Why should the Fed Hike Interest Rates?

Why would the Fed hike? Maybe to put their finger in a leaking dike.

Why would the Fed hike? Maybe to put their finger in a leaking dike.

Why should the Fed Hike?

There is much talk that the Federal Reserve is about to raise interest rates. But what is almost never discussed is why the Fed must raise rates, or incite speculation that it will in the first place.

The economy in the U.S. seems to be doing well. Employment is nominally at full strength, jobs are being created every month at a 200,000 level, and though there is still some drag(or precisely because there is some drag) in the economy, there would be no apparent reason for raising rates at all.

Indeed, the IMF, and the Emerging Markets have asked the Fed not to hike, or to postpone hiking. So what would be the motive for continuing this jabber about an imminent rate hike anyway?

There is very little discussion in serious terms about why the Fed should even consider raising rates.

To be sure, the dirty word D__t is certainly one reason, but there is almost no discussion as to why even D__t should be a worry. In fact the word is not even mentioned.

But the reality is that there are a number of real good reasons why the Fed is even thinking about raising rates, even though the Global Economy is almost unanimously against it.

In order of ascending importance, here’s a few possibilities:

One reason is what we have been saying for a long time, which is that as an economy grows larger, and more complex prices do in fact rise. We have elsewhere gone into detail about why this is so, but just as a reminder, it should not be difficult to understand that serving ten people is much more difficult and expensive than having to serve one person.

Even if all you do is sell frankfurters on the street, you will notice that the more the customers the more complex the orders get. There will be the one person who wants her hot dog with the onions and mustard in the bun, and then the
hot dog, with ketchup and relish on top. There is always more difficulty when having to serve more people. There is also a greater cost in preparation for those people. It takes more room, more planning, more outlays to serve more
people. With increased employment there is increased activity for all businesses that are succeeding. And therefore more cost involved, and this cost must in the end be in part passed to the customers.

Therefore the Fed knows full well that there are rising prices, if not in overall CPI , as they claim, then in specific products and services. The higher those prices rise, the more the danger of contraction. Therefore the Fed would like to
control the rising prices before a short circuit happens. By raising the value of the dollar, they keep prices somewhat under control-assuming real purchasing power is also rising with it.

Another reason somewhat related to the one above is that commodities can quickly overcome an overgrown economy. The dollar is reversely correlated to commodities in most cases. Thefore threatening to raise rates means the dollar
is made stronger and therefore commodities are cheaper. An overgrown economy can never afford rising commodity prices, and such a rise would almost instantaneously destroy the progress of the economy.

The same is actually true for all the import products. The U.S. is a net importer and keeping the dollar strong means imported goods are cheaper and therefore less pressure is put on domestic prices, and the less the chance the
bond market will react to higher prices-which event can cause very sudden, possibly catastrophic disturbances.

A third reason is related to these rising prices and it is that the more micro-economic prices rise, the greater the pressure on bonds. No matter how cheap the Fed makes money, if the returns on loans do not cover increased costs of production and living, there will be pressure to raise real market rates in the banking and bond industries. This too can quickly get out of hand in an overgrown economy.

By threatening to raise rates the Fed in effect limits the flow of money to some extent and thereby tempers the rise of bond yields. Why buy a bond if you think it will drop in value? If nothing else it prepares the market for these bond yield
rises in the future. The Fed thereby forces the market to think things out beforehand. Before any actual rise in rates-and at the same time slows the economy gradually. Or so they would intend. But strangely yet another more important reason dominates, which is that the stronger the dollar, or perception thereof, the more likely foreign funds would be attracted. Thus treasuries which would in theory go down in price with a
rate hike, might actually rise due to the attraction of foreign and domestic savings towards a stronger dollar. Thus the fundamental peg of all interest rates, treasuries might actually have a chance of rising in price and dropping in yields therefore putting pressure on rising yields.

This is especially true if the Emerging Markets are deteriorating. All that money has to go somewhere. If the dollar is rising, there is at least some incentive for actually buying treasuries. Though it is true that bond prices may deteriorate, at least the dollar is rising in value and is in theory a safer asset to hold. Therefore the “smart money” or market money might find itself in the land of the rising dollar. And this would bring us to an even more important reason for this rate hike posturing we see from the Fed -confidence in the dollar is confidence
in the economy of the U.S..

Economic “Altitude”

The economy has not gained all that much altitude for all the money loaned out, the amount of money lent out does not really equate all that well with the results we see so far.and the Fed knows this quite well.

Should the economy stall at this altitude, much like an airplane flying only a few  feet above ground, there would be no time to correct before a plunge into the fiery abyss. With interest rates at absolutely minimum there is no possibility for
any further Quantitative Easing. The dollar was for many years too weak to recover from any further easing and thus catastrophe was only a few feet away.

By threatening to raise interest rates the dollar would gain some altitude and if in the event it became necessary to lower rates further through further Quantitative Easing, there would at least be some room for the dollar to drop in value possibly avoiding an absolute disaster.

The rate hike posturing cushions the the dollar itself against any possible sudden depreciation which is one of the two ultimate economic disaster scenarios possible and often much discussed. Any loss in confidence in the
dollar, would spell absolute disaster for all the world. Yet, continued QE with mounting d__t would begin to bring some doubt as to the viability of the system as a whole. Unless the dollar was still percieved as strong enough to sustain another round of QE in the event it was needed.

Synergistic Depreciation

A very simple truth is often misunderstood: you can engage in monetary easing for so long as your underlying currency has sufficient internal energy. When that energy becomes insufficient then you can no longer engage in easing.

This energy is often gauged in terms of inflation, but it can take many forms. Roughly when the system starts to lag, and sputter, you will have a “qualitative” indication that the currency is weakening in real terms.

This currency inherent weakening can begin within the national economy, or without. That is to say should Japan’s currency weaken for example, it will begin to draw some energy out of the U.S. currency and no matter what day
traders may do at their FX desks.Japan would start to sell U.S. securities for the purpose of stabilizing her own currency, and the oscillation downwards would begin. Both nations, therefore will be forced to tighten.

You would have the impression that Japan’s currency is perhaps losing and the US currency is gaining, but that’s really because they are falling at different rates. But they are both falling.

Therefore, the Fed is jabbering about a rate hike only because it has to. At this altitude of zero interest, a depreciation of the dollar would bring an almost certain apocalypse. And this depreciation can be caused by forces within, or
without the national economy. China, Japan, Europe, Asia, or Latin America can at any time begin the devaluation of our own currency. I’m sure the Fed knows this.

The Last Reason

There is lastly the most important reason why Janet Yellen and the Fed would
consider, and broadcast an interest impending rate hike at these economic
levels and its this: the economy is actually overgrown! Its so big that it cant
gain enough buoyancy to rise, and this is becoming painfully clear.

It is very unlikely that Janet Yellen and her colleagues have not noticed that after
years of Quantitative Easing, and years of Zero interest the economy is still not booming! Its still struggling and you can look in just about any direction to see that. Whether its in Europe, or Japan, or China, or even the United States, all
of these the world’s largest economies, all of these with massive d__t loads
and yet their economies are struggling, even seizing. That could not have been
missed by all these “master” economists no matter how aloof they may be.

The system is faltering, it really has not worked as intended, and its still fraught with severe risks. This can mean only one thing: the time has come for a draw down! The time has come for the central banks, and the central governments
to start hedging their bets. They cannot go on because as we have said above, there is a very real danger that the whole thing comes crashing down in an apocalyptic manner, and the more “inflated” the economy gets, the greater
that danger. They have to take stock now before its too late, and that means
starting to slow the expansion one way or other. That is, Quantitative Tightening
must begin or else.

There will be those who argue that the U.S. economy is doing great no matter what is said. But the reality is that an employment bubble does not accomplish much for long, and even if your bar tender doesn’t charge you interest on your bar tab, sooner or later, you are either going to cut down your drinking, or you’re going to have to pay that bar tab. If you have savings, that might not be a problem, but if you don’t, you will have to look for another bar and that may be very boring-possibly even depressing. Now what are the odds that a rate hike will work? Very low. The world’s
economy is now so overgrown that even a small rate hike is going to cause tremendous instabilities. And a house of cards really does not need instability.

What are the odds that the Fed will ease? Frankly near Zero. An attempt at easing now would pretty much destroy the world’s economy as prices would rise astronomically and instantaneously, and currency depreciation would ravage almost all economies.

What are the odds the Fed will hike, and “normalize” interest rates?

Whatever hikes there are going to be in the future are only meant for gaining a little altitude, and a little buoyancy, and a little confidence. Lighten the load as much as possible(throw out a few seats, and a lot of luggage.) But long term
tightening is not possible now and will not be probable for many years to come. If any tightening does occur, it will be natural and unavoidable as economies around the world try to save themselves. In the final analysis this is
an economic “every man for himself” mentality that is emerging here; as we have made clear in a recent post, this is probably a “natural” eventual outcome of violent economic expansions.

Thefore we can say that the Fed may be stuck in neutral for a while. Either way, the Fed’s options are very limited. Should disaster happen in the
meantime the choices are stark.

Either the Fed would choose to let the economy contract violently and save the dollar and other currencies around the world. Or it can choose to save the economy and in the process risk destroying the dollar and see possibly an
even worse disaster unfold where currencies are worth next to nothing, and still suffer a violent contraction in the end. Either way it would not be pretty.

As a footnote we should say that the attempted solutions to these vast economic problems have been little more than trying to put your finger in a
leaking dike. The problem is that if you put your finger in one hole, another will burst somewhere else. And if the water pressure keeps rising, the levy will break eventually and a flood will drown the town.

In the end the Federal Reserve system really is flawed, and in reality was actually conceived for nothing more than the purpose of preventing disasters, and economic anomalies. Now it seems this same system is going to be a leading protagonist in the event of a massive economic meltdown.

China’s recent actions

It should be said that China’s actions these last days are not really indicative of an imminent collapse. The Chinese are probably just trying to save their economy for now and don’t really see this as an emergency of the highest order- we should say probably not.

However, if commodities should begin to rise sharply, and should Japan begin to sell treasuries at a clip, there would in these acts be a very strong indication that there are expectations of impending doom. These would most likely be the
chief signs that the economic asteroid is about to “reach out and touch someone” or everyone..and cover should be taken. Though currency
devaluations may be good in moderation, sudden devaluations can be catastrophic, and though a nation like Japan may be well insulated against
foreign investment and so capital flight might not be a real danger, a drop in trade numbers might trigger emergency measures, similar, but possibly more severe than those seen in China. Japan has few resources, and is heavily dependent on trade.