interest rates Archives - Bankers Anonymous

July 29, 2019July 29, 2019

Book Review: Foolproof by Greg Ip

Did you notice the weird stock market that emerged, Gorgon-like, from the Upside Down in December 2018?

We’re living this Stranger Things market because the Federal Reserve holds all the keys. The December 2018 panic – a 15 percent peak-to-trough drop in the S&P500 – scared all the adults so much that between January and July 2019 we’ve been living the chain reaction. When I say adults – in my analogy – I mean the Federal Reserve, which sets short-term interest rate policy.

The July 30-31^stmeeting of the Federal Reserve this week may (or may not!) resolve this Upside Down world. By Upside Down I mean all traditional good news for the economy is bad for stocks, because interest rates might stay the same or go up, which could in turn tank the market. Bad news for the economy, on the other hand, is good, because the Fed could cut rates and therefore juice markets further.

Got it? It’s the Upside Down. Love is Hate, No is Yes, War is Peace. I’ll come back to that upcoming Federal Reserve meeting, but first…

I have a weakness for counter-intuitive truths, contrarian wisdom, and oxymoronic statements, especially when it comes to money and markets. This week’s summer reading was Wall Street Journal reporter and economist Greg Ip’s 2015 book Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe

Of course I would fall for a book with the subtitle “Why Safety Can Be Dangerous, and How Danger Makes Us Safe.”

Ip’s main point is that when we act to reduce risks in one place today, we may create greater risks for tomorrow. Or we may unknowingly create risks for other people, in unexpected ways or places. When we seek perfect stability or the absence of volatility, we create unstable systems. Ip cites mid-twentieth century economist Hyman Minsky, who summarized this big idea as “stability is destabilizing.”

A few analogies Ip employs:

Suppressing natural forest fires on national park land may, ironically, create the conditions for uncontrollable wildfires in the future. Small controlled burns, by contrast, reduce the chance of big conflagrations.
The introduction of padded helmets in professional football may have increased the risk of both brain and bodily injury in players, because bigger and faster players tackle head first. Rugby players, by contrast, don’t suffer the same types of brain and spinal injuries because they don’t play with the same head-first recklessness that helmets encourage.
Our reaction to catastrophic-seeming risks like airline crashes and nuclear power plant meltdowns can increase risky behavior – like driving more, or shifting to other, long-term deadlier energy sources.
The Federal Reserve historically has attempted to lower the risk of big blowups by inducing smaller economic slowdowns, like setting a controlled burn to reduce the chance of a big out-of-control forest fire.

As an economist, Ip urges us to think about how seemingly risk-reducing behavior can, counter-intuitively, create greater risks in the future. The attempt to smooth over all dangers completely can make an entire whole system riskier, or create unanticipated risks later on.

To prevent this, in macroeconomic terms, the Federal Reserve often attempts to play a key role in setting a controlled fire, in order to prevent an uncontrolled wildfire. William McChesney Martin, former Federal Reserve Chairman (1951-1970) classically described this action as “take away the punch bowl just as the party gets going,” by raising rates when the economy gets too strong. This sounds good in theory, although it’s always controversial and based on guesswork when implemented in real life.

Incidentally – about that July 30-31^stFederal Reserve meeting – markets clearly anticipate a rate cut. Which also strikes me as something coming from the Upside Down.

With risky asset prices (real estate, stock market indexes) at an all-time high and unemployment at a 50-year low, the traditional macroeconomic case for a Fed interest rate cut in July 2019 is – in a word – absent.

It’s difficult, but maybe necessary, to set small fires to prevent the big fires

In the past, we’d expect a rate hike, not a rate cut, under these booming economic conditions. The Fed would seek to set a controlled burn now, in order to prevent a massive forest fire later. Interest rate cuts, by contrast, were a rarely-used emergency tool for cushioning against recession, boosting confidence in the face of tight lending or adverse shocks to the economy. None of that is apparent now.

Under similar situations of asset price inflation and low unemployment – 1991, 2000, 2006 – the discussion was always about raising interest rates. By classic standards, a rate cut at the end of this month seems insane. But what the heck do I know? It’s just what markets currently expect in our Stranger Things economy.

The Personal Investments Application of This Idea

By the way, moving from macroeconomic theory to personal investments, I think the most important application of Ip’s thesis – although he never spells it out in his book – is in our personal asset allocation choices.

Specifically, should we choose “dangerous” assets like stocks, or “safe” assets like bonds and annuities? Because the perceived riskiness or safety of these assets seems clear in the short term, but counter-intuitively flips in the long term.

The truly dangerous investment– if we’re talking about a long-term project like living comfortably in retirement – comes from “safe” seeming assets like bonds and annuities. For middle-income folks, the true investment danger is that we will outlive our money, a danger that bonds and annuities tend to aggravate rather than alleviate.

Stocks, when given decades to grow, – and diversified, of course – tend to lower our personal risk of outliving our money. In order to be safe in retirement, we need to choose risky in our investments.

Please see related posts

All Bankers Anonymous Book Reviews In One Place

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November 9, 2018November 9, 2018

Federal Reserve and Inflation

The Federal Reserve has raised short term interest rates three times already this year by one-quarter percent, and it seems poised to do so again in December, even though it left rates unchanged this week. Over the next two years, barring an unanticipated war or recession, the Federal Reserve will raise short-term rates by another percentage point.

We may have different reasons for benefiting from higher or lower interest rates, depending on whether we are primarily borrowers or savers, employers or employees, exporters or importers, young or old.

The effects of rate hikes on the economy are complex and incredibly important. But we probably think of interest rates and the Federal Reserve a bit like changes to the earth’s climate – massive forces shifting ominously, seemingly far beyond our individual control. We vaguely understand them to have huge implications. We’d like to know more, but how?

There are two big questions to understand today about the Federal Reserve and rising interest rates.

First, what is the relationship between inflation and interest rate hikes?

Second, what is the proper relationship between political leaders and the Federal Reserve?

I’ll talk about the inflation question here and leave the political question of the Federal Reserve for a later post.

From a multi-decade perspective, we’re moving from artificially low interest-rates – dating back to a period that started with the 9/11 attacks and were renewed by the 2008 financial crisis – to a more “normal range” interest rate environment.

In normal times, the Federal Reserve raises rates when it worries about inflation, and it lowers rates when it worries most about unemployment. The Fed’s not worried about unemployment – currently at a 49-year low. Instead, the Fed seeks to keep inflation in check. But because inflation apparently isn’t rampant, the Fed can take it’s time with gradual rate hikes.

One of the great economic mysteries of the last decade is the absence, or at least inconsistency, of observable inflation, despite the fact that the Federal Reserve pulled out all the stops to make lots of money available in the years following the 2008 financial crisis. Pretty much every observer, even supporters of the post-2008 crisis policy of easy-money-plus-low-interest-rates, predicted a significant uptick in inflation. That, seemingly, was the price we had to pay to kickstart the economy.

But then, it didn’t happen. Or it didn’t happen in the way we expected. From the beginning of 2010 through September 2018, the Consumer Price Index – a traditional measure of inflation – rose only 16.4 percent. Annual inflation averaged less than 1.7 percent in that period, which is totally non-threatening. Consumer inflation from 2010 to today is like the dog that didn’t bark in the night.

We can be a bit more sophisticated though in understanding different types inflation and what it means for different people in an economy.

Inflation types

We should be aware of least three different types of inflation.

There’s the traditional type of consumer price inflation we see, which shows up in the price of gasoline, the stuff we buy at WalMart, health care, tuition, and the cost of a pizza on a Friday night. I know you think you’re paying too much lately for this stuff, but compared to other decades consumer inflation has been pretty modest.

At least two other types of inflation matter as well, however, asset price inflation and wage inflation.

Asset price inflation shows up as the increase in the price of real estate and the stock market. We generally cheer this type of inflation as a healthy sign of economic growth, although it’s not a purely good thing, depending on who you are.

To pick one real estate measure for example, the St. Louis Federal Reserve House Price Index for Texas has risen by 49.8 percent since the beginning of 2010. In other words, even though consumer goods cost just 16 percent more, houses in Texas cost 50 percent more than they did in 2010. What about stocks? To pick another measure, the Russell 2000 Index of small capitalization stocks is up 150% since the beginning of 2010. The rise in stocks isn’t entirely inflation, as its partly due to retained profits and buybacks, but inflation is part of that 150% rise in stocks.

So, is asset inflation good or bad? It depends.

Where you stand depends on where you sit

If you’re a twenty-something or thirty-something trying to save for your first home purchase, and home prices rise by 5-10 percent each year over a decade, this type of inflation actually hurts your plans. Similarly, for a young person trying to accumulate a retirement account nest egg through stock investing, a rising stock market is actually quite a bad thing. A twenty or thirty-something saver and investor should fear asset price inflation because it makes their wealth-building plan much harder to enact.

Interest rates hikes have traditionally had a dampening effect on asset price inflation.

Finally, there’s wage inflation. If you’re a worker earning a salary, you of course want high inflation of your wages and benefits. Measuring the change in the Employment Cost Index for civilian workers since 2010 until the latest 2018 numbers, we can calculate an average of 19.2 percent inflation in total compensation.

An employer, obviously, will experience wage inflation as a big problem, one that directly cuts into the cost of doing business and profits. A worker, by contrast, directly benefits from wage inflation.

I mention all these different types of inflation because interest rate hikes tend to dampen all three types – consumer, asset price, and wage inflation. Depending on who you are, higher interest rates will affect you in different ways, even though we typically only think of consumer inflation. Are you a worker or an employer? Are you an importer or an exporter? Are you young or old? Are you a borrower or a saver?

With observable consumer inflation so low, does it even make sense for the Federal Reserve to raise interest rates? President Donald Trump doesn’t think so. He has argued in recent weeks that the Fed is “loco,” and that “my biggest threat is the Fed,” and because “you don’t see that inflation coming back” that he disagrees with the Federal Reserve’s moves to hike interest rates.

Let’s talk about that in a later post.

Please see related post:

Federal Reserve and an Independent Central Bank

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September 13, 2018September 26, 2018

All My Thoughts On Reverse Mortgages

I’m not the right age for reverse mortgages¹ but a reader asked me for my help. Some deep-down part of me will always be a mortgage guy, so I decided to learn more about these things.²

The reader, named Jesse, aged 73, called to relay his experience trying to get a reverse mortgage on his house, and to ask for my advice.

He’d seen advertisements by Tom Selleckfor a company called American Advisors Group and it seemed to fit his financial circumstances.³

For Jesse, his idea was to use the money he could pull out of his house to help pay for taxes and insurance in the coming years.

Although I had never paid much attention to reverse mortgages, I previously had a vaguely negative feeling about them. I’ll describe those and sure, there are reasons to be cautious.

In the course of following up on Jesse’s inquiry, I also earned a bunch of unique and kind of awesome features of reverse mortgages which I had never seen in any other loan product. My overall thought is that under the right circumstances, these could be very useful mortgages.

No Payments, Ever

The first weird thing is that a borrower can decide to never make any principal and interest payments on the loan. For life! The debt accrues interest of course but the borrower can choose to never pay on that interest or principal. The lender gets paid back eventually, when the house is either sold or the owner dies, but in the meantime the loan doesn’t require any payments. Ever. I’ve never seen that on a loan structure before.

Second, as long as the homeowner complies with the mortgage agreement – which means staying current on taxes and insurance – neither the homeowner nor the homeowner’s spouse can be evicted from the house. Ever. It’s a bank loan backed by collateral, but the bank can’t take the collateral for the life of the borrowers. This is also something I’ve never seen before.

As it turned out, Jesse couldn’t move forward with the reverse mortgage, however, because his husband Ralph is only 51, and Texas requires both spouses to be over age 62.⁴

Other states have more lenient spousal rules, but Texas has its own way of doing things, as you may have heard.

I’ll describe my three previous issues with reverse mortgages, as well as my evolving views.

Complexity is the Enemy of the Good

An important worry is that as a relatively unusual loan product, consumers could be more likely to make bad choices about a thing they don’t understand very well. Even a traditional home mortgage can seem complex but it resembles other products we’re familiar with, like an automobile loan or a personal loan.

A reverse mortgage, by contrast, acts a bit like a retirement account or annuity, in that you can take money out over time as you get older. It’s also a bit like a credit card or home equity line of credit, in that it “revolves,” meaning you can take money out but also pay it back as often as you like. But it’s also different than a credit card or home equity loan, because you don’t have to pay it back with regular or even any payments (until you die). One of my guiding principles of finance is simplicity. Reverse mortgages may be a complicated form of debt for some people, and complicated is the enemy of the good.

Somewhat reducing my fear, however, is that every prospective reverse mortgage borrower must take a financial counseling course by phone, mandated by the Federal Housing Authority (FHA), which regulates reverse mortgages. Guy Stidham, owner of Mortgage of Texas and Financial LLC, a San Antonio-based mortgage broker who offers both traditional and reverse mortgages, says these courses cost about $150 and take a few weeks to schedule, which serves as a kind of “cooling off” function for prospective borrowers.⁵

Borrowing capacity

One of the more complicated topics of a reverse mortgage is how much you can borrow. Big picture, you should know two things: First, you can generally borrow much less initially with a reverse mortgage than with a traditional mortgage. Second, the amount you can borrow against your house trends upward over time, at the same rate as your mortgage’s interest rate. Let me fill in a few details on this issue.

Your initial borrowing amount is calculated according to an FHA formula by taking into account three things: The value of your house, your interest rate, and your age.

The FHA says that the younger you are, the less you can borrow against your house. This makes sense since time will eat away at your home equity, and you are not required to make payments on a reverse mortgage. The FHA also says that the higher the interest rate, the less you can borrow. This also makes sense because a higher interest rate, compounding over time with no payments, will also eat away at your home equity.

With an online calculator you can see how much of your home value you are allowed to borrow against. If you test out the calculator, you’ll see a 70 year-old charged 4.5 percent can borrow less than 50 percent against their house. The typical range of borrowing is between 40 and 65 percent of home value, substantially less than the 80 percent standard with a traditional mortgage.

Here’s a weird quirk of reverse mortgages, however, The amount you can borrow against your house increases over time, precisely in line with the interest rate you are charged. If you’re charged 5 percent interest, your available borrowing limit increases by 5 percent per year. For reverse mortgage borrowers using this as a home equity line of credit, the annually increased borrowing capacity will seem like a cool feature. For people concerned with reverse mortgages eating up your home equity, this increased borrowing capacity may seem pernicious.

I won’t rule either way, except to say that debt in all forms is always a drug, which may be used for good or evil. The increasing borrowing limit just ups your dosage of the drug over time.

Are these high cost mortgages?

My second big worry was that reverse mortgage would be high cost products for borrowers. This fear turns out to be somewhat true, although there’s some nuance to the cost issue.

The biggest cost of a reverse mortgage is mandatory mortgage insurance. Reverse mortgage borrowers are charged by the Federal Housing Authority (FHA) 2 percent of the appraised home value. For a $500,000 appraised home, the FHA would charge $10,000, which would be rolled into your loan balance at the time of origination. The FHA also charges 0.5 percent annually on the balance, as further insurance against losses. I think this is the biggest contributor to reverse mortgage costing more than traditional mortgages.

Next, what kind of interest rate should we expect on a reverse mortgage?

Most reverse mortgages charge a variable interest rate. According to Greg Groh, a reverse mortgage originator with All Reverse Mortgage, last week the starting variable interest rate was 4.32 percent which, added to the insurance cost, would mean a borrower’s cost of 4.82 percent.

What do I think of those rates? They’re slightly higher than a traditional mortgage, but also less than the rate I’m currently charged for my home equity line of credit, on which I pay 5.49 percent, and happily so. So, the floating interest rate isn’t a big knock on reverse mortgages.

Joe DeMarkey, Strategic Business Development Leader of Reverse Mortgage Funding estimated fixed rates now between 4.375 and 5.125 percent, in the same ballpark as a traditional 30-year mortgage. So, again, the cost of a reverse mortgage isn’t particularly from an above-market interest rate.

DeMarkey points out that 80 percent of reverse mortgages have floating interest rates rather than fixed rates. With floating rate loans, the initial interest rate often starts out reasonably low but there’s always a risk that future higher interest rates make that same debt more expensive later.

Broker commissions and origination fees

Stidham allows that a broker like him can be compensated more by the lender to sell a reverse mortgage in part because they are a less competitive product. His fee for brokering a reverse mortgage could be up to 3 times higher than with a traditional mortgage.

Finally, there’s the issue of origination fees. The maximum origination fee is capped at $6,000, and would actually be smaller for smaller loans.

Closing costs like attorney fees, title insurance, and bank appraisals are all basically the same as a traditional mortgage. Groh reports that a reverse mortgage bank appraisal cost might run slightly higher, but on the order of $550 for a reverse mortgage appraisal rather than $450 for a traditional mortgage. Not a big deal there. The main big cost difference, as I said earlier, is the FHA-charged insurance, which is pretty hefty.

Servicing Details

The servicing component of reverse mortgages is slightly different than for a traditional mortgage. Since borrowers must live in their house, does that force a sale if an elderly person moves out to a nursing facility? Yes, and no.

Borrowers may live outside of the home up to 12 continuous months, meaning even an extended hospital stay or stint in a nursing home does not trigger any change with the mortgage.

Each year a lender sends an “occupancy certificate” letter to the home which must be signed and returned, according to Cliff Auerswald of All Reverse Mortgage. If the borrower does not return that certificate, then the servicer may send someone over to do a drive-by inspection of the property.

If the borrower decided to leave the home for more than 12 months, then in fact the loan would become due. For that reason, any borrower who doesn’t plan to stay in their home “for life,” should probably look for another product rather than a reverse mortgage.

Hollowing out Equity

My third big problem with reverse mortgages was that they clashed with my traditional view of the incredible wealth building potential of home ownership– a way to automatically build up a store of wealth by making affordable monthly principal and interest payments on your house over a few decades. Because reverse mortgages drain that value over time, they made me want shout “Wait…But that’s…that’s not how it’s supposed to work!”

Look, my strongest advice would be to fully pay down your home mortgage over 15 to 30 years, don’t borrow against your house, and depend solely on accumulated retirement savings plus social security to support you in your old age. There’s nothing wrong with that advice except for the fact that it sounds a bit like: “My strongest advice to you is to be rich in your old age.”

And, you know, that’s not very actionable advice by the time you actually retire.

If you can’t be rich, my second strongest recommendation would be to take out a home equity line of credit, since these are revolving lines, they allow you to flexibly borrow as needed, and act like a low-interest emergency credit card. They are awesome and we used one to renovate our kitchen and paint our house. I love my HELOC. A reverse mortgage therefore is really a third-best option, but it seems to me a pretty fine choice under many scenarios.

As my wife reminded me recently, one of my other long-standing theories of personal finance is that kids shouldn’t inherit stuff. Since we don’t intend to bequeath our house to our girls, I shouldn’t be opposed to draining the house of our home equity once we hit our 70s or 80s. At that age, the goal shouldn’t be to continuously build up assets (For what? For whom?) but rather to spend money to make our lives better.

If we planned to stay in our house, my wife and I recently agreed we’d be open to a reverse mortgage in our 70s.

Please see related posts:

Homeownership – Part I

Ask an Ex-Banker: HELOCs

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You have to be age 62, minimum. ↩
This post is a combination of a couple of columns I wrote for the newspaper, combined into one long post. ↩
A reverse mortgage, sometimes called a home equity conversion mortgage (aka HECM), is targeted to 62 year olds and up. Home equity, I should clarify, is the difference between the value of a house and the amount of debt on the house. That means a $300,000 house with a $100,000 mortgage has $200,000 in home equity. A reverse mortgage is a kind of home equity loan, specifically to borrow in old age without having to make payments, if you don’t want to. ↩
As an aside, Jesse wondered if discrimination from the bank was at play because he’s gay. I told him he should hope for that, as a class-action attorney could solve all his financial needs and he wouldn’t need the mortgage any more. Alas, Texas law says your spouse can’t be younger than 62 to take a reverse mortgage, whereas in other states your spouse can be younger than 62. It’s age discrimination, not LGBT discrimination. No big discrimination win for Jesse. ↩
Disclosure: I have done consulting projects for Stidham in the past. ↩

April 26, 2015July 13, 2015

Lord of The Rates Part IV – Consumer Rates

I’ve reviewed in recent columns what I believe happens when interest rates rise this Summer, in particular what happens to real estate when the FOMC raises the Fed funds rate, Aka “The One Rate To Rule Them All.”

“…Nine for consumers doomed to die

One for the Yellen on her dark throne

In the land of FOMC where the money’s born…”

While rate hikes generally hurt, I don’t expect this rate hike to change much for consumer interest rates.

Consumers already face a very wide range of interest rates, from 2% Prime auto-loans, to mid-range consumer debt at less than 10%, to the mid-20% for credit card debt, even to stunning 100%+ annual rates for payday loans.

Just as the humans of Middle Earth experienced vastly different Rates of Power, so too do we humans of this Era already face vastly different rates.

I’ll review these different ends of the consumer-borrowing spectrum in turn.

Cheap Prime rates disappear

The very cheapest consumer loans may jump a bit this Summer.

Locking in cheap student loans, mortgages, and auto-loans in this Era left us feeling like the Dúnedain, noble and heroic borrowers.

Credit Unions that offered 1.9% auto loans probably stop doing so immediately following the jump in rates. Historically low rates spurred auto purchases, making us Riders of Rohan, racing across the plain on our fresh swift horses.

In addition, low rates like my 15-year mortgage at 2.75% probably cease being available. In retrospect, those rates will mark a low-tick of the interest rate market.

For a high credit borrower collateralized by a car or home, however, we’re probably only looking at a 1 to 2% jump after rates rise.

Uncollateralized personal loans for high credit borrowers – like you can see on a crowd-sourced lending site like Prosper.com – currently run in the 6 to 8% range. Those rates likely jump a bit as well following the Fed funds hike this Summer.

Credit cards

Moving a bit higher on the consumer interest rate scale, I doubt credit card rates move much at all.

Your basic credit card rate balance already charges substantially high rates. The national average credit card rate on balances runs around 15% right now, which is high enough to leave your finances feeling as woozy as King Théoden under the influence of Wormtongue.

And that’s just the average. The highest rate you will see quoted nationally is 29.9%, although penalties and fees can push effective rates higher than that. As long as they can limit defaults, banks don’t really need to raise credit card rates above 15% to 29% to stay profitable, when the Fed funds rate rises.

What about those seemingly attractive 0% interest balance transfer requests that come in the mail? Will those go away when rates rise? I doubt it.

0% balance transfers

Credit cards offers to consolidate balances at 0% for 6-12 months probably continue even after rates start to rise, because these aren’t really 0% loans.

In the fine print of most of these so-called 0% offers is the requirement that you pay an upfront 3% ‘consolidation fee’ for the privilege of a supposed 0% balance transfer. When you translate the 3% fee into an annual rate, you get something not at all close to the advertised “0% loan.”

How is this not really a 0% loan, but instead is a nasty trick perpetuated by a Saruman-like wizard, in the service of the Dark Lord? Let me explain.

If you transfer a high interest $10,000 credit card balance on which you had been paying, say, 18% per year, it is true you would cease having to pay $150 in monthly interest on your balance.

You would instead pay an upfront 3% fee of $300 (on the $10,000 balance in this example). Even if you paid off that loan after six months – before the 0% rate goes away – you’ve already paid an effective 6% annual rate. Credit card banks will happily take that initial 6% rate when they know they’ll most likely have you paying something like the old 18% on the balance, when the six months is over. Since you’re really paying at least 6% rather than 0%, I think banks will find it worth their while to continue those supposed 0% balance transfers.

But that’s not the worst consumer loan ever.

The Nazgûl of Lending

Payday loans – the Nazgûl of consumer lending – obviously can’t go higher from here. These loans, higher than 100% annually, prey from above on the finances of the people below. These are shrieking nails-on-chalkboard black-winged creatures.

Even Yellen in the land of FOMC cannot push these rates higher.

I just looked up a payday lender online and found I could borrow $500 for 30 days, and owe $629.92 at the end of the month. That’s a 315% annual borrowing rate.

The good news? (He said, ironically.) That rate is not going up this Summer, either.

Please Éowyn, or somebody, put a sword through the crown of these undead creatures.

Please see related posts

Lord of the Rates Part I – One Rate To Rule Them All

Lord of the Rates Part II – On The FOMC ‘Printing Money’

Lord of the Rates Part III – The Mortgage and Real Estate Market

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April 16, 2015April 27, 2015

Lord Of The Rates Part II – ‘Printing Money’

Please see related posts: Lord of the Rates Part I – One Rate To Rule Them All, and Part III and Part IV.

Interest rates in the US are going up soon (maybe September? maybe June?), so what will that do to the money supply?

As the ancient text translated from Isildur bane says:

Three rates for mortgage brokers under the sky

Seven for the bankers in their halls of stone

Nine for consumers doomed to die

One for the Yellen on her dark throne

In the land of FOMC where the money’s born

One rate to rule them all, one rate to find them,

One rate to bring them all and in the darkness bind them

In the land of FOMC where the money’s born.

Printing money

Economists don’t like to say that the Fed ‘prints money’ since the physical act of manufacturing bills and coins has very little effect on the actual money supply available in the US Economy. The US Mint, not The Federal Reserve, creates physical coins and bills.[1]

The Fed funds rate and the open market operations used to enforce the Fed funds rate, plus the market-based reactions of large banks to those interest rates, plus the invisible hand of separate self-interested actions by borrowers in an economy, is really how the Fed ‘prints money’ when it wants to increase the money supply.

In an important sense, private banks are the ones who really ‘print money,’ with the Federal Reserve’s agreement and nudge, when they make loans to businesses, governments, and consumers through our system of ‘fractional reserve banking.’

‘Fractional reserve banking’ kind of works like this: At any given time period, a bank needs to keep available in cash only, say, 10% of its total deposits, while the other 90% is available for investing or lending.

So with your $1,000 CD for 1 year that you opened, your bank actually plans to lend out $900 of that while keeping only $100 on hand as a ‘fractional reserve’ of your CD deposit.

When your bank lends $900 to the local coffee shop,[2] the $900 is really almost like ‘printed money,’ sort of, kind of, invented by the bank out of thin air. How’s that?

You deposited $1,000, and that money still exists as yours, or at least will exist for you in a year from now. The coffee shop meanwhile has use of $900 for its own purposes. When the coffee shop then deposits, for the meantime, the proceeds of its $900 loan into its own business bank, the ‘fractional reserve banking’ system keeps on going, inventing more money.

The coffee shop’s bank can take the $900 deposit, and lend out $810 of that again to another business (again retaining the $90, or 10% fractional reserve.) Continuously lending 90% of deposits is how private banks and the borrowing customers’ create money’ in an economy.

With low interest rates and lots of borrowing in an economy, the original $1,000 CD gives birth to much more money circulating in the economy, first $900, then $810, then $729, then $656, etc.

As long as lots of businesses, governments and consumers want to borrow money – and they generally want to borrow more when rates remain low – the money supply grows via this fractional reserve banking system.

The Fed funds rate
Returning to the role of the Federal Reserve in this process: To the extent the Fed funds rate remains low, a private bank can access money cheaply and make money relatively easy for its borrowers to access.

As long as borrowers have a need for capital, the money supply grows easily in response to economic activity, when Fed funds and other interest rates in the economy remain low.

By contrast, when the Fed funds and other interest rates rise – as they are about to do, soon – a reversal of the fractional reserve lending process occurs. As interest rates rise, fewer business and consumer borrowers may find it profitable or attractive to take out loans, thus slowing the growth of the money supply.

If interest rates rise enough, they effectively reverse the ‘money printing’ of a fractional reserve system. The coffee shop doesn’t want to borrow the $900 in the first place any more, and all that later money ($810 + 729 + 656, etc) remains ‘unborn’ as well.

That’s good for limiting the money supply and therefore inflation, but also risks choking economic activity if an interest rate hike is too high or too fast, relative to the economy’s natural demand for money.

Anyway, in simplest form, that’s the mechanism of how the Fed – via the Fed funds rate, the actions of banks, and subsequent actions of borrowers – determines the money supply.

Please see related posts:

LOTR Part I – One Rate To Rule Them All

LOTR Part III – Fed Funds, Mortgage and Real Estate Markets

LOTR Part IV – Fed Funds Effect On Consumer Rates

[1] For a little tangential info on the profitability – via seigniorage – of The Mint when it does create coins and bills, see this note on why I use dollar coins.

[2] Can you guess where I wrote this?

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February 3, 2014February 3, 2014

Video: Think Like A Bank

When I was a ‘debt buyer,’ acquaintances would occasionally ask ‘Oh, could you buy my debt?’

(and I would think, “uh, that’s not how it works.”)

That question told me two things:

1. Most people do not know that all banks and most investors are ‘debt buyers’ one way or another.

2. Most people don’t understand that the monthly interest they pay on credit cards, car loans, and mortgages all form someone else’s “yield” on an investment. Up until about 30 years ago that someone else would have been their bank, but in recent decades their interest yield typically goes to the investor in an asset-backed bond.

I passionately believe that understanding the math of compound interest will help you think like a bank or investor.

In either case, more people should understand – for personal finance reasons – the connection between the interest they pay and the growth of someone else’s money. Because if you reverse the order – if you yourself become the lender or investor of capital – then you get to earn the compound return available from someone else’s interest payments.

Understanding the compound interest formula – which shows the growth of money today into larger amounts of money in the future – helps provide the mathematical insight into this idea of debt interest = yield.

My short video on this subject: