Fed keeps markets happy, but at what longer-term economic cost?
Is the US Federal Reserve playing the ultimate game of chicken with the market with respect to interest rates? Over the past 12 months the fed has talked tough with respect to interest rates, saying it recognises the dangers of keeping rates too low for too long. The Fed also points to economic growth in the US as clear evidence that its easy money policies have worked.
For these reasons the Fed has consistently said it’s putting in place clear timelines for eventual rate increases. But the problem is that whilst the Fed is prepared to talk the talk, is it really prepared to walk the walk?
There have been calls for Fed action on interest rates dating back several years. For example during February 2012, President and CEO of the Federal Reserve Bank of St. Louis, James Bullard, argued in a Reuters news interview that “the Federal Reserve should start raising interest rates next year.” At the time he disagreed with the Fed’s decision during January 2012 to keep interest rates exceptionally low through to late 2014 in order to bolster the US economy.
The latest comments by the Fed over the past 24 hours indicate that there won’t be any action on interest rates until at least 2015, with Fed Chair Janet Yellen pledging to keep interest rates near-zero for a “considerable time”.
Hardly the stuff that engenders confidence in the supposed robust and sustained health of the US economy, as the media and market analysts might have us believe.
What the Fed did do was raise their median estimate for the federal funds rate to 1.375% by the end of next year. In other words, like they have done for the past few years, they are prepared to talk tough on interest rates, but when push comes to shove, the economic realities dictate that there is actually little room for the Fed to move right now.
The underlying fragility of the US economic recovery means a rate rise anytime soon could have disastrous consequences. The Fed cut rates to near zero more than three years ago and has bought $2.3 trillion worth of bonds in order to try and spur economic activity.
But the Fed’s comments were warmly greeted by the market and speculators, confident that the easy money scenario will continue to pump up the value of their artificially inflated investments in shares and property. For now the game of musical chairs continues and the day or reckoning gets pushed back a little further.
As James Bullard argued back in 2012, many years of near-zero rates risks causing "disaster." Keeping rates low for several quarters is very different from keeping them there for years, which punishes savers. We’ve previously discussed at length the impact of low-interest rate policies on savers and retirees in the US, which have resulted in their wealth evaporating.
Charles Schwab took the argument further, arguing back in 2012 that rock-bottom interest rates were destroying confidence in the economy and were unwisely forcing older savers to take risks with their money in search of decent investment returns.
This greater risk-taking has manifested itself in the form of US share and property bubbles, incentivized by the zero-interest rate environment and the Fed’s easy money policies.
In the US, older savers’ and pensioners’ incomes have been squeezed by falling rates leaving them poorer. Savings rates have lagged behind inflation, reducing real incomes, eroding the real value of savings and lowering consumer confidence.
I have a number of issues with the Fed’s easy money policies in general. They distort market prices, encourage destabilizing financial speculation, and they unfairly punish savers. But the far bigger concern lies in the future: the economy and financial markets have become so dependent on QE and artificially-suppressed interest rates that it will be very difficult for the Fed to reverse these policies without major repercussions.
The danger is that they won’t be reversed in time – resulting in a different (but equally serious) set of potential consequences. The Fed has a well established tendency to not recognize the effects of its loose monetary policy, nor to tighten, until it’s far too late.
On top of having many unintended negative consequences, ultra-low rates may also be ineffective in addressing the real economic issues. The continuation of low rates points to a worrying lack of growth and also highlights the increasing risk of deflation and a potential contraction in economic activity.
As Stanley Yeo, portfolio manager at IOOF commented recently, “Given that growth and inflation are among the primary requirements for a relatively painless reduction in elevated debt levels globally, the enthusiasm with low rates and quantitative easing among investors is curious.”
“The clear hope is that low rates will revive the economy. The theory predicts lowering rates will boost bank lending and increase access to credit for purchases of homes or other goods and services, ensuring economic recovery. However, the reality is quite different. In Australia, Reserve Bank research indicates that the savings from lower mortgage rates are simply being used to retire debt, rather than for consumption. While the reduction in debt levels is necessary, lowering rates will, of itself, do little to boost demand and economic activity,” he says.
Another problem that low rates might provoke is to tempt borrowers into ignoring their balance-sheet problems. The result could be that the problems are left to fester, making it difficult for central banks to raise interest rates to a more normal level in future years, for fear of the damage this might cause.
Banks might also become too optimistic about the ability of borrowers to repay, and fail to make adequate provisions for bad debts. When investments are made during a period of artificially low interest rates they are often ‘malinvestments’ as the low rates may send false signals to entrepreneurs and home buyers that the economy is good and investments/purchases should be made.
The term ‘malinvestment’ is a concept developed by the Austrian School of economic thought that refers to investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply, often blamed on a central bank.
The Fed has driven interest rates down precisely because the economy is not doing well – and to encourage entrepreneurs and consumers to employ capital in places they otherwise might not spend or invest.
In conclusion, the unprecedented moves by central banks which were necessary to stabilise markets have had the desired effect of stabilising the financial system in the short term. The issues stem from the unintended consequences of these ultra-low rates.
Large amounts of existing and borrowed capital have flowed into the stock and real estate markets chasing assets that are rising in price, not necessarily based on fundamentals but on the notion that they are rising and the potential returns are greater than low interest-bearing investments.
Lord Maynard Keynes was a proponent of stimulating the economy to bring forward demand when the economy was in recession. In reaction to criticism that stimulus spending would, in the long run, create problems further down the road, Keynes remarked ‘in the long run we are all dead’.
The problem with this type of thinking is tomorrow often comes and the debts of yesterday’s excesses must be paid for.
And what about gold? In the aftermath of the Fed’s comments, the reactionary herd punished gold, but as we’ve consistently stated we don’t retain much confidence in the views of the so-called experts. We always try and ignore the fickleness of markets.
Last year the gold price crashed once it became clear that the US Federal Reserve was looking to cut back on its Quantitative Easing (QE) program, on fears that it was QE that had been supporting the gold price. What had been forgotten was that the gold price had advanced strongly prior to the term QE even being coined, but the market – with its ultra short-term viewpoint – seemed to have assumed that QE and the gold price were inextricably linked, thus marking the yellow metal down.
And to all the doubters that believe a rising US interest rate environment is bad for gold, over recent weeks we’ve showed that the opposite is in fact true. The real driver of gold prices is negative real interest rates (defined by nominal interest rates minus inflation).
Central bank policies of inducing negative real rates to ‘incentivize’ borrowing, expand the money supply and devalue currencies – have forced investors (especially mums and dads) into real assets like gold and silver. Debt is inherently inflationary if you have the ability to print your own currency.
As we’d discussed recently, gold rose with interest rates during the 1970′s and this is sufficient to prove that gold doesn’t always fall when interest rates rise. The gold bull market of the 1970s was dominated by inflation – interest rates rose steadily to keep up with it, but real interest rates were mostly negative the entire time.
I therefore remain positive on gold and am confident that the flow of gold from West to East will continue. I believe there’s robust price support between the US$1,200 – US$1,300 level, a situation that will continue for the foreseeable future.
