Monday, July 6, 2015

Service sector still healthy, so why are interest rates so low?

The ISM June service sector report came in as expected at 56.0, and that is consistent with a continuation of moderate growth in the biggest sector of the U.S. economy. Meanwhile, a similar report for the Eurozone shows conditions have been slowly improving for the past two years. We're still in a slow-growth economy, but nevertheless it continues to grow and conditions continue to improve. 

We've had six years of this, and with each passing month the rationale for zero short-term interest rates weakens. Years of near-zero interest rates are now the unique feature of the current business cycle expansion, but the reason for low interest rates is widely and commonly misunderstood. I think it's because central banks have conditioned global financial markets to view extremely low interest rates as "stimulative." Central banks want people to believe they are keeping rates low in order to "stimulate" economic growth. But despite trying really hard for many years to pump up growth, they but don't appear to have been very successful, because growth remains rather tepid. Is that because they haven't tried hard enough, or is there some other reason?

I've argued for many years that zero interest rates are symptomatic of a market that is risk averse. Interest rates on short-term, safe assets are low because the demand for them is very strong. Central banks have been obliged to accommodate this demand for safety by supplying tons of bank reserves. They've set interest rates low because that's where the market has driven them. They haven't been stimulative at all; you can see that by the fact that inflation remains very low. And of course, the premise that central banks can stimulate growth is highly questionable to begin with. Just how does a low interest rate environment stimulate growth? Growth comes from productivity, and productivity is the result of harder and more intelligent work, which in turn requires risk taking and motivation. Interest rates don't factor into the productivity—investment does. Besides, if low interest rates encourage borrowers to borrow, then they most likely discourage savers from saving. When the world is risk averse and wants to hold tons of cash and cash equivalents, investment is naturally weak, and that's why economic growth has been disappointingly slow. 

Bank savings deposits—which pay almost nothing in the way of interest—have doubled since the end of 2008, and are now approaching $8 trillion. They have quadrupled in the past 14 ½ years, rising at an annualized 15% per year! Yet they pay almost no interest; demand for the safety of deposits must therefore be intense.  

Service sectors in the U.S. and in the Eurozone are in decent shape, as the chart above shows.

The employment subindex fell from optimistic levels, but this series is notoriously volatile from month to month.

The business activity subindex is also at relatively healthy levels.

We're not going to see much in the way of stronger growth until economic policies increase the incentives to work and take on risk, and reduce the obstacles to investment.


Benjamin Cole said...

All true, although one reason long-term interest rates remain so low is an abundant supply of capital.The Fed can't force people to buy 10-year Treasuries, for example. And if the Fed tries to lower rates by printing more money, we would actually see interest rates on 10-year Treasuries rise.

On the supply side, the US also faces a problem for which I see no solution: every pleasant place to live in the United States has criminalized robust new housing construction.

I do not think we will see supply side solutions to housing inflation anytime soon.

Free enterprise and property rights die at the city line.

William said...

Additional interesting data points provided by Dr Ed Yardini:

"(1) Construction spending rose to a cyclical high of $1.04 trillion (saar) during May. Leading the way was a 1.5% m/m jump in nonresidential private construction, with manufacturing soaring 6.2% during the month. The latter has been climbing almost vertically this year, posting a 70% y/y gain. This is certainly consistent with the view that despite the strong dollar, the US may be enjoying an industrial renaissance based on cheap energy and technological innovation.

(2) Another category of capital spending that’s showing strength is sales of medium and heavy trucks. It rose to 450,000 units (saar) during June, a new cyclical high and the best pace since February 2007. That’s impressive given that the oil patch has been hard hit by the plunge in oil prices since last summer.

(3) Retail auto sales averaged 17.1 million units (saar) during Q2, the best such pace since Q3-2005. Overall retail sales have rebounded smartly this spring following the winter’s ice patch.

Anonymous said...

SF mid-peninsula 4 br 3ba really nice remodeled house listing for $2,080,000. Oh, and it is backed into a hill so the nicely landscaped yard higher up looks over the roof and you have a decent view. No Manhattanization here. It used to be that people would buy in Tracy so they could have a nice house to live in even if it meant suffering the long commute. Now people are forced out and suffer the long commute because they have to.

This is true. 868 Hemlock St., San Carlos, CA Listed by CB Norcal 650-315-8989 to prove it to yourself because what I say is pretty implausible.

As long as total construction spending and new car sales remain positive there won't be a down turn in the economy. Right?

Benjamin Cole said...

Joseph: The reason housing is so expensive is that homeowners all along the California coast have blocked free enterprise, capitalism and property rights.

Try building a 60-story condo tower in Newport Beach, San Clemente, Santa Monica or Sausalito.

The homeowners simply won't have it.

At $400k a unit, a tower facing the ocean would sell out in about 32 minutes. Imagine balconies facing the water, nice ground-floor restaurant, maybe a yacht harbor below--but forget it, ain't going to happen.

There have been some condo mid-rises build in Marina del Rey, part of the County of Los Angeles, but that is all that I know about.

W said...


Could you clarify your points on why low interest rates are not stimulative? I would think that if low interest rates encourage borrowers to borrow (to invest), and discourage savers from saving (to consume), then that might be stimulative.


Thinking Hard said...

It seems that ZIRP is a continuation along the long term trend line in overall interest rate policy since the Volcker years. In order to increase total credit instruments outstanding, lower interest rates are needed, barring higher productivity and growth. Lower interest rates allow increased borrowing which allows for increased spending. This directly stimulates the GDP calculation.

The Fed indirectly controls the Fed Funds rate, which has a strong correlation with other interest rates. The market reacts to central bank policy changes, and the central bank has indicated lower rates for longer. We are not likely to see rate normalization for a significant period of time. The market may dictate interest rates in certain circumstances, such as the huge move we recently witnessed in the German bond market. That kind of volatility in the bond market is extremely rare in theory. I don’t view low inflation as an indicator that ZIRP has not been stimulative. The deleveraging and deflationary pressure we witnessed in 2009 would have been much greater if ZIRP was not introduced along with QE to push the longer end of rates lower.

Scott – How are low interest rates not directly stimulative to the current GDP and inflation calculations?

Johnny Bee Dawg said...

The world continues to be so risk-averse because our current government is hostile to profits and paychecks, through both policy and rhetoric. Constitutional protections are under assault, as the Supreme Court shirks its duty to rule according to law. So risk attitudes have reset, and are still not encouraged by what's in the future. This risk aversion is what is keeping stocks so undervalued with respect to historic interest rates and earnings. Earnings yields vs Treasuries show this market to be in the bottom quartile of historic valuations. At these interest rates, history says P/Es should be sky high. They're just not.

This type of risk aversion remained high during FDR's 4 terms of his Presidency, while he acted like a king and spouted similar rhetoric and assaulted the American People's Constitutional protections. That risk aversion ended only when his rule ended before the war was even over, and Congress immediately passed term limits before he was barely cold in the grave. A Republican Congress instituted pro-growth policies, and we were off to the races, despite the economic destruction of war.

It appears we will have to wait it out once again. Presumably, the American people will elect Hillary and extend this risk aversion for yet another 8 years. History is at least rhyming. Fix the policies and rhetoric that are punishing capital, and you'll fix the risk aversion. It's that simple.

Grechster said...

I think Johnny Bee Dawg is on to something... We just haven't seen pro-growth policies be put into effect. I've been waiting for some (at least) audacious rhetoric from the GOP since the watershed elections of last November. Aside from Rand Paul's economic proposals I haven't heard much. Rather than advocating for lower taxes, better regulations, and a stable currency they seem to be obsessed about inflating foreign risks from Iran, Russia, and China all in the name of boosting their hallowed military budget. Different party, same amount of waste. Scott is right to point out the shrinkage of the budget deficit. But I don't hear the voices for pro-growth policies, policies that result in more risk-taking, more investment, more wealth. I'd like to get Benjamin Cole to run for national office - I like his economics and I like his spending priorities.

steve said...

I gotta disagree that the reason rates are low is due to "risk aversion". a stock market that hasn't had a 10% correction literally in YEARS is not risk averse. there's a lot of money out there chasing a fixed amount of stuff-and that includes bonds and THAT'S the reason rates are low and stocks are by most measures pretty damn high.

Scott Grannis said...


Easy money—whether implemented by printing money or by artificially holding down interest rates—can't "stimulate" because you can't create growth out of thin air. Growth happens as a result of getting more output from a given level of inputs: working harder and/or investing more and/or risking more. As the classic line goes, if easy money were stimulative, Argentina would have the biggest economy in the world. But it doesn't. Making loans artificially cheap inhibits the formation of capital that is essential to increasing productivity and growing the economy, because it reduces the rewards to saving. At the same time it encourages people to leverage up, and use the borrowed money to buy "things" that will appreciate in price.

Low interest rates that are the result of risk aversion and a strong demand for money (which I argue is the situation on the ground today) are also not stimulative. They are merely the clearing price for the supply of and the demand for credit.

Encouraging consumption is also not stimulative. If supply is insufficient to match "stimulated" consumption, the result is simply higher prices, not a bigger economy. Increasing supply (i.e., work, investment, and production) is the only way to grow an economy.

Benjamin Cole said...

Matthew G: I am blushing. I may be one of the few not seeking the GOP nomination.

Benjamin Cole said...

Matthew G---you raise an interesting point: why invest if you think the "world is on fire" to quote GOP candidate Cruz. Scaremongering is a norm now in right-wing politics. But do fearful people invest?

In truth, the US faces nearly zero military threats. In the private sector, business operators take advantage of opportunities to save money. That does not apply to the federal government.

jpnmitchell said...


Could you possibly do an entry with your thoughts on bitcoin? I saw you mention in this past March, and I'm curious as to what an experienced, unbiased economist thinks.


Benjamin Cole said...

Scott: I hope you're still reading comments. You know, I was looking at the chart on bank deposits and from 2001 to 2008 deposits at commercial banks about double. And then from 2008 to present day they about double again.

So when did risk aversion start? Or is this some sort of new normal and we will see constantly growing commercial bank deposits? Given the track record of the last 16 years...

Scott Grannis said...

Benjamin, re growth in savings deposits. You are right to point out that deposit growth in the two 7-year periods was of a similar magnitude.

However, there was a very important difference between the two periods: the interest rate paid on deposits. In the first period, short-term rates (e.g., LIBOR) averaged over 3% and were over 5% for almost two years. In the second period, short-term rates have been very close to zero. Banks had to pay a lot more for their deposits in the first period than in the second. I think that reflects very strong demand on the part of the public for the safety of deposits in the wake of the 2008 crisis, and that is part of the risk aversion that has characterized the current business cycle expansion.

Benjamin Cole said...

Interesting. Of course in parts of Europe they cannot seem to dissuade deposits even with negative interest rates.

Johnny Bee Dawg said...

I don't know of any measures that show stocks are "pretty damn high." For the largest part of the move off the bottom, earnings went up faster than stock prices. Multiple expansion has been more tepid than any other recovery. In fact, a market that creeps along without any significant pullbacks is PROOF of risk aversion. Where's all the excesses? Who's left to sell, with so many sitting idle on the sidelines? If stocks were overblown, they wood have had numerous strong pullbacks with all the recent "crisis" events. Markets are already priced for doom and gloom, which means pullbacks are small. Cash cushions are huge, meaning nobody gets wiped out by a market crash. That just puts off a crash until enough people are in.

The earnings yield of the S&P500 is 400 basis points above the 10 year Treasury. That's among the biggest spreads in history...especially for a market near all time highs. Cheap. The AAII is reporting bullish sentiments that are getting close to historic lows. Record cash sits idle earning zero instead of dipping a toe in the risk pool. Commercials on tv warn of an imminent crash. It's been a great time to make big returns by focusing on stocks with good relative strength. They are easily spotted standing out from the pack. These are the good times for savvy investors. Lots of money to be made off risk aversion....especially with little signs of optimism on the horizon.

Scott Grannis said...

Re: bitcoin. I'm probably more-informed about bitcoin than the average investor, but I don't have much in the way of wisdom to offer on the subject. I think there's merit in the way bitcoin works (e.g., its independence from governments and central banks), but to date bitcoin's value vis a vis other currencies has been extraordinarily volatile, and that all but rules it out as a viable currency. Perhaps this will change with time, so I would not write it off yet, and I plan to continue to study it.