Keeping Interest Rates Low Is a Function of Demand, Not of Politics

This article was first published by me on Talkmarkets:

Donald Trump, who recently spoke about the false economy as if he understood the economy, obviously does not have a clear idea about how that false economy actually works. He tipped his hand when he said that the Fed is deliberately keeping interest rates low until after the Obama presidency. That is an ignorant statement, if we understand what long bonds are used for.

While the Fed certainly created an atmosphere in which interest rates can remain low, it does not keep long rates low. Demand for bonds with limited supply keeps rates low. Trump has spoken of fiscal deficit spending as a means to increase the amount of bonds, but that would not radically raise rates, as the demand is so large for the bonds that it may not matter.

And US citizens don't get much benefit from deficit spending, but Wall Street would.

The conundrum is simply that long bond yields do not respond to raising short term interest rates. The Fed raises short term interest rates in order to control monetary policy.

Alan Greenspan said in 2014:

We wanted to control the federal funds rate, but ran into trouble because long-term rates did not, as they always had previously, respond to the rise in short-term rates.
The conundrum, of course, is not really a conundrum but before I get into that, it is clear that Janet Yellen and Ben Bernanke previously, inherited the conundrum. I have made the argument in previous articles that the conundrum is caused by the hoarding of treasury and corporate bonds, which is caused by:

1. the advent of structured finance, guided by Alan Greenspan, and made famous by Salomon Brothers.
2. the failure of asset backed bonds in the Great recession.
3. the need for more bond collateral in clearing houses governing massive derivatives trades.

So, then, plain supply and demand drives the long UST market. Lack of trust in asset based bonds gives rise to the new gold, the non asset based UST, which has never seen default. Demand for something that appears as sure as anything on earth, even more sure than the price of gold, is the collateral of choice in the structured finance markets.

Is this a good thing? Well, so far for many on main street it has been dreadful. Donald Trump is trying to play into this pulse of despair by his explanations of the low bond yields, but in this most recent attempt, fails miserably. Massive demand for the long bond is here to stay. Would it be good if bonds were not used as collateral? I think so.

But no president could make that happen by himself. Probably the disruption to the financial system would be massive at first. Fractional reserve banking would possibly have to come to an end, which would tighten the money supply and cause a Great Depression.

The only way to avoid that sort of chaos, in the move to keep bonds from use as collateral, would be to immediately substitute other, trusted collateral, in an orderly fashion.

The Fed is not involved in politics, says Minneapolis Fed president Neel Kashkari, in response to Trump's accusations. Clearly that is true, but the economic decisions made in this atmosphere of the new normal do carry political ramifications.

And Donald Trump understands this, sort of. But, he doesn't understand the need for long bonds.

The conundrum, of course, is not really a conundrum. Bond hoarding is something Alan Greenspan understood perfectly well. Very few people understood what was going on in 2005 when Greenspan invented the term, conundrum. But more people now understand that bonds are money, and you can serve them up as collateral while receiving yield on them.

Proof that the Fed does not keep bond yields down in a manipulative fashion is the affect ending QE had. Clearly, everyone thought rates would go up. The Fed set the table for rates to go up, letting bonds reflect market forces, not demand from Fed purchases. But of course, it was clear they did not go up. The demand for the bonds was simply too great even without Fed purchases.

One would think presidential candidates would, or their advisors would, know this simple lesson. But apparently it is not getting through. It is a message, this hoarding and demand for bonds, that is still not getting through to many people at all. 


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