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July 21, 2005

Interest Rates are Headed Higher in the Long Term
by Bud Conrad

Interest rates are low because of newly created money

Interest rates have surprised most economists in the last year, as it was expected that long term rates would rise with the Fed Funds rate hikes. To predict what may happen to interest rates, I must first explain how they became so low. The low rates came from having so much money to loan that it overwhelmed demand to borrow. My base model is that the Credit Market is driven by the supply vs. the demand for credit. We know that there is a lot of demand for credit, such as for housing mortgages and for government deficits, and normally that would drive interest rates up. There is also a lot of supply of credit such as from foreigners re-investing their trade surplus back in to the US, which keeps rates lower. The diagram below shows the biggest suppliers and demanders of credit:

The Federal Reserve reports credit amounts each quarter in its Z.1 publication. I have put together a simple balance sheet of the flow of credit in the latest quarter. It is taken from the F.1 table of the report published June 9, 2005 and uses the Q1 05 data. To see where we are, I greatly simplify the borrowers and lenders to just 7 items including a small plug to make them match:

http://www.federalreserve.gov/RELEASES/Z1/Current/z1.pdf

The key items are shown: Households are the biggest borrowers, mostly for mortgages, with the government deficits also demanding credit; and the suppliers are foreigners, and the expansion of credit from our financial institutions

Lenders
The kindness of foreigners to re-invest what they get from selling goods to us has supplied us with $606B of credit. Foreigners most often buy Treasuries and Agencies, and supply us with $3B per business day of credit. This huge number is crucial for US economic growth. Without foreign capital investment the US economy would be in a shortage of capital and rates would rise. This reinvestment flow is risky, because the decision to continue the investment is not made in the US. If, for example, foreigners decided to buy physical assets such as to build an oil reserve, that money would not be available to support our demand for mortgage funds.

The lenders (suppliers of Credit) are shown below as the financial institutions (banks, insurance companies etc.) and foreigners (mostly recycling our Trade deficit). The simple supply / demand spreadsheet shows that almost double the amount of loanable funds came from our financial institutions, compared to foreign re-investment of trade dollars.

Notice that while foreign Lending is big, our financial institutions are much bigger and growing more. That comes from a Fed that is letting credit grow. It is the key reason why we have had the supply of credit that has kept rates low.

Borrowers
On the demand side, mortgage debt is the biggest user of credit, followed by Federal government, Businesses and then State government. The chart below shows the increase in net new lending for these big sectors. The negative number for the government in 2000 is from a surplus.

The above shows huge growth in new borrowing, even as the economy has been sluggish. The biggest sector is household borrowing, which is dominated by mortgage borrowing. Mortgage debt has grown faster than GDP over the last half century from 15% of GDP to 68%, in Q1 2005. This availability of mortgage money has driven the housing bubble, and is central to the credit bubble.

The growth of all credit is much in excess of GDP growth. This growth exceeds the growth of the greater economy as shown below.

Money creation comes from loans by financial institutions

The following diagram shows how the money is created in the financial institutions more than by the Fed itself. The Fed initializes new credit when it buys Treasuries with newly created money. The point is that it does not stop there: the bank receiving the money loans it out, for example, as a mortgage so someone can buy a home. The seller receives the payment and deposits in it in his bank, and that can be used for yet another loan. This process can be replicated many times through the banking system, giving rise to the multiplier effect of new Fed high powered money.

The chart above shows that the banks are responsible for the majority of new credit (money) created, not the Fed. The Fed just starts the process with its "high powered money". The details are elaborate, but the big picture view is that it is easy to create credit, which acts as money. In a fiat money system, with no required gold backing, there is little limit.

New loan funds come from not just our banks, but also from insurance companies, Government Supported Enterprises (GSE), money market funds and many other institutions that create credit. So a key part of understanding the supply of credit, is recognizing the availability of funds from all the different parts of our financial sector, beyond just the banks. Asset Backed Securities (ABS) are suppliers of Credit as are Ginnie Mae and Fannie Mae, doing much the same function of making loans as the banks. Traditional economics books describe only of the banking system, and the money measures published as M1, M2, M3, are measures of the deposits (liabilities side) of only bank ledgers, so they ignore the credit creation of these other institutions. The diagram below shows their similarity:

Any one of the bank boxes in the first diagram could be exchanged for a GSE or ABS issuing entity, where they take in money to be loaned out. Thus, the amount of credit that can be created is larger than measured by the traditional bank measures. These institutions have no reserve requirement, and have no Federal Deposit Insurance.

There is a theoretical restraint on the credit growth of banks. Our fractional reserve banking system allows banks to lend out all but the fraction called a "reserve", which is nominally at 10% of deposits. The Fed is supposed to watch over this reserve requirement to keep credit in line. But the Federal Reserve has made many changes decreasing the requirement to have reserves on deposit at the Fed to so small an amount that there really is no control on the banks. They are free to expand credit greatly and have done so. The chart below shows how small the reserves really are:

Some numbers from the Z1 report will help explain how big the financial institution's supply of credit is: The financial sector both lends and borrows, so I netted the figures to get the net lending. In 2000 the net lending was $643B and now it is $1505B for an increase of 234%. GDP grew only 124% ($12,192B from $9,817B). So the reason interest rates are low is that there is a huge supply of credit from our financial institutions. That should be no surprise considering the policy that brought us to the 1% overnight rate. The reserve requirement is not talked about in the daily press, but it has been lowered significantly. The reserve requirement is no longer effectively controlling credit growth, so money expands.

The problem is that this credit creation provides the money to bid up prices not just of Treasuries, but of all kinds of assets. Soaring asset prices, first in stocks in the 1990s, and now in houses, are revealing what economists should be telling us: We are creating lots of money (credit) which will cause prices to rise and the purchasing power of our currency to decrease commensurately. Price inflation is happening, despite worries about deflation that are unjustified. For deflation to occur, there would have to be a contraction of credit, and that is simply not the case now.

An indicator of credit market pressure

This analysis of demand and supply to determine the interest rate direction needs a measure of the difference in pressure that is pushing toward higher or lower rates. Supply and demand always match, so we need another measure.

To get a flavor of the direction of the interest rate that clears the market, a measure provided by the Fed is its "excess reserves". It is the amount of reserves that are in excess of the required reserves. If there are excess reserves, then banks are ready to lend more, and that is a signal of potentially lower interest rates, as banks compete to make loans. Excess reserves can expand when the Fed has created new money, or when the reserve requirement is lowered. They can also expand if banks themselves choose not to lend up to their capacity. In the chart below, I inverted the excess reserves and laid it on the interest rate curve to show that the Fed has been providing lots of liquidity which provides downward pressure on rates.

How credit expansion has affected our economy and asset prices

The lowest interest rate in 40 years is the result of creating a large supply of money, first at the Fed and then through the multiple structures of our financial institutions creating credit and loans against many assets, to supply our needs for credit. These low rates have supported the price of underlying assets and kept credit flowing without many defaults, so that credit risk premiums are low. Credit has supported itself; because, for example, mortgage owners have been able to sell houses when they can't make payments leaving default rates low. Even though we experienced a stock market bubble burst, the ensuing recession was tame because of expanded credit. The short-term fix for the economy was for the Fed to lower interest rates by buying Treasuries creating money. Consumers kept the economy expanding by borrowing. We have not had a credit bubble burst as did Japan after 1989 or the US after 1929. On the contrary, we have had an expanding credit bubble.

Implications for the future

But the irony is that in the long run the extra money created to lower interest rates will bring demand for goods, driving prices higher and bringing future inflation, which will force interest rates in the opposite direction, up. The problem of an expanding credit bubble is that it results in price rises in a series of asset bubbles like housing and commodity prices like oil. These specific signs of pockets of price inflation are the result of the money creation. The loss in purchasing power of the dollar, especially internationally, is also a symptom of this credit expansion on the international level from too big a trade deficit. This debasing of the currency will lead to higher interest rates as investors demand higher returns to cover price inflation.

The long term comparison of interest rates with debt expansions shows them moving together. In the chart below, the high money growth in the late 1970s led to high rates peaking in the early 1980s. There has been a general decline in the rate of credit growth and interest rates since that time. There is also a shorter term opposite reaction around the 1981 interest rate peak, when Volker squeezed debt expansion down by raising Federal Funds rates so all rates jumped. The resulting slowing of credit slowed inflation and set the stage for lower credit growth and lower inflation. There are shorter periods where increasing supply of credit drives rates down for a short period. That is what is happening now. My view of the future is that we are on the track for higher debt growth and higher inflation and interest rates, as indicated by the upward arrow toward the end of the interest rate line.

This supply / demand analysis of interest rates suggests that we can understand the direction of interest rates if we know the direction of the suppliers and demanders of credit. The current situation is that the foreigners are still providing new credit, but at slower rates than a year ago. The chart below shows decreasing investment by foreign central banks. The investment was over $400 billion annually in early 2004, but has dropped to $200 billion. This is money placed in Treasuries and Agencies by foreign central banks using the Fed to hold it in custody.

If foreigners were the only big suppliers to the credit market, then their slowing of investment would pressure rates upward. The household demand for mortgages is still the biggest user of credit and has not stopped. The Federal government demand for credit is high and will grow with the demands from baby boom retirees. Summing these, we see demand pressures for additional credit expanding. But we have the big source of US financial institutions expanding their loans. The US financial system is providing more credit than ever, and that is why I use the term Credit Bubble. The future of interest rates supply and demand depends much on the banks and non bank financial institutions creation of credit. Their continued expansion depends on the outlook for inflation that produces a real return. As oil and houses rise indicating inflation, this expansion of credit will be slower unless the rates rise to cover the inflation loss. To bring forth the investment, rates will have to rise, or lenders will find better investments, like assets that inflate.

The situation we have is of a continuing expansion of credit that is much like a bubble that we experienced for stocks to 2000. The credit bubble is vulnerable to contraction if lenders fear inflation. Even greater credit expansion would bring on a loss of confidence in the paper dollars and lead to even bigger inflation. That loss of confidence is what creates a run on a currency called a currency crisis, like what happened to the Argentine Peso, and the British Pound in recent years. It is my prediction that the rise in rates will feed on itself in an inflationary spiral once it becomes a big jump, because high rates add to the cost of everything. The dollar is more vulnerable than most realize, and our government is treating it as if it is strong enough to withstand the twin deficits and free money creation policies of the Fed. Treasury Secretary Snow is even openly advocating letting the dollar drop against the Chinese Renminbi. The long term fixed investments of as 30 years contain more risk than the current rate implies.

As rates rise in the decade ahead to compensate for dollar weakness, physical assets and betting on higher interest rates will be better investments than stocks and bonds.

Bud Conrad

Mr. Conrad holds a Bachelor of Engineering degree from Yale and an MBA from Harvard. He has held positions with IBM, CDC, Amdahl, and Tandem. Currently, he serves as a local board member of the National Association of Business Economics and teaches graduate courses in investing at Golden Gate University. Bud Conrad has been a futures investor for 25 years and a full-time investor for a decade.

Copyright © 2005 Bud Conrad and Macronalysis

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