This is part 3 of a multi-part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”. You can download the episode on iTunes or find it on our Listen page.
In our last installment, we explored the bond market and how interest rates are established in the open market. Bonds are debts and the interest rates are set by risk, reward, supply and demand. Now we will explore how the Federal Reserve Bank affects interest rates. You should already know how interest rates affect you. 😉
How the Fed Influences Interest Rates
The Federal Reserve
The Federal Reserve Bank (the Fed) is the bank of the Treasury. The Treasury is the government. The Federal Reserve is NOT the government. If you want to learn more about the Fed, we highly recommend reading The Creature from Jekyll Island, which is conveniently located in The Real Estate Guys™ Recommended Reading area.
The Magic Checkbook
For now, you only need to know that the Fed can write checks on itself that will not bounce. In other words, it doesn’t need money. It creates money simply by writing a check. That may sound unbelievable, but for now, just take our word for it. This isn’t an expose on the Fed, so you can look it up in your spare time.
Now that we know how the Fed’s magic checkbook works, let’s imagine that Uncle Sam shows up to hold a Treasury bond auction. But there isn’t enough demand, so interest rates start to go up. In prior installments, we discussed what happens to the value of all the existing debt out there when interest rates go up (it goes down), but to toss in some extra motivation for the Fed, the current Fed leadership believes that low interest rates stimulates borrowing, which stimulates spending, which stimulates production, which stimulates hiring. This is a “Keynesian” view of economics. That is, that borrowing and spending is the key to growth and job creation (how’s that working out so far?).
Side note: For an opposing viewpoint, may we recommend you look into “Austrian” economic theory, which puts forth the idea that one must actually produce before one can consume or borrow, and that production and savings are the keys to economic growth. In other words, in its most rudimentary terms, before you can eat, you need to grow or hunt food. And if you have more food than you need, then you have something of value to trade with. If you don’t have anything to eat and nothing of value to trade with, you need to either beg, borrow or steal from someone who actually does produce. And the only way to have trading partners is if they produce more than they consume, so there’s something extra for you to trade for. The bottom line is that production, not spending, is the key to prosperity. That’s why printing money or stimulating consumption doesn’t create jobs. And as real estate investors, we want to invest where jobs are being created. Because unless you’re renting to people subsidized by the government, your best tenants will need jobs to pay you rent. Now, back to our main feature….
Now if you, like Big Ben Bernanke, believe that borrowing is the key to prosperity, where do you think interest rates need to be? Hint: LOW interest rates attract borrowers. Sorry, was that hint TOO obvious?
Let’s get back to our Treasury auction. Uncle Sam is there holding his bonds out for sale, but not enough buyers show up. So Uncle Sam has to start lowering his price (increasing the yield) and interest rates start going up. Big Ben thinks this is bad. So he gets out his Magic Checkbook and buys, say $600 billion of Uncle Sam’s bonds (does the term QE2 some to mind?), to help create some extra demand. Shazam! Interest rates stay low.
Well, if you’re a government addicted to debt, deficits and spending, this makes you very happy. Just like when the interest rate on your growing credit card balance stays low. With low interest rates, you can borrow more for the same payments. No need to cut spending. Let the good times roll! The only thing better than low interest rates is an increase in your credit line (isn’t there some discussion about that?)
To summarize, when the Fed buys Uncle Sam’s Treasury bonds in the open market, the extra demand drives the bond prices up and their yields (interest rates) down. Then, the ripple effect of interest rate pricing kicks in, as all riskier debt pivots off the interest rate of Uncle Sam’s “safest debt in the world”. That is, if Treasuries pay x, then a riskier debt pays x plus a little bit more (usually denominated in “basis points”, which are 1/100 of a percentage. So 25 basis points is 1/4 of 1% or .25). The farther away you move up the risk scale, the more expensive the debt is for the borrower. This is why everyone has their undies in a bunch over Uncle Sam’s credit rating. It he loses his coveted super-duper AAA rating, then interest rates go up….and Big Ben may need to step in with his Magic Checkbook.
But what happens when Big Ben uses his Magic Checkbook? Are there any side effects we should be considering? Hmmm….? Inquiring minds want to know!