For Economic Growth What’s More Important- Interest Rates or Liquidity?

We are going to take a look at the old question- Interest Rates vs Liquidity? What’s most important as we look forward to the growth of both the economy and in the stock markets. Let’s get right into it. 

Hello, this is Bob Gray for Simple Econ. Today, we're going to take a quick look at the old question. Interest rates versus liquidity. What's most important as we look forward to growth in both the economy and in the stock markets? Let's get right into it.

And again, we're going to talk about the Federal Reserve System today and whether it's interest rates or liquidity or a combination of both that affects the markets, we've heard a lot of talk about this. There's been a lot of noise about it for the last seven or eight months especially in last December when the Fed rate hike caused the stock market to drop considerably and get pretty erratic for a few weeks there. And again, you got to remember that the news services are really out there to scare you because that way you'll pay attention and listen and that helps their ratings which is their business model is collecting an audience to sell to advertisers.

So they use fear and a lot of noise to get your attention. And they said the Fed shouldn't raise rates, then that others said they should raise the rates, and that they needed to raise them so that they would have some bullets in their gun if we went into another recession, and a lot of people said, "Oh the president didn't say anything about the Federal Reserve and no one else should there such enlightened group of people that we should never ever say they are totally independent." And of course every president and all the news people for years have always commented on the Fed and whether they were doing it right or not. And I'm not here just to talk about whether they're doing it right or not, I'm just here to talk about the effects their decision making has on the economy.

And if you look back over time and this goes back to actually 1954, this graph on the top and you can see the green line is the real GDP here in the United States, the red line is the federal funds rate. And so I think it is always a dual fear because raising the rates too quickly and at the same time reducing liquidity which is the normal procedure and precursor to a recession historically. This time there's a new twist to it all and that's normalizing a very bloated federal balance sheet at the very same time as lowering or raising interest rates.

And this is a first for the U.S. and the Fed and we all knew would have to start. And so far there's really been no negligible effect of reducing that balance sheet, but it's something we need to keep our eye on. But as you can see by looking at the graph, every time that the red line goes up, the green line goes down. And so the interest rate and liquidity does have an impact on the markets, and keeping the rates down helps the markets move forward at a good clip, especially when there's some other... they call it a combination of monetary policy and fiscal policy and the fed is monetary policy.

And there's also some impacts from fiscal policy that can be a headwind or a tailwind to an economy. But as you can see, that once the interest rates the Federal Funds rate gets over about four and a half five percent, it definitely has a negative effect on the economy. And anyhow let's go on and look a little bit further at this because you can see last December we had the market went down considerably. You can see we had extreme volatility for a short while based on the VIX and the VIX is a volatility index of the S&P 500.

So anyhow, you can see the average for the last, well since January 2nd of 2004, when they changed their methodology. The average since then has been about 18.35%, and you can see we jumped up almost as high as what, 36 in December and from a relatively stable time period before that. And then we have settled back down into a below volatility for the most part position right now.

But as you can see easily, the volatility went up the markets went down and we have settled back down. And what was happening during that time, as you can see starting in about what, 2009, the Fed started their programs called Quantitative Easing and they had three stages of those. And over those three stages, they printed money or created the money to buy $3.6 trillion of U.S. treasury securities and mortgage backed securities. And they held that money on reserve at the Federal Reserve Bank until the beginning of 2018 as they decided to start normalizing or reducing their balance sheet.

And they sold off last year most of it coming towards the last half of the year about 385 billion of those securities. At the same time, the excess reserves. Now, the excess reserves are money held by the banks at the Federal Reserve Bank. And since 2010, actually they've gotten paid whatever the Fed funds rate is by the Federal Reserve Bank to keep that money there. That savings money, that excess money that the banks have on hand, and that's money that can be lent through the banking system into the economy to help build the economy.

So it's the same time that the Fed sold $385 billion in securities, the excess reserves declined by 484 billion which means that money went into the economy. Now, I want to note that at the end of the year there was still about 1.6 trillion in excess reserves on deposit at the fed. So liquidity is not an issue in our current economy. But again, you can see they sold 484 billion which takes money out of the economy and they put, or I'm sorry, they put 484 billion of excess reserves into the economy through the banking system. At the same time they took 385 billion out to wipe the securities that they had bought off their books, which equals of 99 billion of additional liquidity added to the U.S. economy.

And still remember there's 1.6 trillion still there. So that means we do not have a liquidity issue in our economy. But in January 4th, if you remember Fed Powell chairman spoke at a meeting in Atlanta I think it was actually January 4th, yeah January 4th he spoke. And in his speech, he included comments that indicated that the Fed would include market factors in the rate decision making and the balance sheet normalizing processes going forward after recognizing the fear that quickly raising the Fed funds rate injected into the U.S. equity market.

And that became the calming effect which allowed the market to shoot up again and has held the volatility down. Now, since then they have continued to sell off securities and reduce their balance sheet or normalize their balance sheet. And at the same time they have put more money into the economy through the banking system.

And you can see that right now everything's been kind of calm in fact, lately other than a little burst of volatility that went above the average. It's calmed down now till it's in the 15%, 16% range and volatility currently as I'm recording this. But as you can see, a 177 billion of the excess reserves did go into the economy in the first almost five months of this year, and they sold 166 billion of the mortgage backed securities, which still puts an additional $11 billion of liquidity, give or take into our economy.

Now, there's no doubt there's other variables involved in this entire process, there's under other funding sources, international investment, there's other things going on in the economy that helps build business investment and builds our gross domestic product. And the other thing is, interest rates and liquidity cash are both important in my opinion for economic growth. They have to keep the rates at a fair rate to manage inflation at the same time, and we've got to make sure that there's enough liquidity or cash available to go into the marketplace to meet demand for growth.

So it's important to keep on your eye on both as you go forward looking at your investments. And when you hear them talking about this hopefully you'll have a little better understanding of what they're talking about.

As always I appreciate you joining me for this short video on the economy and I'll look forward to talking to you again soon.

And just so you know I have spent the last 52 years speaking to small and large groups, done lots of radio TV and print interviews, I'm always available in the Northwest Illinois area and in the Phoenix area for speaking. Anything on the economy economics, U.S. markets, global markets, and marketing I've spoke on all those many times over the years.

Vanessa Baker