When considering the influence of interest rates on the value of
equities, it is important to consider what the interest rate is
actually measuring. The interest rates you are referring to are most
likely nominal interest rates, which are the dollar return per dollar
of investment. However, the more relevant measure is the level of
inflation in the economy. By essentially having a monopoly on the
issuance of risk-free securities, the federal government only needs to
provide a return to investors to compensate them for inflation because
investors are guaranteed to receive their investment back. When
inflation is very low, interest rates are correspondingly low. As
inflation rises, however, interest rates must rise to bring it under
control, resulting in a decline in economic activity in interest
rate-sensitive sectors and, ultimately, the economy as a whole.
Furthermore, such rises in interest rates place for the pressure upon
the budget when a deficit exists because interest payments increase.
An examination of the difference between the nominal interest rate and
the real interest rate, which is the nominal interest rate minus the
inflation rate, shows that most of the upward movement in interest
rates prior to the beginning of the bull market in 1982 was a response
to increasing inflation. However, it was not until a sufficiently
high real interest rate was brought into effect in 1980 to get
inflation under control that the conditions were established for a
rise in stock market values.
Furthermore, a considerable amount of fiscal stimulus in the form of
tax rate reduction and government spending was also brought to bear
during the 1980s to rouse the economy from the stagflation that took
place during the 1970s. Significant reduction in government
regulation also occurred, freeing many industries from price controls.
However, as government debt increased from the fiscal stimulus
applied during the deep recession of 1982 and increased defense
spending during the decade, a dramatic increase in the budget deficit
occurred. It was not until the late 1990s that annual budget
deficits, excluding the future Social Security and Medicare overhang,
were restored to balance. And, a declining economy, fiscal stimulus
in the form of tax cuts, and new requirements for defense spending
have quickly returned the budget to large deficits.
The objectives for the Federal Reserve and the government as a whole
are stable prices, low unemployment, and rapid growth in real Gross
Domestic Product. Unfortunately, these goals are very difficult to
balance. Low unemployment can be easily achieved through public
employment, but the high taxes and/or deficits required will not
deliver rapid growth and/or stable prices. Rapid growth frequently
leads to low unemployment, such as was the case in the late 1990s, but
rapid growth often leads to inflation as employers are forced to raise
wages to compete for employees.
Concerns about excessively rapid growth leading to inflation and
unstable prices in the form of overvalued equities led the Federal
Reserve to raise interest rates to cool the economy. In addition, one
has to wonder about the effects of the widespread fraud and unethical
business practices that occurred during the period. Many supposedly
successful companies were built on fraud, such as Enron and WorldCom.
Other companies seeking to match their success by emulating their
purported successful business tactics were clearly misled. In
addition, much capital was wasted on profitless Internet-related
ventures and overly aggressive assumptions regarding economic growth.
Many years will pass before all of the fiber-optic cable that was laid
will be used. Even now, as much as 25% of the cable in the ground may
remain unlit. Concern over who had actually won the presidential
election and the effects of the war on terrorism that followed also
imparted substantial pressure on the economy. The resulting decline
in employment, economic activity, and equity values rapidly placed the
Federal Reserve in the position of having to lower interest rates to
try to stabilize the economy. Avoiding a deflation scenario like the
one that has plagued Japan for more than a decade was now the concern,
not rising prices
Following classic Keynesian economics, the Bush administration enacted
tax cuts and engaged in fiscal stimulus through defense spending. The
rate of inflation remained quite low during the initial phases of low
interest rates and large fiscal stimulus. Globalization and the
resulting competition for American industry kept goods prices low, and
the threat of outsourcing of many services-related jobs, combined with
high unemployment, also serve to keep inflation in most services in
check. However, circumstances have began to change as economic
development in Asian countries, particularly China, has continued,
which has begun to exert inflationary pressure on many commodities.
Concerns about the stability of world oil supplies has caused a large
rise in petroleum prices. The growing deficits in both the federal
budget and the foreign trade accounts have also pressured the dollar.
Ironically, although a decline in the dollar should improve the
foreign trade deficit, globalization has increasingly rendered this
unlikely. Although Americans are forced to pay more for imported
goods which should benefit domestic production, many goods are no
longer made in the United States or are not available in sufficient
quantities. Oil, for example, must be imported to a large degree.
Many industries, such as consumer electronics, no longer exist in the
United States and, unless the decline in the dollar is dramatic and
expected to persist for a long period of time, it is extremely
unlikely that these industries would return. Americans also have
relatively little to export other than relatively low value
commodities, so the increasing competitiveness of American
manufacturers is not that material. As a result, instead of driving
inflation down, imported goods will cause inflation to increase when
the dollar declines in value.
In response to these signs of potential inflation, and the end of the
risk of deflation, the Federal Reserve finds itself needing to raise
rates simply to return to a more neutral position rather than a
stimulative one. Because nominal interest rates are well below the
rate of inflation, the real interest rate is negative. The question
for fiscal policy is whether or not the Federal Reserve will be able
to control inflation without having to substantially raise nominal and
real interest rates to a restrictive state. There are several
potential issues associated with long-term structural deficits that
could harm the economy. One economic theory believes that government
spending and deficits are relatively inefficient and crowd out private
business activities, thereby decreasing overall economic output. To
the extent that the large government deficit is resulting in the
decline in value of dollar, reduction of the deficit is needed to
stabilize its value. However, the very low interest rates currently
prevailing are also at least partially responsible for the value of
the dollar, so increases in the interest rates will help. However,
they may not be sufficient by themselves or may have to be higher than
would otherwise be necessary.
It appears likely that the high trade and budget deficits will exert
pressure on inflation and therefore cause interest rates to rise. If
the economy is in fact recovering, the government's tax revenues will
automatically increase because of the progressive nature of our
taxation system. As people make more money, they pay higher rates.
However, it would clearly be helpful for the government to decrease
spending and/or increase taxes (with decreased spending being
preferred) to restore budgetary balance when the economy is performing
well so that there is room for fiscal policy to stimulate the economy
when it is doing poorly. The Japanese provide an excellent example of
the dangers of budgetary deficits. When faced with an economic
downturn, the government engaged in massive fiscal stimulus and
lowered interest rates to essentially zero without reforming the
sources of the trouble, leaving the country burdened with high debt
and an economy that continues to perform poorly. Continuing to
stimulate the economy when it is performing adequately risks placing
the United States in the same position when an inevitable downturn
occurs. The Federal Reserve is already responding by raising interest
rates. Dick Cheney is widely quoted as stating that he believes that
deficits do not matter. This attitude seems likely to prevent the
Bush administration from making any significant effort to address the
budget deficit at this time. In fact, the planned to partially
privatize Social Security would greatly increase the budget deficit in
the short term. (As an aside, I do believe that addressing the
problems with Social Security and Medicare needs to occur, but it
would be nice if President Bush could figure out a way to do it
without boosting the deficit tremendously).
While real equity securities values are enhanced by low interest
rates, this only occurs when the low interest rates are accompanied by
low inflation. While high inflation makes it easier for companies to
increase prices and generate more revenue, they may not be able to
keep up with their increasing costs. Even if they can, there is still
no net increase in output. Employment may be high, but increasing
prices may still make workers as a whole worse off if their wages do
not keep pace. The ideal situation is sometimes referred to as a
Goldilocks economy: not too hot and not too cold. Maintaining this
balance is extremely difficult. Large federal budget deficits will
not make this balance any easier.
There is an economic theory that suggests that no budget deficit would
be bad for the economy as well. Businesses and individuals benefit
from having risk-free securities made available to them with a wide
range of maturities. Furthermore, it is widely accepted that deficits
are appropriate during cyclical downturns and national emergencies.
However, when these budget deficits continue to persist and even grow
during periods of strong economic performance, they become
increasingly problematic. Certainly if the Federal Reserve has to
manage inflationary pressures by itself while the federal government
takes contradictory action, the economy may well be in for a rough
time. Economic theory suggests that appropriate government policy
would be to address the budget deficit while the economy is doing well
by reducing the public debt, preferably through decrease spending, but
also through increased taxation if necessary. Getting Social Security
and Medicare expenditures under control would also effectively reduce
the public debt and the corresponding uncertainty about their
long-term impact on the economy.
Sincerely,
Wonko
Useful material on the subject can be found in "Economics," 14th
Edition by Samuelson & Nordhaus, McGraw-Hill Inc. (1992), especially
chapters 28, 29, and 34. |
Clarification of Answer by
wonko-ga
on
18 Jan 2005 13:43 PST
Oil is a large portion of our trade deficit and is priced in dollars.
Therefore, the declining value of the dollar results in oil-producing
countries wanting to charge significantly more for it because the
value of the dollars they receive is less. The same is true for other
imported goods from countries with whom the dollar has lost purchasing
power. Because the Chinese have pegged their currency to the dollar,
they are temporarily an exception, but an eventual rise in the
valuation of the yuan seems inevitable, which will make Chinese goods
more expensive.
Because trade deficit itself is partially responsible for the decline
in the value of the dollar, importation of cheap goods from China,
although certainly deflationary in affected industries, may create
inflationary pressures in other areas of the economy. Chinese demand
for commodities is certainly creating inflation in certain sectors.
"The Coming Battle Between Profits and Prices" by James C. Cooper &
Kathleen Madigan, BusinessWeek (December 6, 2004) page 33 describes
that inflation in October, 2004 occurred from raw materials, even
beyond energy, but that "... a shift was clear for imported consumer
goods as well. Prices there fell 1.3% in the year ended in February,
2002. By last month they were rising 0.5%." The authors go on to
state that the pickup in inflation essentially ensures that the
Federal Reserve will continue to raise interest rates in 2005.
However, as you point out, "... the dollar has actually risen against
the currencies of countries to make up 40% of the US's trade volume --
mainly Asian and Latin American nations," so the increase in inflation
is likely to be measured provided that the Federal Reserve acts.
In "Why the US Deficit Is Stubbornly Huge" BusinessWeek (January 24,
2005) page 30, it is noted that although "... non-oil import prices
have increased 3.4% over the past year, they have not risen at all for
goods coming from Asia's newly industrializing economies." This is
primarily because of China's currency peg, but also because "... the
dollar is still up 2.5% against a basket of currencies from countries
that make up 40% of US trade volumes."
While the textbook I specifically referenced was consulted during the
preparation my answer, I also relied upon my memory of articles I have
read in BusinessWeek during the past year. Of particular interest to
you will be articles appearing in the December 6, 2004 issue,
specifically "The China Price" by Pete Engardio and Dexter Roberts
(pages 102-112), "How to Level the Playing Field" by Paul Magnussen
(page 114), and "Shaking Up Trade Theory" by Aaron Bernstein (pages
116-120). These articles, along with the ones I referenced earlier,
are available at www.BusinessWeek.com, but may require a subscription
for you to view them.
Sincerely,
Wonko
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