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The Reason the Fed is Raising Rates, and Why It Won't Work

By       Message Mike Whitney     Permalink
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Why is the Fed creating incentives for US corporations to destroy themselves? Why is the Fed pushing insurance companies and retirement funds into bankruptcy? Why is the Fed raising interest rates when inflation is still well below its 2 percent target?

Things are not always what they seem. In theory, the Fed's low interest rates are supposed to have a positive impact on the economy by spurring a credit expansion. But it hasn't worked out that way. Bank lending has remained stubbornly subdued throughout the post-crisis period. But what hasn't remained subdued is corporate borrowing (via the bond market) which has exceeded all previous records increasing the probability of massive corporate defaults sometime in the next two years. Here's a good summary of what's going on from an article in Fortune titled "Corporate America is Drowning in Debt":

"A good portion of Corporate America may have a serious debt problem. According to a report released Friday from S&P Global Ratings, the bottom 99% of corporations, when it comes to the amount of cash they have, are increasingly showing worrying levels of debt.

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"Studying S&P's universe of more than 2,000 nonfinancial corporations, S&P's researchers found that corporate issuers of debt had on hand a record $1.84 trillion in cash. But that statistic doesn't tell us very much about the health of individual companies, because it appears cash is more concentrated at the top than ever. The top 1% of corporate cash holders...have slightly more than half of the total cash pile of Corporate America....

"If you remove the top 25 cash holders, you'll find that for most of Corporate America, cash on hand is declining even as these companies rack up more and more debt at historic rates. The bottom 99% of corporate borrowers have just $900 billion in cash on hand to back up $6 trillion in debt. 'This resulted in a cash-to-debt ratio of 12% -- the lowest recorded over the past decade, including the years preceding the Great Recession,' the report reads....

"One obvious reason for Corporate America's debt binge is low interest rates. With investors willing to lend companies money for so little in return, it makes sense that firms would turn to debt to finance things like share repurchases rather than, for instance, bringing cash earned from overseas, which would then be taxed at a high rate.

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"...'Given the record levels of speculative-grade debt issuance in recent years,' the report reads, 'we believe corporate default rates could increase over the next few years.'" ("Corporate America Is Drowning in Debt," Fortune)

Repeat: The vast majority of US corporations are worse off now than they were in "the years preceding the Great Recession." And the reason they're worse off now is because of low interest rates. The Fed's low rates create lethal incentives for CEO's to pile on the debt which puts their companies at greater risk of default. Corporations are borrowing tons of money from investors in the bond market, which they are distributing to their shareholders rather than using to improve productivity or increase employment. They are also recycling two-thirds of earnings into stock buybacks which is going to dramatically impact their future competitiveness. Here's a blurb from an article in USA Today that sums it all up:

"Capital spending fell 6.2% at an annual rate in the first quarter following a 2.1% drop late last year, its worst such stretch since 2009 and a big reason the economy nearly stalled in that period, Commerce Department data shows.

"Business outlays were sluggish throughout 2015, rising 2.8% compared to an average 4.5% clip during the seven-year-old recovery. 'Business spending typically makes up 12.5% of economic activity but has an outsized impact on the economy and stock market. Purchases of equipment and software, and the construction and renovation of buildings, create thousands of jobs for manufacturers. And such investment makes up nearly 30% of the sales of Standard & Poor's 500 companies,' says David Bianco, Deutsche Bank's chief U.S. equity strategist....

"Instead, public companies are plowing their large cash reserves into stock buybacks and dividends despite low borrowing costs." ("Business investment is in a slump and its hurting the economy," USA Today)

Stock buybacks -- which were illegal before the Reagan administration -- are a deceptive form of financial circle-jerk that distort prices, create bubbles and lead to crisis. The reason the Fed ignores these issues because it sees profit-making as a higher priority than ensuring the safety of the system. Go figure?

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Since Donald Trump has been elected, the buyback frenzy has gained momentum mainly because he's promised a one-time "repatriation holiday" for tax dodging US corporations who will be allowed to bring upwards of $1 trillion back to the US at a meager 10% corporate tax rate. Market analysts do not expect the money to go into production, hiring or infrastructure development, but into more buybacks that will send stocks higher into the stratosphere. Here's the story from the WSJ:

"Corporate stock repurchases are on the upswing once again, wrong-footing skeptics who predicted 2016 would mark the beginning of the end of a post-crisis spending spree. Through Dec. 16, companies this month have stepped up their buybacks by nearly two-thirds over the same period last year, according to Goldman Sachs Group Inc....

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Mike is a freelance writer living in Washington state.


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