Chairman Powell’s Bias

Interest rates remain top of mind for a wide range of investors.  But it is important to remember that not all investors have the same backgrounds and objectives.  When the question of real interest rates arises, one’s preference has much to do with whether they tend to be borrowers or lenders.  And remember, at some level, Fed Chair Powell is the “Borrower in Chief”.

We’ve all heard that Powell is the first non-economist to helm the Federal Reserve in decades.  He’s a lawyer by training.  But it is crucial to remember that his greatest success came as an investor.  His biography shows that he worked as an investment banker after graduating law school and eventually he became a partner at the Carlyle Group, which began as a private equity firm doing leveraged buyouts.  This type of investing relies upon borrowed money – lots of it. 

This is one of the reasons why markets tend to give Chair Powell the benefit of the doubt.   Sure, he’s an investor rather than an economist, but he’s also an investor who aggressively utilized borrowed money to achieve his returns. 

Those who borrow money prefer low, or ideally negative, interest rates.  They greatly prefer entering into a contract that enables them to pay their debts in a currency that has lost purchasing power – especially if the borrowed money can be used for assets that appreciate faster than the cost of money.

Those who lend money prefer positive real interest rates.  They enjoy the opportunity to invest in relatively safe investments that offer yields above the prevailing rate of inflation. 

Now, think about where the power in this economy lies.  The modern financial system rests upon layers of debt.  At the root is government debt, then various types of corporate and other private debts are priced to offer rates that are typically priced in relation to government debt.  All those who borrowed the trillions of dollars would prefer to pay their lenders back with cheaper money, i.e. lower real rates. 

Inflation, which is bad for consumers and those who hold cash, can work in the favor of borrowers.  Of course, too much inflation can cause a wide range of economic issues that can adversely affect those borrowers, but a moderate level of inflation, say, 2%, suits most of them just fine. 

This is also why if inflation is bad for an economy like ours, deflation is worse.  Deflation impedes borrowers’ ability to service their debts.  If an economy rests upon a foundation of debt, deflation erodes that foundation, negatively impacting both borrowers and those who lent them money.  We have a government that has immense borrowing needs and a wide range of assets that were purchased with borrowed money.  All of them would prefer to see some inflation alongside low nominal interest rates. 

Yesterday we published a piece with several charts, including two with historical real interest rates.  Negative rates were an extreme abnormality for most of economic history, yet we became accustomed to them during the 2010’s and beyond.  It is clear that Fed Funds traders and equity investors would like to see them return.  In fact, they might even expect them to return.  My gut says that barring some sort of economic crisis there should be little reason for negative real rates to return.  But when we consider the inherent biases of the man who steers the economy along his preferred rate path, the idea is not that far-fetched.