Ask An Ex-Banker: Debt, Inflation, Federal Reserve

Q.  Michael, I am trying to understand something here. The government spent a ton of money that it didn’t have stimulating the economy post Covid. This caused inflation to increase. So the Fed boosts its rate to cool inflation. When the Fed boosts its rate, banks have to pay to borrow money from the government. Does that higher rate go back to the government? It’s sort of like a tax on those who don’t have money to pay for houses and cars. So the poorer portion of our society is being taxed to pay for government spending. Those who have funds to pay cash aren’t really affected by the higher rates. Is this logic correct? Thanks, I always read your column.

Alexander McLeod, San Antonio TX

A. My short answer to your final question of “is this logic correct?” is mostly “no.”

But I like your question because it combines the top three drivers of economic news in the past two years – federal debt, inflation, and the Federal Reserve – and asks for logical cause and effect linkages between them, and real-world implications. Understanding how they interact is important. I’ll do my best to break them down, using your question as prompts.

Federal_debt_2024
Federal Debt Reaches $34.5 Trillion in April 2024

Yes, the government did spend money it didn’t have. That is an ordinary thing for the US and most other governments in the world over the past century. Or basically forever. The magnitude of US borrowing has gotten substantially larger in the past decade. We do not have an actual answer yet for “how much is too much debt?” but the activity itself is highly precedented. Am I worried? Yes. But we don’t have certainty on whether we’ve hit limits or what the limits are.

“This caused inflation to increase” is not the right cause-and-effect. More accurately, the combination of low interest rates, extra fiscal (COVID) stimulus, and an energy shock from the Russian invasion of Ukraine probably caused inflation to spike dramatically in the summer of 2022. The rate of inflation has since dropped to a normal range, even if prices (outside of energy) have not declined. Prices rarely outright decline. 

The Fed did boost rates beginning in 2022 to cool inflation, as a 2 percent inflation rate is one of its key goals and mandates. Inflation is around 3.5 percent as of this writing, and the Fed as a result has indicated recently that it may not lower rates until further progress is made on inflation.

Fed_Fund_Rate_2021_to_2024
Fed Fund Effective Rate 2001 to February 2024

Higher benchmark interest rates are set by the Federal Reserve, technically both the country’s central bank and also technically a non-governmental entity. The interest paid and the interest earned by the Federal Reserve requires an extra step of explanation for accuracy. 

As the central bank for the US, the Federal Reserve actually pays interest to banks for their excess reserves. The Federal Reserve also uses funds to go out in the marketplace to buy US government bonds, and earns interest on the rate that the US government pays on its bonds.

“Who is making extra money off of higher interest rates?” is part of your question, and viewed a certain way, the Federal Reserve actually books extra interest income based on the difference between what it pays banks for deposits and what it earns on securities with its balance sheet. 

Private banks, which raise interest rates on consumers and businesses when the Federal Reserve raises interest rates on them, may earn higher interest income in this environment than they did before. But private banks are not the government. 

The federal government, by contrast, earns no big amounts of money from higher interest rates. 

Not at all. Basically, just the opposite. The US government, as a massive borrower, pays more in terms of higher interest rates.

The Federal Reserve may earn money as a net lender if it chooses to own more bonds, especially following times of monetary stress like 2008 and 2020. Private banks may earn more as lenders in a higher interest rate environment. The federal government, however, pays a lot more. 

To your question of whether higher rates are like a tax on people who do not have money to own cars or houses by paying cash for them, I would say “sort of,” but that it’s not very specific to our current higher interest rates environment. What I mean by that is that in every interest rate environment, low or high, individuals who borrow month to month on their credit card are paying in the 12 to 25 percent interest range. That’s the real and substantial tax on people who borrow, but it happens all the time, not just now. And the “tax” goes to banks and credit card lenders, not the government.

Wealthier folks, or people with substantial savings in the bank, are in a position – right now – to earn more on their savings than they have over the previous 2 decades, roughly 2001 to 2022. That’s again neither a tax nor a government bonus, but a private sector cost or benefit of participating in the banking system and earning interest on one’s savings. 

Your statement “the poorer section of our society is being taxed to pay for government spending” is an inaccurate understanding. To vastly simplify things, I would generalize the situation the following way instead:

Folks with no savings (generally poorer, but this can include middle- and upper-income people as well) are generally paying high interest rates to credit card lenders in every interest rate environment. At all time.

Folks with middle and upper incomes who borrow to own a car or home are paying higher interest rates, right now, to private lenders on their car and home loans. But again that extra income is captured largely by private lenders, not the government. 

Wealthier folks and institutions with surplus funds are earning higher interest rates on their savings and interest-bearing investments. If they lend to the US government by buying government bonds, they are earning a lot more now than they did two years ago.

The federal government is a pauper in this scenario, and is paying out higher interest rates. Not exactly like on a credit card, because the rates are roughly 4.5 to 5.5 percent. But that’s much worse than the 1.5 to 2.5 percent it was able to pay a few years ago. The Federal Reserve pays higher rates of interest for private bank deposits, but also earns higher rates on the bonds it buys. Although it has higher earnings in recent years, that has more to do with its larger post-crisis balance sheet than anything else. 

Federal_Reserve_Balance_Sheet_April_2024
Federal Reserve balance sheet 2008 to April 2024

As for “those who pay cash aren’t really affected by higher rates,” I’d say that’s somewhat true. But more than that: those who have cash are benefitted by higher rates, since they can earn more money on their savings. 

A version of this ran in the San Antonio Express News and Houston Chronicle.

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Ask an Ex-Banker: How To Fight Upcoming Inflation?

homebuyer

A reader wrote me recently:

“Given the staggering debt of the United States and Congress’ seemingly laissez-faire attitude and impotence towards addressing it, I am starting to be concerned about the value of U.S. currency. Historically, wars and corrupt governments have led to hyperinflation in other countries where the costs of goods and services skyrocket. The likelihood of this happening in the U.S. may seem remote but it is not impossible. Are there ways for individuals to protect themselves from this?” — Dom D. From San Antonio

I really like this question. Dom recognizes our unprecedented current debt situation and the unfortunate parallels with other countries where hyperinflation followed. I have no idea what’s going to happen.

If it’s comforting, hyperinflation would require a failure by the Federal Reserve to do its job. The Fed withstood the last few years better than most institutions. But, yeah, increased inflation seems increasingly likely for the reasons Dom named. So what to do?

federal_reserve_seal
The Fed has to fail for hyperinflation to happen

Something to remember about inflation is that if the underlying economy is unchanged but the amount of available currency doubles, it is reasonable to assume that the price of things approximately doubles. This is bad when we have to pay for things. It is not necessarily bad if the price doubles of things that we already own. Things that you could own, which should double in price if the supply of money doubles, include real estate and stocks. As a result, these make for very good inflation hedges.

So the first great way to hedge against inflation is to own a business, or preferably many businesses. Some insist on the hard way to do this.1 I would like to focus everyone’s attention on the lazy way – my preferred way – which is to own hundreds or even thousands of businesses through a single low-cost diversified stock mutual fund. In an inflationary environment, successful businesses raise prices in response to their higher costs. Successful businesses adjust dynamically to earn profits despite inflation. 

Similarly it is reasonable to expect – all else being equal – that a stock worth $100 today will be worth $200 tomorrow, if the amount of currency doubles overnight. One explanation for the record rise of the stock market in the last few months – the one I find most plausible – is that the Fed has dramatically increased the supply of currency in the economy. The record stock market rise is probably a specific form of inflation hitting one very visible corner of the overall economy.

The second great hedge against inflation is to own real estate in advance of inflation. For starters, try to own your home. And then live in it for a long time. The price of your home should appreciate roughly at the rate of inflation. That’s the definition of a good hedge. Let’s say, for example, you own a home today worth $250,000. And then we suffer a patch of 10% annual inflation for ten years. Your house at the end of 10 years will be worth a little over 648 thousand dollars. Compound interest math uses the same formula as inflation math.

homebuyer
Homeownership is good

Now, here’s an even more interesting twist on inflation hedging via home ownership. The triple lindy inflation hedge, if you will. Are you ready for it? 

Do you have a long-term fixed-rate (let’s say, 30-year) mortgage on your house?

Ta da! You did it. You are amazing. Have you ever thought about being a hedge fund manager? 

Here’s why this is an amazing inflation-hedging tool. Using the previous example, as your home value leaps upward over 10 years of 10% annual inflation from $250K to $648K, your 30-year fixed rate mortgage decreases dramatically, both in nominal and real terms. Using a standard 30 year amortization schedule, your mortgage would pay down from $200K to $162K during the first ten years. At the end of ten years, a $162K amount of debt on a house worth $648K is actually pretty easy to handle. You moved from owning $50K in home equity to $486K in home equity, nearly a ten-times increase. 

Also, just as money isn’t worth as much following inflation, debts are also not worth as much in an inflationary future, so $162K in debt is not as big a deal in that future as it would be today. In other words, being a borrower during an inflationary period is actually a powerful inflation hedge. (Provided, of course, your debt has a fixed rather than variable interest rate.)

By owning your home with a mortgage, you’re a fancy inflation hedger, and you didn’t even know it.

Next, what should you specifically not do if you anticipate future bouts of inflation?

Do not buy fixed income products for any investment purposes. Traditional fixed income investment products include bonds, bond funds, annuities, and CDs. Inflation absolutely wrecks the value of these fixed income investments. Even money market funds, savings accounts, and cash could be considered fixed income, just with an extremely short (same day) maturity date. If your net worth or income is in any of these fixed income products, inflation will unfortunately destroy your wealth.

gold_as_an_inflation_hedge
Not an inflation hedge I endorse!

Next, do not buy gold as an inflation hedge. Gold is a pretty but useless metal sold by preying on the fears of unsophisticated financial minds. I understand you don’t believe me, because of all those plausible sales pitches on your video screens, but it’s true.

Also, do not buy bitcoin as an inflation hedge. Bitcoin is a fake currency, neither useful for buying beer nor paying taxes. It has no legal use case and produces no wealth, except for people hyping you to buy it, based on the greater fool theory of speculation.

In sum, own your own home, own some businesses either directly or through the stock market, and if you must borrow, then borrow at a fixed interest rate. Avoid the standard inflation-hedge scams.

Bitcoin
Avoid Bitcoin

What I really like about the previous two sentences is that in anticipation of heavy inflation – and I can not emphasize this strongly enough – you should pursue the exact same investment actions I would advise to anyone who is not anticipating a future bout of heavy inflation. 

Did you catch that? It’s important. Do exactly the same prudent things you should always do.

Finally, is Dom’s scenario likely to come to pass? I don’t know. Neither does anyone. Pundits who predict the economic future with certainty are fools or confidence men to be deeply distrusted. 

I have personally (but silently) expected significant inflation since aggressive interest rate drops in September 2001. I’ve been wrong every time. 

Although, maybe not. Come to think of it, my home value and my stock index funds have suffered quite a bit of inflation over the past twenty years. Haven’t yours?

A version of this ran in the San Antonio Express News.

Please see related posts:

Homeownership is great, including as an inflation hedge

Bitcoin and Bullocks

Never Buy Gold

ETFs and Mutual Funds

Trump_federal_reserve
This guy…would have happily caused hyper inflation if he thought it served his short-term political or narcissistic interests

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  1. Being an entrepreneur is the hard way. I’ve tried it. It’s…hard.

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 30-31stmeeting 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: 

  1. 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.
  2. 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.
  3. 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.
  4. 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 30-31stFederal 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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Federal Reserve Independence

Fed_Reserve_Bank

When it comes to Federal Reserve policy, we need to focus our worries about the correct thing. Hint: It’s not inflation. Also, it’s not recession. Also, It’s not the rate of interest rate hikes.

Trump_federal_reserveIt’s the Fed’s independence. Even President Trump agrees with me. Although admittedly, for reasons diametrically opposed to my reasons.

In recent weeks, President Trump has ramped up his attacks on the Federal Reserve. Trump told Fox News that “my biggest threat is the Fed.” Also, that the Fed is “loco,” and he’s unhappy “because the Fed is raising rates too fast, and it’s too independent.”

After three interest rate hikes earlier in 2018, the Federal Reserve will raise short-term interest rates one more time this year. The Fed will likely rise another 1 percent over the next two years, according to their future guidance, and barring unexpected developments like war or recession.

The fact that Trump is unhappy is not particularly surprising. In fact, White House grumbling about the Federal Reserve is a common enough theme over the last eighty years. Not using Trump’s uniquely colorful language, mind you, but it’s still not wholly new.

History of Presidential Jawboning

Political leaders in power always want pro-growth policies. Low unemployment and high asset prices tend to make leaders look good. Presidents generally don’t want the Federal Reserve to – in Fed Chairman’s William McChesney Martin’s famous phrase “take away the punch bowl just as the party is getting started.” President Nixon reportedly blamed his 1960 loss to Kennedy as a result of Fed Chairman Martin’s tight monetary policy of high interest rates.

President Johnson complained as well, saying “Martin, my boys are dying in Vietnam, and you won’t print the money I need.”

President Nixon reportedly both put pressure on Martin’s successor at the Federal Reserve Arthur Burns to keep interest rates low and money flowing during his 1972 re-election, which he handily won. Paul Volcker, Fed Chairman during the 1980s, published a book in late October 2018 in which he claims President Reagan’s Chief of Staff James Baker told him in 1984: “The president is ordering you not to raise interest rates before the election.”  Volcker adds to the story that the Federal Reserve at the time had no plan to raise interest rates.

federal_reserveGeorge HW Bush was upset in the fall of 1992 that the Fed was raising interest rates, before he went on to lose his re-election to Bill Clinton.

President Clinton’s budget chief Leon Panetta and later Chief of Staff twice tried to preempt the Federal Reserve, saying at his 1993 confirmation hearing “we ought to have cooperation from the Federal Reserve,” meaning lower interest rates, and then in a 1995 interview “it would be nice to get whatever kind of cooperation we can get to get this economy going,” referring again to Federal Reserve policy. Despite the instincts of leaders in power, Federal Reserve observers think we have made a lot of progress since the bullying of President’s Johnson and Nixon.

Presidents George W. Bush and Barack Obama avoided appearing to try to influence interest rate policy. Inevitably, political leaders oppose higher interest rates because they reduce business borrowing, risk increasing unemployment, and knock down asset prices of real estate and stock markets. Political leaders want lower interest rates – it’s stimulative to the economy, and therefore helpful for their political prospects.

Volcker’s legacy

Since Paul Volcker famously raised interest rates early enough in the Reagan presidency to tame inflation in the early 1980s, the Fed has built a rock-solid reputation as independent from political influence. It is believed to manage the money supply without favor or political influence, giving investors worldwide confidence in the dollar.

OldSchoolCool: Paul Volcker

The key question then is whether Trump’s attacks on the Federal Reserve will have an effect. We need to hope they do not. Just as the greatest risk to Trump’s presidency is not the independence of the Fed, neither is the greatest risk to the US economy inflation or the rise in unemployment, the two typical concerns of the Federal Reserve.

Rather, the greatest risk to the US economy is that people the world over would come to believe that the US Federal Reserve is not acting independently of political pressure. A primary reason the dollar still remains the global reserve currency of choice is that global allocators of capital believe the Federal Reserve is not captive to the US political system.

In a clever take that emphasizes a silver lining in the storm clouds, the Wall Street Journal’s Spencer Jakab recently argued that Trump’s recent Fed bashing is actually a good thing, since it proves that the Fed is willing to do an unpopular thing for the right reasons. Since it continues to defy Trump’s wishes, we should be happy that the Federal Reserve is under attack. I mean, I guess? Like a Category Five hurricane slamming against the retaining wall protecting the coastal city is a good thing, because it didn’t break the wall this time, and that shows us how strong the retaining wall is right now. So, yay, hurricanes? I’m sorry, that logic is bass-ackwards.

The real risk

We can survive a recession. We would have a harder time surviving the loss of confidence that would follow if Trump could jawbone the Fed into keeping rates low, for political purposes.

We can survive a little inflation. A little inflation does not make us much closer to Venezuela. Rather, a political leader who can get what he or she wants with monetary policy does make us a lot more like Venezuela.

 

Please see related posts:

The Federal Reserve and Inflation

 

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Federal Reserve and Inflation

federal_reserve

Federal_reserveThe 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.

prices_increaseFirst, 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.

federal_reserve_sealIn 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?

Trump_federal_reserveWith 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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New and Old Ideas For Fixing Banking

Kirsten_Gillibrand_postal_banking

 

Kirsten_Gillibrand_postal_bankingTraditional bankers won’t like this blog post. But you know what? Many people don’t like their own banks, and many people aren’t being served well by our banking system. I’m intrigued by recent proposals to fix a gap in the deposit-taking function of banking, specifically a US Postal Bank on the one hand, and an even more disruptive idea of a Federal Reserve bank account – known as a FedAccount – available to individuals and businesses.

Postal Banking

Senator Kirsten Gillibrand (D-NY) introduced a bill in April to revive US Postal Service banking, something that we used to have. It began in 1910 under President William Howard Taft until it was ended by Lyndon Johnson in 1966, according to banking scholar and University of George law professor Mehrsa Baradaran, in her Ted Talk on postal banking.

How_the_other_half_banksIn the Gillibrand proposal, the Post Office would offer free deposit accounts for amounts up to $20,000. For-profit banks tend to ignore small depositors as unprofitable, or they charge high checking account fees to make up for that unprofitability.

The Post Office already has branches everywhere, including in “banking deserts” that have been abandoned by community banks as unprofitable, and where check cashers and payday lenders have moved in. While the Post Office by charter must be financially self-sustaining, it has a history of subsidizing services for the public, as it does for example when it unprofitably delivers mail to remote rural areas.

In Gillibrand’s proposal, personal loans of $500 could also be offered. Her proposal came with an unreasonably low rate for this type of personal loan. But even at rates as high as 20 to 25 percent, it wouldn’t be hard to offer an interest rate that reflected the risk of these loans, while still undercutting payday lenders.

The people who would be most helped by postal banking are the estimated 10 million US households who are “unbanked.” Among the very poor, up to 10 percent of disposable income gets used for basic financial services, such as check-cashing and payday loans.

The FedAccount

But how about an even more intriguing and radical solution proposed last month, that would help not only the poor, but the wealthy and everyone in between from small businesses to you and me?

The proposal by three economists and former US Treasury officials is to offer a FedAccount – free checking accounts of any size at the Federal Reserve to individuals and business. The Federal Reserve currently only has deposit accounts for financial institutions.

Capital_One_KittyIn a fiat money system like ours, as you hopefully already know, money is a kind of collective fiction we all weirdly agree to. The beautiful thing about the Federal Reserve is that they are the dream weavers of this fiction. They invent money. An electronic ledger in a FedAccount with your money will always be there basically because the Federal Reserve says it’s there, and they perform magic.

When you can invent money there’s no problem whatsoever guaranteeing unlimited amounts of money both to the under-banked poor and the extremely wealthy. A $100 deposit by a poor person will always be there. A 100 million deposit by a wealthy person will always be there. 100 percent guaranteed.

The FedAccount could also handle merchant processing for free between FedAccounts, something that businesses currently pay extraordinary amounts of money to credit card and debit card companies to do. Small businesses in particular, with little negotiating power against credit card companies, could reap huge savings on processing fees. Eliminating those fees would ultimately lower costs for consumers. Also, a business using its FedAccount should be able to receive payment on the same day, which could be a life-saver to cash-strapped businesses.

Is a FedAccount a threat to traditional banking as currently provided by a combination of megabanks and smaller private community banks? I don’t think so. If the Fed Account stayed out of the lending business it should not threaten legacy banks.

FedAccountWhat about costs to create the program? The Federal Reserve already keeps deposit accounts for all banks, so adding that capability for individuals and businesses would be simply a matter of straight-forward software programming.

How could this all be free? The Federal Reserve earns profits on financial assets it owns, and sent $98 billion, $92 billion and $80 billion in excess profits to the US Treasury in 2015, 2016, and 2017.

Would it need an army of customer-service employees? Doubtful.

With an easy phone app I know it could attract most of my deposits. I don’t need to talk to banking employees about my account. When was the last time you had an important and helpful conversation with a bank employee regarding your checking account? I’m guessing for most of us, approximately, never?

I can anticipate a libertarian aversion to these expanded government-as-banker roles. Would government banking be competent? Would it protect privacy? As the proposers of FedAccount argue, the Treasury processes billions of payments per year, and disburses millions of Social Security checks per month, basically without a problem.

The Federal Reserve handles $3 trillion worth of Fedwire payments per day. They’re good at this stuff. Unlike the private banking sector, which has to be regulated and subsidized to keep it from periodically failing, the Federal Reserve doesn’t need a subsidy and implied public bailout. Remember, it can create money virtually whenever it needs to. It’s magic.

On the issue of privacy and government intrusion, the FedAccount would be an option, not a requirement. People who fear government intrusion could continue to only patronize private banks.

Look, I wouldn’t bet a single dollar of mine that the low-cost, needed, solution of FedAccounts will happen in our lifetime. We’re talking about something that would make every for-profit banker in the country nervous. And nervous bankers make for a powerful lobby. But I’d be up for it.

The US Postal Bank as proposed by Gillibrand is more modest in scope and has a successful historical precedent. That one’s not impossible in the medium term, and it’s also worth trying.

A version of this post ran in the San Antonio Express News and Houston Chronicle.

 

Please see related posts:

Book Review: The Color of Money by Mehrsa Baradaran

Interview with author Mehrsa Baradaran

Why You Hate Your Bank

Another Reason You Hate Your Bank

 

 

 

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