The Fed and the Bond Market

I worry that the Fed has permanently damaged the bond market.  The bond market has been a relatively stable institution for hundreds of years.  The idea was that people with money would loan it to other, usually poorer people, for things like starting businesses.  In return they would get enough interest to make the risk of the loan worthwhile. If wealthy people did not like the risk outlook, they would demand higher interest, which meant that fewer and fewer borrowers would be willing or able to borrow at the higher rate.

The Federal Reserve has eliminated the risk in the bond market and thus reduced the interest rate to about zero.  By buying up a substantial part of the entire bond market, it has reduced the risk associated with bonds is almost zero, because the Fed will buy almost anything.  The lenders may not be happy with the interest rate, but they like the security of no risk.  The borrowers like what is essentially free money.  This looks like an ideal situation, but it works only because the US government finances at least part of it.  In essence the Fed pays the risk premium, eventually causing the national debt to skyrocket.  The Fed can also print paper money. At some point printing money should be inflationary.  It may be that currently it is creating asset inflation, driving up the stock market and house prices, while not yet driving up consumer prices.  It may be that consumer inflation is kept down because so many of our consumer products come from China and other Asian countries.  If inflation takes off in Asia, we may quickly feel it here.

One thing that helps the US is that most international trade is done in dollars.  As long as the dollar is the world’s reserve currency, we are less affected by economic conditions in other countries.  If the US continues to be a spendthrift, running continual huge budget deficits, and printing huge amounts of dollars, then the dollar’s status as the world’s reserve currency may be threatened.  If so, then we become less insulated from vagaries of the world financial markets.

Basically, interest rates have been zero since the 2008 great recession.  This was when “quantitative easing,” bond buying by the Fed, started, which drove down interest by reducing bond risk.  So far, it seems to be working, but it’s not clear what it means for the long term.

There may be a price to pay in the future.  Asset inflation of stocks and real estate may worsen income inequality, which is already a problem.  It will solidify and worsen class differences and/or create social unrest.  It might undermine the value of the dollar, which would be good for exporters, but bad for every other sector of the economy, particularly consumers.  Prices of clothes, TVs, computers, etc. will skyrocket.

So far, though, the Fed’s machinations seem to be working.

In Friday’s New York Times, Paul Krugman wrote a whole column about the national debt and the future of interest rates without mentioning the Federal Reserve.  His explanation for why interest rates are so low is:

That’s a longish story, probably mainly involving demography and technology. Basically, the private sector doesn’t seem to see many opportunities for productive investment, and savers who have no place else to go are willing to buy government debt even though it doesn’t pay much interest. The important point for current discussion is that government borrowing costs are now very low and likely to stay low for a long time.

So Krugman says interest rates are low because there is nothing worth investing in in the US; so, rich people just buy low-interest bonds.  He doesn’t mention that the Fed is buying bonds like there is no tomorrow.  Then he also says the US government should not be afraid to spend money to deal with the pandemic.  Isn’t that investing, isn’t that the very thing he said was not worth doing because there is nothing to invest in?  His is an unpersuasive argument for doubling the national debt.

Saturday’s Barron’s “Up & Down Wall Street” column blames the Fed for zero interest rates.  It quotes Mark Grand of B. Riley as saying, “I assert … that you are not getting paid for credit risk….”  Barron’s adds, “This bond-market veteran put the blame on the Fed and other central banks for creating a ‘borrower’s paradise’ and a ‘fixed-income investor’s hell’ by holding interest rates down, in part to help finance the massive fiscal deficits.”

I think Barron’s has a better understanding of the situation than Paul Krugman.

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