Since spring, people have been obsessing about whether or not the Federal Reserve will raise interest rates this year. While I don’t think gradually raising rates to 1% over a year or so is a big deal, markets treat it like is monumental.
For the record, I think Janet and The Feds have been looking for cover to raise interest rates all year. With this past week’s very good – not great – employment number, it looks like there will indeed be an interest rate hike this December, albeit small, and maybe, just maybe, accompanied by a small quantitative easing to smooth volatility and support liquidity.
Before I talk more about interest rates and the economy, I want to plug a radio show I did recently that has been syndicated. The show is called Boomers Rock hosted by Tom Matt and this episode is titled The Optimistic Realist. On this show we talk about why pessimism in America is misplaced, how the Millennial’s will drive the economy forward and how to deal with creative destruction.
The Fed’s Motivations
The official mandate of the Federal Reserve includes influencing money and credit conditions in pursuit of full employment and stable prices. Most people view this dual mandate as the core of what the Fed does. While I agree those are things the Fed does, I believe there is much more, including something that does not get mentioned directly, which is to do what it can to keep the dollar the reserve currency of the world.
Being the reserve currency is THE FREE RIDE of the planet. When trade is done in your nation’s currency, it plays a role in the pricing not only of products and services, but of debt. This allows a country to carry more debt than they would otherwise be able to.
Back in September 2009 I discussed the effect that the United States increasing money supply would have. I specifically discussed how the emergence of China would manifest with the Dollar and Yuan eventually sharing space in IMF Special Drawing Rights or SDRs:
“…it is very possible that the U.S. Dollar and Chinese Yuan somehow share reserve currency status in the future.”
We now know that the Yuan is likely to be added to the SDR in 2016. This is vital information in forecasting and understanding the Fed. While employment still suffers from structural issues of lower labor participation – which may or may not be a problem as households making the same amount of money in less work hours should be perceived as good if that can be achieved – and inflation is below target – although when oil and gas prices rise that largely changes – the Fed still seems intent on raising interest rates. Why would this be? Simply put, it is defending the dollar from the chipping away of its reserve currency status that is going to go on for decades.
The United States is entering a new monetary era where competition for reserve currency status will result in Fed monetary policy that protects the strength of the dollar and its purchasing power. With the exception of deeper recessions where monetary stimulus is called for, the Federal Reserve is no longer going to be so generous with policy.
The idea that we have been in a “currency war” that was a race to the bottom is a pedestrian argument made by people who are trying to lead other people down a particular path. Their drones repeat those arguments bringing others into the sphere of influence of an incorrect thesis. The internet has made it easy to repeat something so much that it becomes believed by many.
The ideology driven thesis that the Fed has somehow destroyed the future of the dollar is a myth. Its actions have led directly to the dollar being so pervasive that it has not only added decades to its life as a reserve currency, but made that life stronger.
The coordinated efforts of the central banks, led by the Fed, have in fact fought off the worst years of the deflationary cycle and prevented an outright depression. The main reason we have seen low interest rates and QE globally is that we have been fighting a deflationary demographic wave in 3 of the 4 largest economies – Europe, China and Japan – that has years to go. [Of the four largest economies, only the United States is neutral demographically.]
It is just simply not true that low interest rates and QE are first about stealing growth from competitor nations. It is about preventing aggregate demand from falling off further and smoothing the path to the “new normal” of slower growth forever.
While theorists are postulating a global recession in 2016 – which might be true – will prevent the Fed from raising interest rates, it is not purely on the U.S. to prevent that recession. The Fed raising rates would be seen as a signal that other central banks are now up for fighting deflationary forces and that the Fed is now the last to stimulate rather than the first. That is supportive of a strong dollar which I argue is a primary goal of the Fed now in an era of challenges to the dollar’s reserve currency status.
Ultimately, the Fed’s job is to maintain the standard of living of Americans. Protecting the dollar is paramount to that end. A firm dollar allows for more lucid economic and financial decision making, as well as, the ability to buy goods and services from abroad. It also allows for dollar rich investors to take advantage of any global displacements in asset markets.
To make sure the point is made, it is a mistake to believe that a weak currency is beneficial on net even if it stimulates the export of some widgets. It is far more important to know that the dollar is desired by those outside of America and useful to citizens of America for buying the goods and services of life, as well as, tomorrow’s global growth assets.
Energy’s Important Role in Monetary Policy
Because the U.S. needs imported energy from OPEC half as much as she did 7 years ago, America is now in a perfect position to make rational decisions regarding monetary and fiscal policy. No longer must the U.S. patrol the Middle East on a full-time basis which saves hundreds of billions of dollars and frees up capital for other financial needs. No longer is the U.S. exporting as much money for energy, which in turn is money that gets recycled domestically.
The current low price of oil is one that the Fed has cited as temporarily holding inflation down. When oil and gas become more expensive the Fed will have to fight inflation a bit. That day is not nearly as far off as many believe. Don’t forget that Saudi Arabia has a budget to deal with too. Their pain threshold from here can be measured in months or quarters, but certainly not years. The price of oil and gas will rise soon stimulating inflation.
Keep an eye on Saudi Arabian actions with OPEC. They have an important meeting with OPEC not two weeks before the next Fed meeting. If they should come to a production deal that creates a price band target for oil prices, you might see the Fed raise interest rates in response to expected inflationary pressure. Because I believe the spring meeting is a likely time for an OPEC agreement, raising rates ahead of that, if the Fed has good information, is significant possibility.
I am not certain the Fed will raise rates in December, however, I am convinced it will happen by spring. The simpleton thesis regarding global recession is a false one. While we are certainly still fighting deflationary forces, other nations can stimulate besides the U.S. and have been doing so. Expect more stimulus from the BOJ, ECB and PBoY, and only from the Fed in emergencies or to facilitate rate hikes. Don’t discount a rise in energy prices and don’t discount that those with the most dollars would like to see international asset prices fall a bit.