Fed Angst and the Interest Rate Tragedy

As traders and investors around the world try to decipher the Federal Reserve's use of such terms as "not impatient" in lieu of "patient" in its guidance on interest rates, it is fast becoming clear that the Fed realizes that it has been painted into a corner between "stimulating" the economy and returning it to a course of 'normalcy' -- precisely the kind of tight corner that naturally creates economic angst.

But what is a normal return on, say, benchmark three-month U.S. Treasuries? Consider that in August, 1981, the yield on such treasuries was well over fifteen percent, meaning that the retiring pensioner who had managed to save a million dollars and invest in three-month treasuries could expect an annual return of about $155,000.00, or about $12,925.00 a month. As of March, 2015, the return on one million dollars in three month treasuries was about one-hundredth of one percent, yielding about $100 a year, or about $8.33 a month. Indeed to earn the same amount on three month treasuries today as in 1981, the hapless retiree today would need to accumulate a half trillion dollars.

Obviously these figures represent the extremes of Fed interest rate policy over the years, and neither reflects normalcy. But they nevertheless illustrate the extent to which our economic system has relied almost exclusively upon the Fed and its brutal axe-wielding use of interest rate power to keep the economy on a precarious course between the Scylla of destabilizing inflation and the Charybdis of deflationary depression -- with innocent victims as the inevitable collateral damage. In 1981, the sacrificial lambs were debtors and homeowners paying exorbitant mortgage rates, while in 2015, the victims on the altar are the savers, retirees, and the elderly.

It doesn't have to be so, but the fact that it is reflects a fundamental misapplication of Keynesian theory. Like those who cherry-pick lines from the Bible to support a religious agenda, political demagogues are fond of cherry-picking phrases from Keynes to justify their demand for higher spending, while conveniently ignoring that higher spending by itself ultimately leads to the need for corresponding taxes to maintain governmental solvency and the integrity of its currency and credit rating.

In fact, the crux of Keynesian theory is that the solution to the problem of insufficient purchasing power in the economy is the infusion of purchasing power through sound fiscal policy, which can achieved by a reduction of taxes and wasteful government spending. The advantage of tax reduction over government spending is that it puts purchasing power into the hands of consumers who will demand goods and services which in turn leads to employment, production, and wealth production for all. The latter, however, puts large chunks of it into the hands of bureaucrats who tend to create more paper than actual goods and services.

Sound Keynesian policy therefore suggests that in times of insufficient purchasing power in the economy, taxes should be reduced, while in times of excessive purchasing power, taxes should be raised.

But therein lies the political problem that Keynes largely ignored. Tax reduction through sound fiscal policy more fairly and broadly enhances purchasing power across the entire economy, unlike the narrow tip of the Fed's interest rate spear which disproportionately affects specific sectors such as housing, stocks, and bonds, heaping financial windfalls upon the wealthy who invest in those capital stocks, but leaving the poor and much of the middle class which strives only to make ends meet as hapless victims in its wake. When partisan political agendae, rather than sound fiscal considerations dictate tax policy, the Fed is left in the unenviable default position of addressing purchasing power through the exclusive use of the bloody interest rate hatchet.

The implementation of sound fiscal policy is further inhibited by the fact that our tax system has degenerated to 53 percent of the electorate carrying the entire federal income tax load (including the top 10 percent who carry 70 percent of the tax burden). The remaining 47 percent don't pay a dime. Any politician foolish enough to note of this inconvenient truth, and suggest that leaving half of the electorate with no financial stake in their own government is not only unhealthy, but unsustainable, is likely to suffer the fate of the proverbial hapless messenger (witness Romney in 2012). But the result is that few of those who pay no federal income taxes are apt to send any legislator to Congress on a platform of tax reduction.

That, by default, leaves the Fed. We should keep that in mind as it wields its Bloody interest rate Hatchet.