Tag Archives: investment

Thought on Forward Guidance: Proposal for the Fed

The FED has been pursuing its so called “forward guidance” program hoping it could stimulate economy by convincing the persistence of low interest rate policy. It stated that it sees the current low interest rate appropriate as long as the unemployment rate remains above 6.5% and the expected inflation in one to two years is below 2.5%. According to the statement, it will consider the broader labor indicators and inflation expectations to decide how long it will continue the near zero interest rate policy once the unemployment rate drops to 6.5%. Therefore, it is very up in the air when the FED is increasing the federal funds rate.

We know that the latest report shows the unemployment rate is 6.6%.  This rate indicates that even though the monthly net number of jobs added hasn’t been up to the projections for last two months, the FED will soon be deciding its future policy and writing up its well-into-future forward guidance once the unemployment rate hits 6.5%.

After all, the FED’s low interest rate policy has been directed toward increasing investment. But there could be different type of “forward guidance” that could potentially create more investment as the FED wishes. My proposal to the FED is that:

a) It should forward guide the market by putting hard deadline on when it is increasing the federal funds rate and therefore the market interest rates. How this clear deadline for increase in federal funds rate works is following: If the FED successfully (!) convince the market that it will indeed push up the federal funds rate, the investors will have clear expectation of when the overall market interest rates are rising. Therefore, realizing the higher investment cost in the specific future, firms will have incentive to borrow and invest today before the FED raises the interest rate. Hence, the investment could increase as the FED has been wishing. This argument is analogical to the people’s consumption when there is very high inflation expectation. If the expected inflation is very high, people would try to buy goods as soon as possible. But the one difference between these two analogies is we don’t know what interest rate is very high to be analogy to the high inflation rate.

One might say that then if there is higher demand for loanable funds because of this policy, the interest rate will rise in the loanable funds market. But we have to remember, the FED has control over overall interest rate in the economy (or I believe so), it will pursue its current near zero interest rate policy until the date it forward guided comes.

b) Again, to succeed in increasing investment, the FED must be able convince the market that it is indeed increasing the federal funds rate at that certain date, To convince the market, the FED should set the date to be in near future and interest rate minimally higher in first few periods and commit to what it said.

According to latest report, the expectation of the FED’s federal funds rate in June 2015 has lowered in a recent month. This might be showing that the FED’s forward guidance indeed successfully convinced the market that the FED will be pursuing near zero interest rate policy. If current forward guidance is indeed somewhat successful, I believe the proposed forward guidance could be also successful.

Remember, at the time when the FED sets the specific date to increase the interest rate, the interest rate will be still zero percent, therefore there will be no negative shock to the total investment.

The problem to implement this forward guidance is that the FED cannot surely know how bad or good the economy will be performing at the time of its forward guided date. The FED could announce its first date to increase the interest rate once the unemployment rate reaches 6.5%. If the FED chooses 3 months to increase the federal funds rate after the unemployment reaches 6.5%, it can study how the investment behaved during this 3 months when the market believes the increase in the interest rate is coming. If the sign turns out to be good, the FED can further implement this “hard deadline for minimal increase in federal funds rate” forward guidance.

United Who Stand, Divided Who Fall?

An interesting read from WSJ about Carl Icahn’s new effort on pushing eBay to split up triggered my thought on the relationships between companies and investors.

First of all, why would investors want to split up a company? To answer the question, let’s look at the problem from an investor’s perspective. On one hand, the return of investment (ROI) matters to an investor. And ROI depends on a company’s growth rate. Take Facebook as an example. Peter Thiel invested $500,000 in Facebook in 2004, which turned into 1 billion by the year of 2012 when he sold out most of his shares. A return 2000 times more than the original investment in 8 years, this legendary investment story can only happen during Facebook’s skyrocketing growth period. As companies’ marginal speed of growth decreases, the bigger the company is, the slower it grows. Now an investment in Facebook hardly doubles itself in a year, let along having an annual rate of return of 25000%.

On the other hand, as the company expands, it adds more business lines, often unrelated. This brings distraction to the company’s management team and therefore yields non-optimal outcome. Splitting up a big company into smaller ones so that each can be managed individually will help maximize profitability. In eBay’s case, the marketplace unit (ebay.com) and payment unit (paypal.com) have to work as a strategic bundle and unavoidably distract each other. In contrast, their competitors Amazon and Square have gain greater momentum thanks to their focus. Therefore, from both the speed of growth and the profitability aspects, splitting up companies is beneficial to their investors.

However, is spinning off really helpful to the companies? Let’s take another look at eBay. As an online marketplace, it is only natural to see ebay.com and paypal.com work together as they provide a complete workflow of shopping: displaying and processing payment. The complementary relationship between the two components makes them benefit from each other’s user base. The more sales eBay generates, the more payment processed through Paypal; and the more customers use Paypal, the more sellers attracted to eBay. It is painful or even destructive to separate either one from the other.

As a strategic bundle, ebay.com + paypal.com creates a unique advantage: a seamlessly integrated shopping environment where people don’t have to leave the system or whip out their wallet to complete the purchases (although this advantage is fading away as other marketplaces are catching up on their integration with payment systems as well). This advantage has been the most effective barrier and weapon against new players and existing competitors. Now if eBay spun off Paypal, it will lose control to the payment unit and therefore break the integrity of the environment. Although the standalone Paypal service would grow without distraction, would this be good for eBay? I don’t think so.

Does the recent low interest rate induce more investment?

As Keynes argued that the solution to the Great Depression was to create more investment through a reduction in interest rates, one of the goals the Fed pursued through its near zero interest rate policy was to lower overall interest rate in the economy and create more investment. As we studied from IS-LM model, I(nvestment) part of the model is a decreasing function of the real interest rate. But, of course, IS-LM model is very simplified but useful to see effects of certain changes in the economy isolated from other factors. If we naively assume the model’s argument and recent economic condition since the recession, we would expect total investments to be risen since the Fed has shifted to zero interest rate policy. As the monetary policy makers lowered the interest rate to near zero, the economy has been seeing the only period of below zero real interest rate which wasn’t created by high inflation as it was in the 1970’s.

Historical real interest rate ( 10 year rate minus personal consumption expenditure inflation rate)

Historical real interest rate ( 10-year rate minus personal consumption expenditure inflation rate)

We would expect businesses to borrow money with negative real interest rate and invest it to their businesses, right? Recent research done by by Federal Reserve staff economists Steve Sharpe and Gustavo Suarez showed that businesses investors were inelastic to low interest rates. According to the paper,

The vast majority of CFOs indicate that their investment plans are quite insensitive to potential decreases in their borrowing costs. Only 8% of firms would increase investment if borrowing costs declined 100 basis points, and an additional 8% would respond to a decrease of 100 to 200 basis points.

Strikingly, 68% did not expect any decline in interest rates would induce more investment.

In addition, we find that firms expect to be somewhat more sensitive to an increase in interest rates. Still, only 16% of firms would reduce investment in response to a 100 basis point increase, and another 15% would respond to an increase of 100 to 200 basis points.

Read more: http://www.businessinsider.com/business-investment-sensitivity-to-interest-rates-2014-1#ixzz2qXqvjHoN

In other words, one of the goals, namely to increase investment, that the policy makers hoped to achieve through the low interest rate policy hasn’t been achieved.

Private non-residential fixed investment, federal funds rate, and real interest rate

Private non-residential fixed investment, federal funds rate, and real interest rate

If we look at the above graph, business sector hasn’t been really responding to the historically low real interest rate. It may be due to the uncertainty created by the Fed’s policy tools.

Overall, total real private investment hasn’t gotten back to a level it was at before the recession.

GPDIC96_Max_630_378

This slow increase in private investment has been one of the reasons the recovery has been slow since the recession. The Fed should increase the business and consumers confidence to increase investment.

 

Why 3.2 Billion?

Ever since Jan. 13, it’s like everybody who has a slight interest in technology is talking about one Internet giant, one big number and one small startup – Google spent 3.2 billion buying Nest Labs. Look at the title of this article from gizmodo: Holy Crap: Google Just Bought Nest for 3.2 Billion in Cash. Usually these picky technology reporters don’t say “Holy Crap” in their articles unless they have a really good reason to.

In fact they do have a good reason. What does Nest Lab do? A smart thermostat and a smart smoke detector. That’s all, for 3.2 billion, 4 times of its value. So it must be the smart stuff that really worth the price? Well the thermostat does have an IQ of 193 and the smoke detector just cracked an art heist… Of course it’s just a little smarter than your normal home gadgets! It’s hardly even an “innovation”, let alone disruptive. There are thousands of companies do hardware hacks just like this and maybe even more innovative. So, why?

Because although the little gadgets Nest Lab created is a small step in its own industry, it’s a big step for the world towards the “Thingternet”. What is it? It’s the Internet of things. It’s an era when human beings are served by their surroundings. Looking back in time, thousands of years ago, human were defined by the things they live with – cave people, Stone Age… Human beings were controlled by the surroundings. Then when we learned how to use tools, we are defined by the tool we use – from the Age of Steam to the Internet era. We control the surroundings. Now following the trend, it’s time for the Thingternet era to come. Everything will be smart, nothings will be disconnected. You will never need a key to open the door, nor will you every use a switch to turn off the light. Everything responds to you. The concept of “tools” disappears.

It’s a brave new world. The market size is infinite. 3.2 billion should be dwarfed by the big implication behind this trade: the company that knows everything about you is now taking the step to physically serve you. Your heater will be shut off for you because Google saw you just booked a flight leaving tonight. Your car will be washed, recharged, warmed up and drive itself to your front door because your bed just gently woke you up and your closet helped you get dressed 30 minutes ago. Think about what this means.

The technology is ready to be used, the world is ready to be changed, are you ready to be redefined?

Drivers of U.S. Growth in 2014: Politicians and Corporations

The outlook for U.S. growth in 2014 depends largely on the actions of politicians and corporations.

How might the actions of politicians impact U.S. growth in 2014? Easing the federal fiscal restraint and increasing government spending at the state/local levels would be very beneficial for growth. Obviously government spending brings up the conversation of public debt. On that note, the debt ceiling will need to be resolved by mid-February and it is crucial that this issue is handled swiftly. On the one hand, a positive resolution would probably result in a modest acceleration in overall growth. On the other hand, a poor resolution would probably result in  volatile financial markets and a negative impact consumer/business confidence. The last time we neared the debt ceiling, there were disturbing talks about a default on U.S. debt and the massive implications that we would face. I don’t think anyone wants to see this happen again and a better handling of it this time around is extremely important for growth in 2014.

Drawing parallels between U.S. growth and China is interesting to consider because it sparks the question of how they achieved such amazing growth. According to the Wall Street Journal, “China is an economic miracle. Lawrence Summers, the former U.S. Treasury secretary, puts it this way: When the U.S. was growing at its fastest, it doubled living standards about every 30 years. China has been doubling living standards roughly each decade for the past 30 years – and it has done so without following Washington’s playbook for development”. How on earth has China been able to do this? Maybe the U.S. should take a page out of China’s playbook in order to increase their own growth? Among many things, a big difference is that China has a massive government (technically, they are a communist country). And the Chinese government spends massive amounts of money both at a federal level and a local level. Although by no means am I promoting communism, I think it is interesting to consider the drivers of growth in China and compare them to the U.S.

How might the actions of corporations impact U.S. growth in 2014? Whether firms choose to increase spending and investment ahead of any perceived economic acceleration will also be extremely important for U.S. growth. According to the Wall Street Journal, “[America’s businesses] say they want to see the economy growing faster – generating sustained growth in demand for their goods and services – before they would be willing to splurge on new equipment, software and buildings. But lackluster business spending is one thing holding back growth”. I think this is an especially important point as well as a troubling paradox. Some firms refrain from spending when economic conditions are anything short of spectacular (although this might not be the case for all firms). However, these corporations should understand that their lack of investment is perpetuating the cycle in which there is weak economic growth. If firms hope that they can wait to invest until they see accelerating economic growth, then they may be waiting until they are dead.

Fortunately, there may soon be evidence of economic growth that would encourage firms to spend and invest. According to the Wall Street Journal, “If U.S. gross domestic product, the sum of all the goods and services produced in the economy, comes in at a 3% growth pace for the final three months of 2013, as many economists are forecasting, the economy could see the best half a year in a decade”. If this happens, then we should see corporations increase their spending and investment significantly. Investment, which is an important component of GDP, would then further spur economic growth. Although I have high hopes for U.S. growth in 2014, I think there are many parts that need to fall into place in order for the U.S. economy to finally reach escape velocity.