There’s this idea making it around that the Fed’s current interest rate policy is actually inflationary. The logic goes something like this:
First of all, Luke is fantasic and I highly recommend following him and his work on Twitter.
I’m sympathetic to the idea because I don’t think higher interest rates bring CPI inflation down short of absolutely crushing demand by means of a recession.
I think the inflation the Fed has been so doggedly fighting for the past year was one part fiscal policy driven (out of the Fed’s control) and two parts supply-driven, and I think you bring more supply (i.e. investment) online with lower rates, butI digress…
Ultimately, I think Luke is wrong here, and the reason why gets at what I think is one of the most important post-GFC economic questions/challenges of our time: what to do about growing wealth inequality?
The Marginal Propensity to Spend
The reason I disagree with Luke is that while stimmy checks get spent, interest payments on T-bills get reinvested. This is because the marginal propensity to spend of your average stimmy check recipient is much, much higher than your average treasury coupon clipper.
Think about who owns all the treasury securities and, thus, is receiving those interest payments. The largest holders of treasuries are the Fed, foreign governments, pension funds/target-date funds/other retirement savings vehicles, commercial banks, and corporate treasuries. None of those entities is spending interest payments in the real economy.
To be fair, Luke explicitly says the difference is “the speed at which the Cantillon Effect distributes that money into the economy.” But grandma is probably drawing the same amount on her pension each month regardless of interest rates (although she’s enjoying a nice cost-of-living bump to her social security checks this year!), and those interest payments are getting reinvested by the pension manager back into the fund — i.e. they are going to buy more treasuries and other financial assets.
Same with foreign governments, who seem to be plowing those payments into gold:
Same with the Fed who is currently letting their balance sheet roll off. Same with the commercial banks who are just depositing interest payments at the Fed to collect more interest and sure up their balance sheets. Maybe some well-run ones are using the additional capital to make loans and grow credit, which would indeed be stimulative, but you get the point.
The idea is that very few of us are treating ourselves to first class on our next flight because we’re collecting more on our T-bills because very few of us directly own T-bills. And the ones among us that are collecting more on their T-bills are probably already flying first class.
Yes, indeed: I believe that, over time, high interest rates are a rich-get-richer policy that exacerbate wealth inequality.
Perhaps counterintuitively, raising interest rates is functionally similar to lowering taxes on wealth, and vice-versa.
Money In, Money Out
Think about it.
Interest payments = money out from the government and into the hands of citizens and corporations (and foreign governments).
Taxes = money out of the hands of citizens and corporations and into the government.
Interest is a cost, taxes are revenue, and they both impact the bottom line (the fiscal surplus or deficit) the same.
With U.S. debt > GDP, a 1% absolute reduction in borrowing costs saves the government more than a 1% absolute increase in tax revenue.
U.S. tax receipts have averaged 17% of GDP over the past 10 years. At 2022 levels of debt and GDP, reducing rates from 5% to 1% saves the U.S. as much money as raising taxes from 17% to 22% earns it.
This concept — that interest rates and taxes are functionally fungible tools for collecting and distributing money from and to the wealthy — is an important one as we think about the challenges of wealth inequality, wealth redistribution, politics, and economic growth.
Capitalism, for all its benefits, has a flaw: it tends towards extreme wealth inequality over time.
In addition to being an obvious social and political problem, this is an economic problem as well because as wealth concentrates, economy-wide spending slows and economic growth becomes more challenged. The marginal propensity to spend reduces the wealthier you get, and goes to zero/functionally reverses for extreme levels of wealth — i.e. at a certain threshold, you’re making it faster than you can spend it.
While you or I would probably love to enjoy more expensive wine or upgrade to first class, Jeff Bezos can only drink one bottle at a time and fly on one private jet at a time.
And when he lands, he’s usually wealthier than when he took off.
Thus, capitalism needs a mechanism to redistribute wealth, or correct the imbalance between rich and poor, less all the wealth eventually concentrates into too few hands and the economy collapses.
There are generally three.
The Three Ways Wealth Gets Redistributed
1. A Great Depression-style economic collapse that destroys asset values and resets the economy. This is more "correcting the imbalance" by destroying wealth than it is redistributing the wealth, and is generally probably the least politically and socially palatable of the solutions. This is what we were on the verge of in 2008, before we opted into a combo of 2 and 3 below instead.
2. Policies such as higher taxes on the wealthy and increased entitlements and social programs, potentially among them universal healthcare, free public education/student loan forgiveness, universal basic income.
3. A long period of negative interest rates.
Huh?
Think about it: negative rates slowly destroy the wealth of bondholders, i.e. savers, the wealthiest of us being the primary among them.
At the same time, they allow the government to borrow at negative real costs to finance social programs. In this way, negative interest rates are functionally the same as a wealth tax. They are both mechanisms for restributing wealth from the rich to the poor and middle class.
In fact, I think you can even argue NIRP (negative interest rate policy) might be better than wealth taxes for social cohesion. It’s a more subtle way to redistribute wealth. It’s less political, divisive, obviously in your face and demonizing of the generally most productive members of society. Billionaires are less likely to want to flee to other jurisdictions for “favorable interest rate policy” than for favorable tax laws.
“But, what about the part where asset prices have an inverse relationship to interest rates, and that asset prices moon whenever rates get cut to zero or negative and that makes the rich richer and exacerbates wealth inequality!?”
In the short-term, yes. In the long-run, however, high asset prices and negative rates reduce forward expected returns. They inhibit the ability to compound wealth over time. Perhaps counterintuitively, the value of equity (which is what most wealth is created and stored in) grows more over time if profits/dividends are able to be reinvested in the business at a high rate of return.
Buying back stock or reinvesting dividends at 10x earnings is more accretive than doing the same at 50x earnings, and will result in a higher stock price over time. I illustrated this in Facebook Shareholders, Rejoice in February, 2022 if you want to see how it works on a spreadsheet.
Or maybe to illustrate with a simpler, obvious example, take investing a million dollars in treasuries for a quarter century at 5% vs. 1%. I know nobody can think in terms of 25 years, but imagine you amass a million in retirement savings by age 40 and invest it until, you know, retirement age. Not too farfetched right?
At 5%, your $1mm has grown to $3.4mm.
At 1%, your $1mm has grown to $1.3mm.
Negative interest rates bring forward future returns, but sustained high interest rates and/or attractive returns on capital over decades is how fortunes are amassed.
Negative interest rates over decades reduce fortunes, pay for social programs and are a mechanism for redistributing wealth not all that dissimilar to a wealth tax.
What’s The Likely Path for the U.S.?
So, of course, the next question becomes: which path will we follow in the U.S. and how to play it?
I think scenario 1 (Great Depression part deaux) will be avoided at all costs and can be ruled out.
Under scenario 2 (high wealth taxes and increased social programs) you might expect high CPI inflation as direct transfer payments make their way into the real economy, necessitating high interest rates, which is destructive for asset prices. While, as mentioned, under scenario 3 we have negative interest rates and correspondingly high asset prices.
Since 2008, I think we’ve generally been living in a ZIRP/NIRP world and financial assets have performed admirably as the world adjusts to the new economic regime and comes to grips with what it means.
However, in 2020, the covid policy response of stimmy checks, PPP loans, rent and mortgage moratoriums and increased unemployment benefits for everyone who applied represented turning on the direct transfer payments in a big way that had not been tested before — helicopter money, if you will, and perhaps a trial run for UBI-esque policies in the future. These policies contributed to the high inflation of 2021-current, which prompted the fastest rise in interest rates in recorded history, which prompted widespread destruction of asset prices. 2022 was only the 5th time since 1928 both stocks and bonds declined in the U.S. in the same year, and the combined magnitude of the drawdown was the largest ever given than the bond market is larger than the stock market:
So we’ve got two likely paths to resolving extreme wealth inequality over time and while one of them results in mooning asset prices the other one results in cratering asset prices.
Helpful!
I think the answer to the question at the top is some combination of 2 and 3, with 3 being the dominant force at play in financial markets for the forseeable future.
If debt to GDP were lower I think the economy would better be able to tolerate higher taxes, increased social programs, and higher inflation and interest rates. But with debt to GDP of 130%, I don’t think the economy can tolerate high interest rates for any meanigful length of time because debt service costs will compound and begin to crowd out all other spending.
Thanks to Lyall Taylor and his blog for informing the framework presented in this post. I recommend this post for a deep dive on the subject.
1. "Interest payments = money out from the government and into the hands of citizens and corporations (and foreign governments). Taxes = money out of the hands of citizens and corporations and into the government. Interest is a cost, taxes are revenue, and they both impact the bottom line (the fiscal surplus or deficit) the same."
This sentence sounds like MMT. Obviously MMT got politicized but the core insight (monetary & fiscal policy are two sides of the same coin) is valuable and explains the 2010s well: QE was printing money and giving it to rich people who have a high marginal propensity to save so why can't the government instead print money and give it to poor people who have a high marginal propensity to consume. The answer turned out to be that nobody minds asset price inflation, but people do mind goods price inflation.
2. "Think about it: negative rates slowly destroy the wealth of bondholders, i.e. savers, the wealthiest of us being the primary among them. At the same time, they allow the government to borrow at negative real costs to finance social programs. In this way, negative interest rates are functionally the same as a wealth tax. They are both mechanisms for redistributing wealth from the rich to the poor and middle class."
The distinction between performance-to-date and go-forward performance is such a simple distinction that gets lost in a lot of financial writing- most often in ESG debates. In 2021 you had all these articles saying "ESG portfolios have outperformed" citing performance-to-date driven by higher present values due to lower forward-looking discount rates, and obviously inverse for coal assets etc which had been crushed on a PV basis and were trading cheap on a go-forward basis. But for some reason even sophisticated financial writers like Matt Levine seem to get tripped up and confused by the distinction.
I had not thought of it before with respect to Fed policy but it's a really important distinction: low rates benefit old people who already have amassed wealth whereas high rates benefit young people who are just beginning to invest. This is the argument QE of the 2010s pulled forward a decade of investment returns and forced younger generations to start investing at much less attractive price levels.
3. "If debt to GDP were lower I think the economy would better be able to tolerate higher taxes, increased social programs, and higher inflation and interest rates. But with debt to GDP of 130%, I don’t think the economy can tolerate high interest rates for any meaningful length of time because debt service costs will compound and begin to crowd out all other spending."
In the long-run this is probably true ("meaningful length of time") and part of the logic behind why high rates should slow the economy, but in the short-run we could see the government just run higher deficits to counteract Fed policy ... I am with you that the endgame here probably has to be some kind of inflation (probably hidden) to dig out of the hole.