The Fate of U.S. Interest Rates

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With the global economy in a tenuous spot, our Federal Reserve faces a difficult situation: Move interest rates in the wrong direction and you unleash Hell’s demons upon Asia … and you remove bulwarks buttressing our own economy.

With those words, I am not painting for you a picture of modern America.

I am, instead, recapping for you the state of affairs that confronted the Federal Reserve’s then-Chairman Alan Greenspan when he spoke to the Haas School of Business at the University of California, Berkley, in September 1998.

In that speech, Mr. Greenspan first uttered the phrase “island of prosperity” to describe what the U.S. could not afford to become in an ailing world. Doing so would clip the U.S. economy by, effectively, killing Asia. It meant that even though the U.S. itself could bear the burden of higher interest rates, the world certainly could not — and, thus, the Federal Reserve was in no position to hike rates, as so many observers were expecting.

Though the brushstrokes and details are different today, we are, in effect, staring at the same painting Mr. Greenspan saw nearly two decades ago. The U.S. cannot — and will not — raise interest rates until spring, more likely summer, of 2016.

As Janet Yellen explained in a press conference on September 17 why the Fed had decided, yet again, to leave U.S. interest rates unchanged, I was building a quick spreadsheet.

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Every quarter for the past few years the Fed has published an economic update that sheds some light on what Fed governors see in our economy. I’ve dived into these numbers each quarter. They’re the reason I told my readers in the May 2012 issue of The Sovereign Investor that the Fed would not raise interest rates until “2015 — or even 2016,” a position from which I have not deviated in more than three years.

The spreadsheet I built as Ms. Yellen dissembled shows me, unequivocally, that America is not on a path to anything remotely resembling the prosperity we once knew. We’re on a path to a new mediocre. We’re looking at a generation of subpar economic growth that has direct implications on the Fed’s road forward.

Here’s that chart:

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In essence, the deeper we get into the recovery, the bleaker our future looks.The sadly declining lines (the blue line is the lower end of their estimate and the gold line is the upper end of the estimate) indicate that Fed governors are increasingly pessimistic about the long-run potential for the American economy. Their range of expected outcomes looking out toward and past the end of the decade has consistently decreased as this post-global-crisis “recovery” has unfolded.

That’s incongruous to all that we’re fed today by cheerful economists, sycophantic business-news reporters, the president, even many of the Federal Reserve governors themselves.

A New Lower Neutral Rate

The Fed has said over and again that it wants to get back to what it calls “neutral interest rates” — the rate at which the Fed’s interest-rate policy neither stimulates nor depresses economic growth beyond its natural pace.

A neutral rate is not expected to persist over the next year or two, but rather the rate expected to persist when the economy is growing at its long-term potential, unhindered by crises or euphoria. Economic theory going back a century holds that as potential GDP rises, so does the natural rate of interest. Conversely, then, as potential GDP declines … so does the natural interest rate.

Fed governors are telling us the natural pace of long-term economic growth in America is in the 2% range, possibly lower as time goes on. Therefore, a neutral interest rate is likely lower than the market currently expects.

In short, America’s interest-rate destination is much lower than most commentators suspect. It’s certainly nowhere near traditional neutral rates in the 5% range.

If the economy is growing at its long-term expected rate of roughly 2%, then we can back into the Fed’s likely interest-rate destination by using something called the Taylor Rule. It was developed back in the 1990s by famed economist John Taylor, and various studies have shown that the rule is pretty good at plotting the path of central bankers around the world. Plugging in the Fed’s GDP expectations and various factors for expected inflation, I come up with a terminal Fed Funds rate ranging between about 2.25% and, maybe, 3.25%.

Think about what that means for your life…

Sure, interest rates will remain subdued for housing and consumer credit. But if your goal is to earn a greater return on your assets … well, it’s not going to be found with traditional fixed-income instruments. We will not see a 5% CD until well into the 2020s, unless inflation explodes higher — and if it does, then we will be stuck in a very stagnant 1970s-style stagflationary environment that will make today look like Bill Clinton’s roaring ‘90s.

The only solution we have: high-quality dividend stocks.

Though you don’t hear this a lot, dividends are the key reason the S&P 500 has been such a good investment long term. A $1,000 investment in the 1970s turned into $20,873 in terms of stock-price appreciation alone through the end of September. Dividends added another $63,037 — triple the price appreciation.

We are in a long (looong) term period of subpar growth in America. The Fed’s own expectations tell us as much. Dividends will prove to be our savior over the next decade.

Until next time, stay Sovereign…
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Jeff D. Opdyke
Editor, Profit Seeker