In Fed We Trust!

Tomorrow the Fed will announce its decision on whether to increase interest rates for the first time since 2006, and the markets seem to be thinking we’ve got at least another meeting until it happens. Markets are up in the last couple of days and even long-beaten gold is catching a bid, sensing that interest rates won’t rise. In one of my last posts I opined that the Fed wouldn’t increase rates, but I can’t disagree with one of my favorite economic commentators, Jim Grant, who above argues that Ms. Yellen is simply tired of the question. He may be right…if the Fed gives a pretty clear signal its one for now, and–if more come in the future–they will be very measured and delayed. Nevertheless, the problem is twofold.

First, the Fed has no good options. They should have increased interest rates quite a long time ago, and now it is clearly more risky to increase interest rates than say a year ago. Yet the continued failure to begin rate normalization allows the uncertainty that keeps our economy down to remain. The Fed was rightly criticized for telegraphing their tightening in 2013 and then backing down when the stock and bond markets buckled in the so-called “taper tantrum.” The Fed desperately wants to send a signal that they are not under Wall Street’s thumb (hence Jim Grant’s point in the video above that Janet Yellen wants this issue off the table), but they likewise don’t want to be blamed for driving a precarious recovery into the ditch. Expectations of increased U.S. interest rates have driven the dollar sharply higher over the last year, leading to financial flows heading back to the U.S. from emerging markets such as Brazil, China, Turkey, etc. in pursuit of higher yields. These financial flows are the natural result of profit maximizing financiers trying to profit from the Fed’s artificial manipulation of interest rates and therefore currency values. Yet those changing financial flows are a driving factor in world-wide market stress. So they really are between a rock and a hard place, much of it their own making.

Second, I’ve just watched the Republican debate and no one has yet mentioned the Fed unless I missed it. Why is it in a free economy we think the Fed should be in control of its most important price? Mr. Grant correctly notes that the result of the Fed’s zero interest rate policy (ZIRP): we have significantly mis-priced risk in financial assets. The Law of Demand applies here as everywhere, when the price of something goes down, the quantity demanded rises. In this case we have lowered the price of risk and it leads to increasing risky assets. Ultimately riskier assets may yield more or less, but it leads to ultimately more volatility. As Rand Paul argued in the WSJ today (gated),

Consider an analogy. When the U.S. Forest Service took a zero-tolerance approach to forest fires 100 years ago, what ultimately happened was a massive wildfire at Yellowstone National Park in 1988 that wiped out more than 30 times the acreage of any previously recorded fire. Paradoxically, by refusing to allow small fires to run their natural course, the forest managers made the entire park vulnerable to a giant inferno.

What is true of forests holds for the economy: When governments create a lie, whether it’s a fabricated ecology of no fires or a fabricated economy of no failures, the truth reveals itself even more violently than otherwise. Attempts to stop any dips in the stock market with monetary stimulus postpone the necessary adjustments to how and where resources and workers are deployed. Interest rates are a vital signal in the market; they must be allowed to do their job—that is, they must be allowed to be free.

But perhaps the most important question is what good has the ZIRP done?  Clearly its made it easier it easier for big government–the interest costs of our debt are far lower than they should be, putting us significantly at risk when interest rates normalize.  Our interest rates will one day be punishing, but not today–today money is essentially free to our government.  When the price of government goes down, the quantity demanded rises.  Wall Street also loves low interest rates.  When interest rates fall, the future cash flows from every financial asset become more valuable–every asset’s price rises with lower interest rates.   So the stock markets have done well.  But has a ZIRP made main street better?  If so, by what measure?  The Fed can only echo Mr. Obama’s claim, the counterfactual that cannot be proven, that it would have been worse.  Perhaps, but perhaps not.

The Bible says nothing about monetary policy, but I can’t help but draw the analogy from 1 Sam 8, when the Israelites demanded a king.  God warned them through Samuel  that when they refused to trust Him, but seek a king to fight for them, they’d regret it.  Why do we think we need a “king” for monetary policy?  Do we not yet regret the Fed?  How many bubbles bursting will it take?

Edit Update 18 Sep:  Markets drop on Fed Uncertainty.  Maybe in Fed We don’t trust?

“The signaling by the Fed yesterday doesn’t see confidence to pull the trigger to raise from zero to 25 basis points, I think is negative sentiment that’s hitting the market,” said Art Hogan, chief market strategist at Wunderlich Securities. “I think they’ve done more harm than good,” he said.

9 thoughts on “In Fed We Trust!”

  1. Jim Grant is a great writer and a snappy dresser, but his predictions on the markets have been wrong so many times that I fear that his credibility is all about gone.

    It’s not quite down there at the level of early morning “buy gold now” (i.e “buy it because you will make a lot of money, and we are so nice that we are going to sell you some of ours”) infomercials on cable, but gettin’ there!

    I’ll be observing interest rates, too.

    1. When I first started watching financial markets in the 80s I regularly watched Wall St Week w/Louis Rukeyser, who often had Jim Grant on as a guest, who he regularly chided for his bearish predictions. I thought him odd, and in general (as a young market bull) I wanted to take the opposite position of Mr. Grant. Yet while he was wrong (at least at times) on his bearishness on stock markets, his bullishness on bond markets (based on his fundamental analysis) made him and investors that followed his logic a ton of money. As I’ve grown older, I’ve come to appreciate his analysis more and more. In part because, like another Wall Street Week regular, Martin Zweig used to say, “Money makes the mare go.” Financial flows driven in large part by the Fed are really the most powerful mover in markets, at least in the short term. Like most financial prognosticators who live by the crystal ball, Mr. Grant also “eats lots of broken glass.” But at least he has coherent economic framework to predict misallocation of capital ex ante, as opposed to the usual crowd who are always bullish until the crash. Then they loudly proclaim “who could have known it? We all thought this way.” Mr. Grant is at least not afraid to go against the grain. And despite your concern over his predictive ability, his research continues to be highly sought after (and paid for). Apparently many others do not share your concern.

      1. As you can probably tell, I have little respect for financial gurus.

        Indeed, the whole investment expertise business is shady.

        Fund managers who make millions only to underperform an index fund. And who still keep their jobs anyway, because they are usually in the majority.

        CEO’s who get paid millions in golden parachutes after running companies into the ground. And then go on to run for the GOP nomination.

        “Experts” going on CNBC making predictions, and when those predictions fail to come true, are invited back on the network to give more bad advice.

        Gold-bugs who blather on about the overpriced stock market and who keep on egging people to buy gold, not matter how high (or how low) it gets, because, hey, financial armegeddon is coming, because of Obama, blah, blah, blah.

        I don’t doubt that many respect Grant’s research, and some put up their hard-earned money to purchase it; but that does not mean that Grant’s research is worth it.

        If Grant was so good at what he did (I admit that he IS good at convincing others that he knows what he is talking about), why then is he still writing a newsletter thirty years after the heyday of WSW? One would think that if his research were that great, he would have made enough money by now in the markets (the bonds markets are far greater in size than are equity markets) to stop writing.

        If he still has to sell his advice, what does that say about the quality of it? What it says to me is that the story told by Grant’s research, like Shakespeare put it in Macbeth, is,” a tale told by an idiot, full of sound and fury, signifying nothing.”

        Have a nice Monday.

  2. Yellen got her job by promising no interest rate increase on Obama’s watch. She has been quoted as saying this administration deserves to be supported by low interest rates. Which is why I’ve thought all along there won’t be more than a quarter point rise until the election.

    As for the stock market…could there possible have been a leak of the no rate hike? Why else would the market go up two days prior to the announcement?

    One of the candidates has it right, their all stupid.

  3. Frankly, the fact that the Federal Reserve did not raise interest rates this week did not surprise me. However, as you mentioned keeping the interest rates artificially low could prove to be disastrous and exponentially increase the national debt when the rates are eventually normalized.

    I found an article in the Dallas Morning News that discussed why Yellen was hesitant to consider raising interest rates and what must happen before the Fed does raise the rates according to economists. It cited fears over slowing economic growth around the world, especially in China as the preeminent reason why the Fed declined to raise interest rates. The article also speculated that a more stable dollar, steady oil prices, and a more robust job market would be necessary before the rates were increased. To be honest, I doubt that even if those things happened that the Fed would decide to raise the interest rate because they have been kept artificially low for so long.

    Here is the link to the article I found:

  4. I found what Jim Grant had to say about deflation to be interesting. He said, “in a time of wondrous advances in productive technique such as uber or amazon… shouldn’t the cost of production decline and cost of buying decline?” Why do central bankers see this as deflation and not progress? To me, in support of free markets, that looks like progress. Take Uber for example. We no longer need the production of taxi cars because of the use of personal cars and the cost of the service is less (depending on the driver). This is allowing people to save their money and, if the taxi service was obliterated, there would be less government spending/regulation. Again, how can that be deflation?

  5. While I did not expect the fed to increase it’s interest rates, I’m curious to see the consequences of this decision this year. Like you mentioned the Fed should have raised interest rates a long time ago, but they did not. Unfortunately, we are know seeing the consequences of such a choice with uncertainty. I am not well versed in monetary policy, Dr. Haymond, what would be your recommendations for how the Fed should proceed? While many believe we should eliminate the Fed because it would allow the market to determine prices, would this ever be possible? Also, I’ve heard many people talk about the special interest groups that control the fed, could you elaborate on which groups are controlling the fed and ways to eliminate this?

  6. The Federal Reserve continues to be an unrelentingly fascinating enigma. With their continued refusal to raise rates, I cannot help but fear for QE round 4. On another note, I am also shocked by the silence toward the Fed among the Republican candidates in this election. I am espescially confused/disapointed by Rand Paul’s failure to bring this issue to the public. Ron Paul was successful among republicans despite his foreign policy because he talked about issues that typical voters and politicians for that matter were largely unfamiliar with. I wish Rand would follow his father’s example, or even that of Donald Trump in this current election. Regardless of being wrong on the issue, Trump has succeeded early in the election process by owning a controversial issue in immigration and forcing the public to treat it as a real issue. Like he continues to say, nobody would be talking about it had he not brought it up. At this point, Rand is quickly falling behind the pack of demagogic candidates and desperately needs an issue to make his own. He won’t win on foreign policy, so I believe he must begin talking about the Fed in the debates. He has the potential to embarrass the other candidates on this issue and engage the public with an unfamiliar, yet undoubtedly intriguing topic.

  7. I really like Rand Paul’s analogy of the forest fire. In addition to his points, I also believe by not allowing market participants to experience the “small natural fires”, they will not understand the importance of responsibly managing risk. Also, by allowing the market to experience small fire, the number of large fires would decrease.

    I also agree with the point that the Fed needs to get out from under the thumb of Wall Street. To me it feels like the Fed is letting powerful entities such as international financial organizations, Wall Street, and politicians influence their decisions. The best thing the Fed could do for itself would be to put blinders on, lock themselves in a room, and look objectively at the economy to decide what policy is best for the United States moving forward.

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