inflation interface

A Very Bad Idea

Increasing interest rates in the United States would be a very bad idea , but that is exactly what most financial market participants expect the Fed to do some time later this year. Traditionally, the Fed uses interest rates to manage the economy. When the economy is weak, the Fed lowers rates to give it a boost; and when the economy is too strong, it increases interest rates to prevent inflation. Higher interest rates prevent inflation by causing the economy to slow down. Here’s how it works. Higher interest rates:

  • Reduce borrowing and consumer spending (which makes up 70% of GDP).
  • Reduce home sales, home building & refinancing.
  • Cause home prices (and probably stock prices) to fall, causing a negative wealth effect that reduces spending.
  • Strengthen the dollar, causing US exports to fall.
  • Reduce business investment.

All of the above:

  • Cause unemployment to rise; and
  • Cause wages to fall.

The Underemployment Rate, which measures those unemployed and those working part-time because they can’t find full time jobs, is now 11.3% of the US workforce. Median income in the United States is at the same level as it was in 1989. The Consumer Price Inflation Index (CPI) actually fell by 0.2% in January compared with one year earlier, meaning the country is experiencing deflation, rather than inflation. This you can see in the following chart.

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Why in the world, then, would the Fed increase interest rates at a time like this? It is exactly the lack of wage growth that has been dragging the middle class ever closer to the poverty line for decades. A rate hike is not only unnecssay, it would also be cruel. I don’t believe the Fed will do it. I think they just want the markets to believe that they will.

In my view, the Fed does not want to increase interest rates any time soon because it is afraid that higher rates would cause the stock market, the property market and the economy to weaken, which is true. But, it wants the market to believe that it is getting closer to hiking rates so that the stock market won't keep inflating too rapidly and turn into a bubble.

The global economy is very weak. The unimpressive US recovery has been built on Quantitative Easing pushing up household sector net worth (through higher stock prices and property prices). If the Fed does increase interest rates, it would cause stocks, property and net worth to fall. And that would cause a new recession.

The Fed wants the world to believe that the US economy really is getting stronger fundamentally, but the Fed itself is not actually so sure that it is. The economic data last week was all pretty disappointing. Fourth quarter GPD was revised down from 2.6% growth to 2.2%. That put full year GDP growth at 2.4%, which is not much to brag about considering the Fed created half a trillion dollars and pumped it into the financial markets last year. Existing and new home sales remained depressed. Initial jobless claims jumped back above 300,000. The Chicago PMI, a measure of manufacturing strength in the mid-West, came in lower and much below expectations. And, the CPI data showing deflation was released. This hardly paints a picture of an economy rapidly overheating!

In Congressional testimony a few days ago, Fed Chair Janet Yellen, stated that the Fed would not raise interest rates until it is confident that inflation will move back to its 2% target over the medium term. That doesn’t exactly seem to be just around the corner to me, especially given the plunge in oil prices over the past six months. I still believe the Fed is more likely to launch QE 4 than to hike interest rates. If I’m right, those betting on higher interest rates are going to lose a great deal of money.

I’ve made a number of Macro Watch videos explaining what the Fed does, why it does it and what it’s likely to do next. If you have not yet subscribed to Macro Watch, join here:

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