Global Economic Outlook: Why Is The Fed Raising Interest Rates?

Journalist:
November 25, 2015

Market expectations of a December Fed rates hike are running high (at the time of writing the US Dollar Index had just breached 100 points). The question about why there is a need for higher interest rates is missing from the market and media discourse, so today’s Global Economic Outlook considers the reasons for this central bank action.

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Economic Indicators

World Indexes and Forex Rates

Commodities

In the Calendar This Week

Mon 23 November
US Fed Announcement

Tue 24 November
US Prelim GDP q/q (actual:2.0% previous:1.5%)
US Consumer Confidence (actual:99.3 previous:97.6)

Wed 25 November
US Unemployment Claims (actual: 260k expected:273k previous:271k)

Thu 26 November
Japan Household Spending y/y (expected:0.0% previous:-0.4%)
Japan Core CPI y/y (expected:-0.1% previous:-0.1%)

Fri 27 November
UK Second Estimate GDP q/q (expected:0.5% previous:0.5%)
Europe ECB Financial Stability Review

Making The News

The most significant economic announcement of 2015 is barely three weeks away. If you’re in finance this must be so exciting – but why, exactly, is the Fed raising interest rates?

Why Rates Fluctuate

The market-wide expectation is that the Fed will enact, on December 16, a 25 basis points interest rate increase, from 0.1% to 0.35%.

Market Discovery

Interest rates had, from a historical perspective, always been market led. In this traditional model, market participants influence prevailing interest rates according to their buying and selling – at their preferred rate of interest – in the bond market (lending to government); and also in their decisions to lend to or borrow from banks or other institutions. Hence, in a “normal economy” interest rates are continually “discovered” by the market. The process, in a simplistic model, works as follows:

The Business Cycle

During periods of economic growth, interest rates gradually increase as the demand for loans increases. The loans specifically being referred to are “productive loans” – those used to finance business start-up or expansion; to purchase or develop real estate, etc. In other words, loans that add value to the economy and pay themselves back in the process.

As the business cycle matures, the prevailing high rates of interest (i.e. expensive credit) result in fewer loans being taken and, as a result, less business development and, therefore, less consumption. Expansion slowly transforms into contraction: production slows down and at the tail-end of the business cycle there is typically an economic and social recession. The characteristics are high-interest rates, stagnant businesses, high unemployment and “low velocity” of money, meaning, a little money circulating slowly through the system.

The only way for bondholders (i.e. lenders to government) to convert their debt certificates into much-needed cash is to sell them at lower rates of interest, and similarly, banks can only extend productive loans by dropping the rate of interest they charge, and so make their loans more attractive (or affordable). As the economy bottoms out businesses take up the cheaper loans, begin creating more jobs and, in time, consumption and “velocity of money” increases. Increasing economic activity incentivizes banks and the bond market to respond by offering more loans at attractive (lower) interest rates.

As interest rates “normalize”, the business cycle starts again: production speeds up, employment increases, etc. So, larger economic cycles and rhythms lead the collective of all investors, businesses, consumers and banks to determine, through their interaction, the suitable rate of interest for their economy’s stage in the business cycle.

It is not being proposed that interest rates lead the Business Cycle but, rather, that interest rates are a barometer of the stage of the cycle.

Control The Banks, Control The Rates

Central banking, since the early 20th century, has proposed that interest rate manipulation offers the ability to shortcut the business cycle. Specifically, the unwanted contraction and recession part.

When contraction becomes evident, why wait for it to run its tedious course? Simply lower prevailing interest rates and kick-start a brand new business cycle! Combine that with monetary stimulus (money printing) via the central banks’ control of national currencies, and conjured credit can be dished out cheaply (at low interest) to the banks for the purpose of extending the loans that fund business activity, investment, and consumer spending.

The Fed’s reaction to the 2008 credit crisis was exactly as described above: Rather than let the financial market’s crash play out as a full recession, they slammed interest rates to zero (ZIRP) and started printing money/credit (QE).

Consequences? What Consequences?

In the open market, nothing worth anything is free, of course. For every financial transaction there is an accounting double-entry – whether acknowledged or not. The penalty, or economic karma, of monetary stimulus and artificially imposed 0% interest, is that the conjured “cheap” credit will eventually evaporate in the uncompromising light of day. Another analogy is that “cheap” credit is like heroine: its effect inevitably wears off and prolonged use requires larger doses. If the supply dries up, the junkie must endure painful “cold turkey”.

“Normalization”

In the context of the Business Cycle, the Fed must now “normalize” the prevailing rate of interest from their artificially imposed zero percent.

In pre- central bank economies, the low (but rarely zero) interest rates that naturally accompanied the start of a new business cycle went hand-in-hand with a societal tendency toward socio-economic rejuvenation and expansion.

Businesses and innovators respond to the prior recession with creativity and increased activity; their projects and endeavors require workers, so they create jobs; people feel motivated toward greater productivity; national and regional optimism generates opportunities for business and the feedback loop results in objective economic growth.

Glum Social Mood

In most world economies, today, there is none of the optimism or psychological impetus to expansion described above. The cheap credit and zero percent interest failed to generate economic recovery, higher employment rates or increased consumer spending. Acknowledging the law of diminishing returns, the Fed figures: if more zero percent credit won’t do it, then manipulate the interest rate. Push it to what it should be during the next phase of the business cycle: not of a recovering economy but of a growing economy. Turn the dial.

Yet, annoyingly, the Fed knows it must first wean the junkie (global markets) from its seven-year habit. In order to impose a change of direction, the central bank of all central banks must steer the herd into a gradual turn, or else risk chaos.

Appropriately, the Fed’s euphemism for the rehabilitation (or steering) task is “forward guidance“. So, for example, during the thick of the market’s cheap credit binge in June 2013 the Fed hinted (“forward guided”) that they were considering an end to money printing via a “tapering off” period at some time in the future. The market responded by throwing a tantrum: volatility spiked, stocks crashed, and safe-haven gold saw buyers relentlessly pile into a two-month long rally. All of those reactions were fully retraced by the time the market had been gently coaxed, four months later, into accepting the fact that QE couldn’t last forever.

For most of 2015, the Fed has been massaging the market’s stiff neck and denial-knotted collective mind with a new guidance: We might raise interest rates. Actually, we’re not certain… Surely, we should? We’re going to do it – December lift-off!

The Patient’s Coming ‘Round

With the idea now cemented in the market’s psyche, acceptance is becoming evident:

  • a US dollar chart that is rearing for a rally
  • bond yields are pushing higher
  • and (the bottom line) the tribe’s finance capital is increasing via an advancing stockmarket

The Cuckoo’s Nest

However, let’s not confuse the Fed’s burden of rehabilitating the junkie with the real accrued cost of ZIRP and QE. The audacity of assuming control of macro-economic forces and then manipulating them – on a global scale – is not an undertaking devoid of ethics or accountability.

The Fed, and any other central bank or centralized entity, does not – cannot – control the economy of an interconnected world market. There are too many forces at play, too many contingencies of supply-and-demand, and underlying it all: human psychology that is sometimes rational, sometimes irrational and prone to control, but also defiance.

Collective Psychology

If we agree, for a minute, that the Business Cycle has its own rhythm, and that it is comprised of a collective psychology that seeks to discover price and value, then the absurdity of centralized manipulation of this all-too-human cycle becomes apparent.

It makes sense that, where a people’s collective psychology has become rejuvenated and motivated to action, their collective economic effort causes interest rates to rise. Yet, to raise interest rates in an effort to emulate the effects of a rejuvenated economy – that does not make sense. Think about it: a happy person tends to smile, so, will pushing up the corners of a person’s mouth tend to make them happy?

In reading a history of major depressions in the US from 1830 on, I was impressed with the following:
Some outside event, such as a major failure, brought the thing to a head, but signs were visible many months, and in some cases years, in advance. None was ever quite like the last, so that the public was always fooled thereby.
– Hamilton Bolton

Strike The Hammer While The Iron Is Hot

How does one estimate or even begin to calculate the consequences of the macro-economic manipulation that has been practiced since World War II? A mountain of four decades of fiat credit expansion cannot be quickly and cheaply off-ramped. Whatever the payback, it has the potential to end the era of the central bank. Not only through the evaporation of trillions of fiat dollars worth of credit (debt), but through loss of credibility (trust) and the subsequent negative sentiment directed at the self-serving banking class when their game is done.

It is a good time to start thinking about what it is that we want in the place of the central bank fiat system: It should be something decentralized that cannot be censored. A value token that cannot be co-opted or controlled by any entity. Or woven into a dystopian government-bank-corporation three-corded rope around the peoples’ neck.

Whatever we choose as the replacement won’t be a silver bullet for the human condition – there will be more lessons to learn – that is for certain. Yet, as matters stand, our single option is self-evident: an accessible, majority owned block chain is the only practical solution we have in the face of the four-decade fiat credit crisis that is presently coming to a head.

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
– Ludwig von Mises

Also In The News

Goldman Sachs: The Fed Will Raise Rates Four Times in 2016

Business Insider reports that, in a note released over the weekend by Goldman Sachs’ US chief economist Jan Hatzius, he argues that the Fed’s adherence to Taylor Rule estimates will require it to do at least a 100 basis point hike during the course of 2016. That’s one credit contraction per quarter.

There you have it.

Final Thoughts…

This analysis is provided by xbt.social.

Global Economic Outlook is published every Monday on CCN.LA Readers can follow Bitcoin price analysis updates every day on CCN.LA

Disclaimer

The writer trades Bitcoin. Trade and Investment is risky and subject to probability and market changes. CCN.LA accepts no liability for losses incurred as a result of anything written in this report.

Charts from TradingView, financial data & cartoon from Investing.com, images from Shutterstock.

Last modified (UTC): November 25, 2015 21:59

Venzen Khaosan @venzen

Market analyst and Open source developer with a keen interest in blockchain technology, consensus mechanisms and the decentralizing effect. He has found a solution to the PKI mechanism. Email me to discuss.