The accuracy of the US Federal Reserve’s position with respect to interest rates is becoming more convincing. The Fed has just announced an end to its bond buying program (which at its peak saw the purchase of $85 billion worth of bonds each month), but the Fed still appears a long way from reining in interest rates.
Despite the Fed’s recent chatter about apparent timelines with respect to interest rate rises, it’s possible remain skeptical as to the Fed’s genuine commitment to take action on interest rates. The Fed says it will continue to support the US economy by leaving US interest rates at record low levels.
The Fed over the past 12 months has tried to talk tough with respect to interest rates. It says it recognises the dangers of keeping rates too low for too long. It also points to economic growth in the US as clear evidence that its ‘easy money’ policies are working.
For these reasons the Fed says it’s putting in place clear timelines for eventual rate increases. But whilst the Fed is prepared to talk the talk, it hasn’t been prepared to walk the walk. Rate rises appear to be in a perpetual state of deferral.
Perhaps what it underlines is the apparent fragility of the US economic recovery – something the Fed won’t directly admit for fear of spooking markets.
The Dow Jones at record levels does not necessarily reflect a robust economy. What it does reflect is a sharemarket bubble that’s been pumped full of Fed-administered hot air. The same can be said of the property bubble that exists in the US right now.
The Fed knows however that it cannot actually raise interest rates anytime soon because of the potentially disastrous economic consequences that such a move could create.
Fed action (or a lack of it)
For several years now there have been calls for Fed action on interest rates. For example during February 2012, President and CEO of the Federal Reserve Bank of St. Louis, James Bullard, argued “the Federal Reserve should start raising interest rates next year.” At the time he disagreed with the Fed’s decision during January 2012 to keep interest rates exceptionally low through to late 2014 to bolster the US economy.
As Bullard argued back in 2012, many years of near-zero rates risks causing “disaster.” Keeping rates low for several quarters is very different from keeping them there for years, which punishes savers.
Charles Schwab took the argument further, arguing back in 2012 that rock-bottom interest rates were destroying confidence in the economy and were unwisely forcing older savers to take risks with their money in search of decent investment returns. This greater risk-taking has manifested itself in the form of US share and property bubbles, incentivized by the zero-interest rate environment and the Fed’s easy money policies.
In the US, older savers’ and pensioners’ incomes have been squeezed by falling rates leaving them poorer. Savings rates have lagged behind inflation, reducing real incomes, eroding the real value of savings and lowering consumer confidence.
The Fed’s easy money policies have distorted market prices, encouraged destabilizing financial speculation, as well as unfairly punishing savers. But the far bigger concern lies in the future: the economy and financial markets have become so dependent on QE and artificially-suppressed interest rates that it will be very difficult for the Fed to reverse these policies without major repercussions.
The danger is that they won’t be reversed in time – resulting in a different (but equally serious) set of potential consequences. The Fed has a well established tendency to not recognize the effects of its loose monetary policy, nor to tighten, until it’s far too late.
On top of having many unintended negative consequences, ultra-low rates may also be ineffective in addressing the real economic issues. The continuation of low rates points to a worrying lack of growth and also highlights the increasing risk of deflation and a potential contraction in economic activity.
As Stanley Yeo, portfolio manager at IOOF commented recently, “Given that growth and inflation are among the primary requirements for a relatively painless reduction in elevated debt levels globally, the enthusiasm with low rates and quantitative easing among investors is curious.”
“The clear hope is that low rates will revive the economy. The theory predicts lowering rates will boost bank lending and increase access to credit for purchases of homes or other goods and services, ensuring economic recovery. However, the reality is quite different. In Australia, Reserve Bank research indicates that the savings from lower mortgage rates are simply being used to retire debt, rather than for consumption. While the reduction in debt levels is necessary, lowering rates will, of itself, do little to boost demand and economic activity,” he says.
Another problem that low rates might provoke is to tempt borrowers into ignoring their balance-sheet problems. The result could be that the problems are left to fester, making it difficult for central banks to raise interest rates to a more normal level in future years, for fear of the damage this might cause.
Banks might also become too optimistic about the ability of borrowers to repay, and fail to make adequate provisions for bad debts. When investments are made during a period of artificially low interest rates they are often ‘malinvestments’ as the low rates may send false signals to entrepreneurs and home buyers that the economy is good and investments/purchases should be made.
The term ‘malinvestment’ is a concept developed by the Austrian School of economic thought that refers to investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply, often blamed on a central bank.
The unprecedented moves by central banks which were necessary to stabilise markets have had the desired effect of stabilising the financial system in the short-term. The big picture issue involves the unintended consequences of these ultra-low rates.
Large amounts of existing and borrowed capital have flowed into the stock and real estate markets chasing assets that are rising in price, not necessarily based on fundamentals but on the notion that they are rising and the potential returns are greater than low interest-bearing investments.
A golden opportunity?
Thisultimately brings us to gold. Yet again, sections of the media have been in a frenzy suggesting that gold has lost its safe haven status. The reactionary herd punished gold in the aftermath of the Fed’s September commentary, but the price is showing resilience.
Last year the gold price crashed once it became clear that the US Federal Reserve was looking to cut back on its Quantitative Easing (QE) program, on fears that it was QE that had been supporting the gold price. What had been forgotten was that the gold price had advanced strongly prior to the term QE even being coined, but the market – with its ultra short-term viewpoint – seemed to have assumed that QE and the gold price were inextricably linked, thus marking the yellow metal down.
This chart is fantastic because it demonstrates that despite perceptions of gold being an arcane relic, it has outperformed the Dow Jones Index since 2008 and the NASDAQ Index since 2005. In fact, only with the Dow at its current all-time high has it managed to recently surpass gold.
And to all the doubters that believe a rising US interest rate environment is bad for gold, in fact the opposite is true. The real driver of gold prices is negative real interest rates (defined by nominal interest rates minus inflation).
Central bank policies of inducing negative real rates to ‘incentivize’ borrowing, expand the money supply and devalue currencies – have forced investors (especially mums and dads) into real assets like gold and silver. Debt is inherently inflationary if you have the ability to print your own currency.
Gold of course rose along with interest rates during the 1970?s and this is sufficient to prove that gold doesn’t always fall when interest rates rise. The gold bull market of the 1970s was dominated by inflation – interest rates rose steadily to keep up with it, but real interest rates were mostly negative the entire time.
It’s possible to remain positive on gold and remain confident that the flow of gold from West to East will continue. China and India continue to be major buyers, but over recent times they have been joined by the Russian central bank. In fact the latest figures show that the country’s central bank purchased another 37.33 tonnes of gold during September, bringing its gold holdings to almost 1,150 tonnes – the seventh month in a row it has increased its gold reserves. It was also its biggest monthly increase overall.