It’s treated as a platitude that interest rates are at “historically low levels,” that the Federal Reserve has just begun tightening US monetary policy, that it anticipates raising rates only slowly in the coming years. But treating these facts as background noise, instead of a concrete fact of everyday life with important implications, is a real misunderstanding of the current situation.
Why does the Fed manipulate interest rates?
The Federal Reserve has a number of policy levers it uses to meet its “dual mandate” of price stability and full employment: the rate it charges banks to borrow directly, the reserve requirement (this used to be a much more important policy lever), and in the current environment the quantity and duration of bonds that it buys and holds.
But all of these policy levers have a single goal: the management of the supply of money. The Fed also houses a lot of other regulatory functions, but the management of the money supply is the key way it tries to affect the economy’s output.
If money is plentiful, the logic goes, like any other commodity it will become cheap, and more kinds of economic activity will be worth doing if money is cheaper, causing economic output to accelerate. If money is scarce, fewer kinds of economic activity will be profitable and economic output will decelerate or even reverse.
The Fed wants your assets to be overvalued and low-yield
The persistently low interest rates of the last 8 years or so have often been said to have perverse effects on a number of industries. Insurance companies that are required to hold super-safe assets to pay for future liabilities have become less profitable, for example. But many of the effects of low interest rates are not perverse at all: they’re working exactly as designed.
Consider what happens when the interest rate on deposits drops from 5% APY to 0.01%. People who were previously able to earn a 5% risk-free return are suddenly forced to decide whether they’ll accept a lower return at the same risk, the same return at a higher risk, or whether it is worth saving at all. All three outcomes serve the Fed’s purposes: those who leave their money in super-safe securities provide lower-cost financing to people who want to borrow it; those who “chase yield” by investing in riskier securities paying the previously safe return decrease the cost of borrowing for riskier and speculative investments, making them worth pursuing where they may not have been before, and those who decide it’s not worth saving at all boost economic output by spending more of their income.
Meanwhile, for those invested in the securities markets, there’s a surge in asset values. Safe bonds that have to pay nothing in yield trade close to their face value. Publicly traded companies are able to borrow huge sums at low costs to buy back their shares. The allure of high stock valuations causes firms to publicly list their shares to raise money and pay off early investors.
Investors are stubborn and boring
I have recited the above facts because they illustrate just how weak the Federal Reserve’s control over the real economy really is. The Fed wants you to invest your savings in riskier assets, or even better, borrow money to buy a house, a car, a yacht. But a perfectly rational, arguably much more rational, reaction to a lower return on your savings is to save even more. If you think you’re going to earn half as much on your savings, you need to save twice as much to retire with dignity (or a speedboat, or whatever else you want to retire with). This is part of the process the financial press calls “deleveraging,” but is really just a natural response to low returns on savings and high debt costs: aggressively saving and paying down debt.
The Fed wants you to sell everything and start a business
That’s all well and good, but it ignores the key fact: the Federal Reserve has orchestrated these high asset values for one and only one reason. The Federal Reserve wants you to sell all your highly-appreciated assets and start a business.
Jack Bogle has a concise formula for the returns you should expect on your equity investments: the starting dividend yield, plus earnings growth, plus (or minus) the speculative return. Over a long enough investing horizon you can pick your own speculative return (sell when the price/earning ratio is high), so your expected return should depend on the first two factors. A dollar added to your equity investments today should be expected to earn 4-6%.
The Federal Reserve wants you to look at your assets and think, “is there anything I could be doing that would generate a higher return than 4-6%?” If so, they want you to sell all your highly-appreciated assets, take the money, and go do it.
Congress is fighting the Fed
It’s impossible to read anything about personal finance without arriving at the conclusion that “personal finance” is just a barely-concealed code word for minimizing your taxes. I make no secret of the fact that I detest this genre. Anyone who’s afraid of paying taxes is afraid of making money.
Nonetheless, there are concrete ways that, through the tax code, Congress works directly at cross-purposes to the Federal Reserve in order to encourage you to hang onto your highly appreciated assets instead of selling them, and continue working at wage labor instead of starting and building your own business.
- By taxing appreciated assets that are held for less than a year at a higher rate than appreciated assets that are held more than a year, Congress encourages you to wait to sell your appreciated assets, instead of selling them right away to start a business, as the Fed would prefer;
- By encouraging assets to be deposited in so-called “retirement” accounts, like 401(k) and IRA accounts, Congress chooses to penalize people who sell highly-appreciated assets in order to start a business;
- By excluding income on capital from FICA (Social Security and Medicare) taxes Congress encourages holding securities instead of starting your own business, which would be subject to self-employment taxes.
You can fight back (with the Fed on your side)
Those are serious obstacles, and Congress should do away with them if they want to create an economy of entrepreneurs and entrepreneurship (this will be a recurring theme on this blog). But they have given you a few tools to fight back if you are ready to take the Fed up on their offer.
- Roth IRA contributions (not any earnings or appreciation of those contributions) are penalty-free and tax-free to withdraw. That means a $10,000 contribution that has since doubled in value to $20,000 gives you $10,000 in capital to start your business, with $10,000 in earnings that can only be withdrawn under penalty.
- Up to $10,000 in withdrawals of Roth IRA earnings are allowed penalty free for a first-time home purchase. That means if your business involves owning a home in some way, you have penalty free access to up to $10,000 in capital appreciation.
- You can finance your business out of retained earnings. If you have investments in a taxable account, instead of reinvesting dividends and capital gains distributions, you can take them as cash. If you properly use low-cost Vanguard index funds for your investments, those distributions are very likely to be treated as long-term capital gains, giving you lower-cost access to capital.
It’s a mistake to treat Federal Reserve policy as irrelevant to your personal finances. The Federal Reserve is on a crusade to stimulate economic activity by making the returns on the secondary markets unacceptably low to ambitious, entrepreneurial spirits.
If you are such a spirit, it’s time to get the message and get on board.