The Fed, Interest Rates, and Credit

It is by now well-known that the Fed did not raise interest rates yesterday.  The Fed has kept short-term rates tethered near zero since the financial crisis in 2008, and it has been since 2006 that the Fed has actually raised rates.  You can debate the efficacy of monetary policy (I am a skeptic myself), but it’s hard to justify keeping short-term rates near zero with unemployment currently 5.1%.  As First Trust’s Brian Wesbury tweeted out, the previous three times unemployment was at 5.1%, the Federal Funds Rate was:

August 1996 – 5.2%

March 2005 – 2.6%

March 2008 – 2.6%

It is currently .13%.

Today, in response to the Fed’s non-action, Steve Forbes wrote a column criticizing the Fed for its easy money policy.  Mr. Forbes writes:

Two undesirable things have happened [as a result of the Fed’s zero interest rate policy or ZIRP]:  Big companies have borrowed more than they would have done in a properly functioning credit market (the ZIRP has made interest companies have paid on bonds irresistibly low), and they’ve engaged in considerable financial engineering.  

For instance, why would Apple, with a global cash hoard of $200 billion go out and issue $40 billion in bonds?  Because it could.  At one point this tech giant sold 10-year bonds that had an interest rate of 2.4% and bought in its stock, which had a dividend yield of 2.8%.

Contrary to Mr. Forbes’s assertion, the Fed does not control interest rates.  NYU professor Aswath Damodaran has dealt with this persistent myth both here and here.  While those posts are both worth reading in their entirety, it suffices for us to summarize by saying that long-term inflation expectations have a much greater impact on bond yields than Fed policy, which affects the short-term rates at which banks lend with one another.  Furthermore, in a previous post I noted that bond yields started to decline earlier this century, long before the Fed implemented ZIRP.

Regarding the second charge that Mr. Forbes directs at the Fed, – that it is encouraging financial engineering, – it should be said that while corporations have been issuing debt at very high levels these last few years, it is easily enough explained without having to blame the Fed.  Take, for instance, Mr. Forbes’s own example of Apple.  Even though Apple has $200 billion in cash, much of that cash sits overseas, and Apple would have to pay much more in taxes to repatriate that cash than it would to borrow at 2.4%, which is deductible to Apple.  The reality is that the tax code has long favored indebtedness to equity financing for corporate operations, and Apple’s bond issuance is just another example of rational corporate behavior to maximize shareholder value.  Furthermore, as economist John Tamny wrote this week, the Fed cannot create credit; Apple can borrow at low interest rates, but “no amount of Fed ease would make borrowing simple for Radio Shack.”

Finally, it should be noted that, as we wrote back in February,  despite the record levels of corporate bond issuance, corporate net debt to equity stood at 41% at the end of 2014, versus 156% in October of 2007, before the financial crisis.  Corporations might have issued more debt, but their balance sheets overall are healthier now.

One can certainly argue that Fed policy has been counter productive, and the experiences both here and abroad (see Japan, for instance) are testimony to the misplaced faith in the efficacy of monetary policy.  Too many people believe in the omnipotence of central bankers and the roles they play in our complex financial system, and the sooner things return to normal, the better off we all will be.