Interest rates, otherwise known as the present price of capital, are perhaps the most important signals to the market, bearing weight on time-sensitive risk-reward calculus, the character of consumer behavior and the true long-run costs of assets such as homes.
Ever since the United States endured the so-called Great Recession, from which the nation has hardly recovered, it has embarked upon an assumed stimulative course of near-zero nominal rates of interest, all in an attempt to avail itself of the disrepair caused by the previous boom by expanding the pool of available credit to consumers and producers who might then put it to work.
Of course, this sort of wisdom neglects that inherent qualitative signal being delivered to the market while rates are near the zero lower bound.
For some context, let's consider Japan in 1989, whose relatively tight monetary policy followed excessively easy, speculation-inducing policy to produce deflation which resulted in a zero nominal rate of interest.
In this specific case, deflation describes a general scenario of broadly falling nominal prices, or in this case correcting or re-balancing prices from artificial heights, and thence an appreciation of present savings and the purchasing power of the sovereign unit of account, known as the yen, which literally translates to round object.
Now, in the case of Japan, the nominal rate surely failed to capture the real rate of interest, which was much higher due to the increasing value of the yen. This low nominal rate of interest, then, signals to the market an abundance of available wealth and credit following massive inflows into safe-haven bets on the relatively stable fixed-income instrument of government bonds. This flight to safety was enabled by the existence of savings by a nation of persons who have historically saved a greater share of their household incomes than their American counterparts.
Ultimately, the headline objective of such a near-zero interest rate policy is to encourage a higher rate of investment, ideally in income-producing capital formation to desperately lubricate the economy through what is truly a clandestine, surreptitious and disingenuous method of rewarding debtors and speculators at the expense of savers.
Instead of realizing this end, though, US government policy has tacitly discouraged such practical investment, as evidenced by the collapsing quantity of business investment as a share of total US GDP, by incentivizing banks, through ultra-low rates of interest and government guarantees, to extend credit to homebuyers and students, effectively subsidizing consumption and speculation at the expense of productive business investment. This has showed up in the DJIA-to-GDP ratio, which today nears its pre-dot-com-collapse high. Meanwhile, record-low interest rates and record-high levels of margin debt and stock buybacks continue to fill the punch bowl.
In summary, the rate of interest is a function of available wealth and credit. Where this fails to exist, a near-zero interest rate policy feigns wealth by making credit available today at the largely unforeseen or unconcerning expense of future USD holders who will eventually pay the real price or distant creditors who may ultimately fail to collect.
The Ultimate Effect of Normalizing Rates
Throughout the 20th century, the United States and much of the world have affirmed a real near-natural prime rate of interest of roughly 5% to offset the present and future opportunity costs associated with the foregone personal employment of this capital across that timeline.
The following calculations will bear the true gravity of a resumption of normalized rates in the United States.
In the United States, the Average 30-year mortgage is generated in the amount of $309,200 at 4.1% interest. This brings the total mortgage cost to $537,857.77, or a total monthly cost of $1,494.05.
A return to normalcy, near 7.5%, would bring the total cost of the same 30-year mortgage to $778,309.65, or a monthly cost of $2,161.97. This means a total difference of $240,451.88, or a monthly difference of $667.92.
This seems hardly tenable for a nation of households living paycheck to paycheck, 50% of whom are wildly unprepared for a financial emergency, while nearly 20% of them have nothing set aside to cover an unexpected emergency and roughly one-third of them don’t have at least $500 set aside to cover an unexpected emergency expense.
And to make matters worse, a 5% prime rate would mean more than $1 trillion in annual interest on the national debt, constituting roughly 25% of anticipated total federal government outlays for FY 2018 and more than 5% of GDP on interest alone.
Ever since the United States endured the so-called Great Recession, from which the nation has hardly recovered, it has embarked upon an assumed stimulative course of near-zero nominal rates of interest, all in an attempt to avail itself of the disrepair caused by the previous boom by expanding the pool of available credit to consumers and producers who might then put it to work.
Of course, this sort of wisdom neglects that inherent qualitative signal being delivered to the market while rates are near the zero lower bound.
For some context, let's consider Japan in 1989, whose relatively tight monetary policy followed excessively easy, speculation-inducing policy to produce deflation which resulted in a zero nominal rate of interest.
In this specific case, deflation describes a general scenario of broadly falling nominal prices, or in this case correcting or re-balancing prices from artificial heights, and thence an appreciation of present savings and the purchasing power of the sovereign unit of account, known as the yen, which literally translates to round object.
Now, in the case of Japan, the nominal rate surely failed to capture the real rate of interest, which was much higher due to the increasing value of the yen. This low nominal rate of interest, then, signals to the market an abundance of available wealth and credit following massive inflows into safe-haven bets on the relatively stable fixed-income instrument of government bonds. This flight to safety was enabled by the existence of savings by a nation of persons who have historically saved a greater share of their household incomes than their American counterparts.
Ultimately, the headline objective of such a near-zero interest rate policy is to encourage a higher rate of investment, ideally in income-producing capital formation to desperately lubricate the economy through what is truly a clandestine, surreptitious and disingenuous method of rewarding debtors and speculators at the expense of savers.
Instead of realizing this end, though, US government policy has tacitly discouraged such practical investment, as evidenced by the collapsing quantity of business investment as a share of total US GDP, by incentivizing banks, through ultra-low rates of interest and government guarantees, to extend credit to homebuyers and students, effectively subsidizing consumption and speculation at the expense of productive business investment. This has showed up in the DJIA-to-GDP ratio, which today nears its pre-dot-com-collapse high. Meanwhile, record-low interest rates and record-high levels of margin debt and stock buybacks continue to fill the punch bowl.
In summary, the rate of interest is a function of available wealth and credit. Where this fails to exist, a near-zero interest rate policy feigns wealth by making credit available today at the largely unforeseen or unconcerning expense of future USD holders who will eventually pay the real price or distant creditors who may ultimately fail to collect.
The Ultimate Effect of Normalizing Rates
Throughout the 20th century, the United States and much of the world have affirmed a real near-natural prime rate of interest of roughly 5% to offset the present and future opportunity costs associated with the foregone personal employment of this capital across that timeline.The following calculations will bear the true gravity of a resumption of normalized rates in the United States.
In the United States, the Average 30-year mortgage is generated in the amount of $309,200 at 4.1% interest. This brings the total mortgage cost to $537,857.77, or a total monthly cost of $1,494.05.
A return to normalcy, near 7.5%, would bring the total cost of the same 30-year mortgage to $778,309.65, or a monthly cost of $2,161.97. This means a total difference of $240,451.88, or a monthly difference of $667.92.
This seems hardly tenable for a nation of households living paycheck to paycheck, 50% of whom are wildly unprepared for a financial emergency, while nearly 20% of them have nothing set aside to cover an unexpected emergency and roughly one-third of them don’t have at least $500 set aside to cover an unexpected emergency expense.
And to make matters worse, a 5% prime rate would mean more than $1 trillion in annual interest on the national debt, constituting roughly 25% of anticipated total federal government outlays for FY 2018 and more than 5% of GDP on interest alone.
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