Every once in a while I’ll get some sort of backhanded slight when I’m discussing a topic, where some person or persons have deemed, all beforehand, I couldn’t have the vaguest notion of what I’m talking about. After all as their thought process will inevitably yield: How could I? For I don’t have a Ph.D. or other such self-identifying moniker of “wisdom” they require as “club worthy.”
Usually that’s precisely the reason why I do have a better grasp than “the club.” And what I want to bring forward today is something I addressed going back nearly 4 years hence. The topic?
R*: aka “The natural rate of interest.”
It was in direct relation to this monetary policy phenom held out via the Federal Reserve that I stated, without question, was going to bring havoc to the very ones touting “They got this!” e.g., The Federal Reserve itself.
When I raised this argument (October, 2016) it was met with derision and more. What I now find absolutely comical is that it is now none other than the Chair himself, Mr. Powell having to make a special appearance to make sure everyone gets “the message” that R* going into negative boundaries is not something they are in favor of. As – it is already pricing in. And – just about to do it ever-the-more.
To reiterate, what was being told-and-sold back then (i.e., years back) about monetary policy and interest rates was that we were told – It’s all about R* – and they can always control that phenom at will.
It appears “that will” is now just as I said it would be: a problem. And not just a small one, but a very, very, very (did I say very?) big one. Why? Easy…
It will take raising rates to stop it. Something the “markets” know can not be done.
Not only does the “market” know it – but so does the Fed. i.e., the very reason (my conjecture) for the sudden “Hey, we’re against negative rates…”
Hint: As you’ll read below, that “you can always refinance” dilemma I warned about is now here. Imagine that, who’d a thunk it?!
Below is that article, originally published
I know more than a few of you reading this looked at the above headline and thought, “Huh? What the heck is R*?” And if you did, chances are, you’re one of the few remaining people with your heads down working tirelessly as to keep whatever en-devour you may be pursuing to stay afloat (i.e., your business, your job, etc.) For you don’t have time to think about esoteric monetary principles or theories now being debated, hypothesized, and pondered in the wood-paneled rooms reserved for Ivory Towered academics, policy wonks, Nobel Laureates, and central banks the world over.
However, with that said, make no mistake; as of today the entire global monetary system is riding upon those two seemingly unimposing characters: R*.
So what is R*?
Basically it is defined as : the neutral rate of interest. Also known as “the natural” or better yet, “The Goldilocks rate of interest.”
If reading the term “Goldilocks” and “interest rates” in the same sentence just made your blood chill? Congratulations – you’re normal. Yet, in the hallowed halls of economic policy wonks? Yes, that is a real moniker. And to prove that point here’s an excerpt from a recent FT article. To wit:
“A crucial part of the debate is a term which had previously been confined to economic textbooks – the neutral rate of interest, also known as “r-star”. It can be best described as the “Goldilocks” rate of interest – consistent with stable economic growth that does not cause inflation to overheat. Not too hot and not too cold.”
Now don’t get me wrong, I’m not taking shots at the Financial Times™ for trying to explain to the casual reader what R* means. What I am pointing out is this: Suddenly this once obscure term now needs explaining in the first place.
Media outlets such as the FT and others speak to a very specific crowd. i.e., (Ph.D economists, policy wonks, central bankers, et al.) And that crowd knows precisely what R* is and what it means. What I find interesting is just how often this once little known text-book equation and theory has now been referred to by not only The Fed, and in particular: Janet Yellen – but the entire global monetary spokespersons, along with the media and sycophantic think tanks that follow them.
This once obscure economic equation has now practically jumped into every current conversation today as it pertains to monetary policy. Suddenly, it’s everywhere. Nearly every conversation over the past few months whether it be television, radio, or print pertaining to monetary policy can no longer go more than a few minutes without delving into “the neutral/natural rate.” e.g.: R*
Even next-in-rotation fund managers have gotten in on the R* jargon bandwagon. And to my thinking – it rings the alarm-bells louder and louder with every increased mentioned. And here’s why: (Remember: This is meant to be an exercise as to grasp the concept of what’s taking place as a result. Not a working explanation of the theory.)
The way I explain R* is this: Think of R* as the “adjustable-rate” or “interest only” mortgage payments on the global economy. Yes, precisely like those wonderful mortgage vehicles that blew up housing and the entire financial system along with it in ’07/’08.
In other words: R* is the working equivalent that’s facilitating corporations to borrow and borrow as to buy back shares, conduct M&A and more by acquiring ever more debt at low-interest rates, while their top and bottom lines continue to deteriorate.
If that sounds a lot like another vehicle (e.g., Liar Loans) from that same period which allowed and facilitated people to buy bigger and bigger, or more houses right before the financial crisis? That’s because in principle – there’s no real difference. i.e., Financially engineer your books to state whatever it is you need (think Non-GAAP) then borrow money against it as to either put on an addition (think M&A) or to just increase your curb appeal raising the perceived value (think buy backs.) Rinse, repeat.
Not that dissimilar, are they?
(On a side note: I’m not even adding in the other more concerning fact of enabling governments the equivalent of a blank checkbook, forget about just a check.)
However, if you understand just how eerily similar the above is – here comes the part in which it becomes inherently frightening. Ready?
What was the working thesis during that period, as well as the repeated response when any concern was raised? Hint: “You can always refinance.”
How’d that all work out?
If you remember (or were unfortunate as to take one) adjustable rate mortgages and-the-like were speciously sold, or advised, to people as to not only buy homes or refinance, but also afford homes far beyond their means. Again, to reiterate the presumed working thesis: If the time came when interest rates moved higher or some other measure? They could always just refinance into some other vehicle. i.e., a fixed rate product, etc., etc. And if push came to shove: Just sell for either a profit, or wash.
The problem as we all now know is “refinance” became an empty promise – right before the guarantee of foreclosure, bankruptcy, or both.
Yes R* assumptions for stability and control-ability can turn into WTF* moments of panicked reality in the blink of an eye. All it takes is one (and just one at that) hiccup and the whole theoretical construct comes crashing down along with all those seeming stable lofty values and assumptions when suddenly – no one trusts who’s solvent, if anyone, regardless.
Whether you’re listening to the Fed. or any other central bank today the immediate response along with their working assumptions hinges around the same presumptive arguments that revolved right before the last crisis. i.e., “We have more tools.” “We’ll do whatever it takes.” “Sometimes you just have to believe.” etc., etc.
This is today’s equivalent by both Central bankers, and their gaggle, intoning words of “surety” much like the mortgage brokers, banks, real estate agents, media and more right before the crisis. i.e., “Relax, you can always refinance.”
In the days leading up to the first wave of the financial crisis in 2007 it all seemingly began with what appeared like only “a hiccup” in the ever burgeoning mortgage and real estate market. For then, out-of-the-blue, New Century Financial™, one of the largest subprime lenders went into a death spiral. Approximately 3 to 4 months later it would be gone.
After that? Again seemingly out-of-the-blue, only 3 to 4 months later, what was also regarded as “one of the largest if not largest” subprime lenders Ameriquest Mortgage™ would be gone. This was near inconceivable when less than 2 years prior (’05/’06) it appeared they were sponsoring everything from stadiums, NASCAR™, Super Bowl™, and even the Rolling Stones.
It was hard for anyone to imagine just how violent, as well as devastating this would all turn, again, just barely 24 months after 2005. Especially those who controlled interest rates and monetary policy. e.g., The Fed. (in particular) and central bankers globally.
If anyone cares to remember, during the initial crisis the Fed. then headed up by Chairman Ben Bernanke raised interest rates because? He felt (along with whomever voted along to enact it) that the housing crisis was both contained, and believed, for whatever the reasoning, that during that initial period of panic was precisely the right time to raise.
Question: How’d that all work out? Answer: Don’t worry – they now say they’ll know what to do should something like that ever happen again. Feel better?
Now there are two very important factors I would like to remind you of dear reader that I believe is very germane to this whole argument, and they are these:
First: Before the ensuing financial crisis the Fed. had kept interest rates low as to help ward off the lingering effects remaining in the economy from the dot-com crash just a few years prior. Many educated interest rate and monetary policy adept people and pundits (think James Grant, Bill Gross, et al) were sounding alarm bells that the Fed. was just enabling another asset bubble. e.g., The dot-com bubble being the first, then the subsequent housing bubble.
Second: It was during this period of time (i.e. 2005, you know, right before everything came off the rails) that a little known to the public-at-large Fed. member Janet Yellen, then the Vice Chair was articulating what was then an obscure theoretical model to what is now on the lips and tongues of nearly anyone concerning today’s monetary policy effects: e.g., Neutral monetary policy, or R*
And Third: Not to make anyone nervous, but one of the largest banks in the world with contagion risk via derivatives (think subprime products for banks) in the 10’s of TRILLIONS of $dollars looks to be entering a phase which many have dubbed “a death spiral.” e.g. Deutsche Bank™. Yet, just to add to the already frightening similarities of the last crisis, now it appears Commerzbank AG™ is raising alarm-bells in unison. The reason for these distresses? Current central bank policies and financial repression. Imagine that.
Make no mistake: On the global scale Deutsche Bank and its portfolio of derivative exposures alone has the ability to cause financial contagion across the global monetary system in ways similar to the initial days of the financial crisis. i.e., Who has exposure to what, along with the resulting freezing up of banks dealing with other banks as the fears feast upon themselves.
But not to worry, after all, we’re told over, and over again when it comes to things like this – “They’ve got this all under control.” And if that doesn’t make you feel better – take a line of resilience from that real “rock star” of calm and composure, Alfred E. Neuman….
“What, me worry?”
© 2020 Mark St.Cyr