects matter much more than the slight decrease in a mortgage payment or the payback time on a piece of equipment.
But there is another factor at work here as well. In the last ten years, the federal government’s share of debt in the economy has grown enormously, and now exceeds that of both households and businesses.
Since 2008 we have seen a fundamental change in the source of new debt in the US economy. Whereas household and business borrowing used to drive credit creation and therefore stimulate growth, today the biggest creator of new debt is the federal government. Unlike households and businesses, Washington doesn’t change its borrowing practices due to interest rates, except for one line item—interest paid on the debt. Since the Treasury issues more debt to pay the interest on existing debt, it will borrow more as rates rise– the opposite of the standard economic theory.
For example, the Treasury will pay out around $60 billion more this fiscal year than last just because the average interest rate on its debt has steadily risen (2.29% last June vs. 2.51% this year). This additional spending is financed by increased borrowing and boosts the incomes and spending of savers and retirees. In my opinion, it is as much a stimulus as any other increase in federal spending. Obviously, lower rates would produce the opposite effect.
The bottom line: lowering the Fed funds rate will not induce new borrowing and spending, contrary to standard economic theory.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.
Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a Registered Investment Advisor. Great Valley Advisor Group and Doylestown Wealth Management, Inc. are separate entities from LPL Financial.