Download now: How To Invest in the Coming Bitcoin Boom

Fed Parties Like it's 1929

Written by Geoffrey Pike
Posted June 19, 2015

The Federal Open Market Committee (FOMC) wrapped up its June meeting on Wednesday, followed by a Janet Yellen press conference.

As expected, the FOMC did not raise the federal funds rate that has been near zero since late 2008.

It was originally speculated that the Fed would raise rates in the June meeting, but that expectation went away quickly over the last several months with less-than-stellar economic growth. The first quarter GDP came in negative, and the Fed does not seem to be worried about price inflation.

The Fed has actually had a tight monetary policy since last October, when it finished up its latest and biggest round of quantitative easing.

The federal funds rate — which is the overnight borrowing rate for banks — was always important in the past because it dictated the Fed’s buying and selling of assets (monetary inflation or monetary deflation). But since the fall of 2008, the Fed’s balance sheet has been seemingly independent from the federal funds rate.

The banks have built up massive excess reserves, so they have little need for overnight borrowing to meet reserve requirements. Therefore, the Fed can buy or sell assets, and it has little effect on the federal funds rate.

Aside from selling trillions of dollars in assets — which it isn’t going to do — the only option the Fed has to raise the federal funds rate is to pay a higher percentage on bank reserves. In other words, the banks will get more money for keeping their reserves parked with the Fed. (Bank bailout, anyone?)

So at this point, this is really what all of the fuss is about. It is a question of when the Fed is going to pay a higher interest rate (currently 0.25%) to the banks.

With that said, there is a lot of concern in the market about what will happen when the Fed finally does raise this rate and how it will affect the economy.

The Ghost of 1937 or 1929?

There are recent articles talking about the “ghost of 1937,” a reference to the Great Depression. In the mid-1930s, the economy appeared to be improving a little, and the Fed started tightening in 1936. In 1937, the economy sunk back down into depression, and the stock market went back down another 50% or so.

Some people worry this will happen again with our economy today. Some think the Fed should just keep rates low, since price inflation is low anyway.

Others are concerned the Fed is worried about this situation and therefore delaying. In other words, the Fed doesn’t want to be blamed for a bad economy if it raises rates too fast and too soon.

Regardless of whether raising the federal funds rate is actually the cause, there will be critics who blame the Fed if we see a recession or a stock market downturn after the Fed finally does raise its target rate.

Of course, we live in a different time now than during the Great Depression. There are no food lines, but maybe that is because all of the food stamp recipients just get their electronic debit card in the mail. Is there an app for food stamps?

In the early years of the Great Depression, there was no FDIC, and bank runs became common. This was a major reason for the price deflation. Unfortunately, it has led to a lot of bad economics, with people believing that any sort of price deflation is bad for the economy. But it is a confusion of cause and effect.

In addition, we are far less likely to get bank runs today because of the FDIC. The bank runs of today happen when other institutions refuse to roll over their loans to others (think Lehman Brothers in 2008).

The Great Depression went on and on because of central banking and government interference. There was a massive increase in government spending, including the New Deal.

The government also attempted to keep wages high (started by Hoover), which did not let the market clear. This kept unemployment high.

History almost never repeats exactly. Sometimes there are similarities. Interestingly, I believe we can learn a better lesson from 1929 than 1937 for our current situation.

The Fed had a loose monetary policy in the latter part of the 1920s, even though the U.S. was still on something of a quasi-gold standard. This led to speculative asset bubbles, particularly in stocks. The interesting part is that price inflation was low.

In other words, people weren’t worried about a loose monetary policy because consumer prices were not rising quickly. But they did not consider asset prices.

This should be a reminder for us today that you don’t have to see high consumer price inflation in order to have bubbles and dislocations in the economy. When the Fed creates money out of thin air and it manipulates interest rates, it distorts the economy. It causes resources to be misallocated into places away from actual consumer demand. False signals lead to bad investments.

Join our newsletter for FREE!

Plus receive our new free report, Predicting the VIX Moves

 E-mail Address:  

We never spam! View our Privacy Policy  

Wealth Daily Members Receive:

  • Daily commentary and advice from financial market experts.
  • Access to some of the best gold, silver, and option stock picks around.
  • Foresight designed to help you stay on top of the market.

After getting your report, you’ll begin receiving the Wealth Daily e-Letter, delivered to your inbox daily.

Different Perspectives

If the economy does not fall apart before the end of the year, then a Fed rate hike looks inevitable. It will have been seven years. Whether or not market interest rates follow suit, we will have to see.

But what will happen if the economy does go into a major downturn after the Fed hikes the federal funds rate? Or what if the stock market crashes by 50%?

All of the Keynesians will immediately be saying the Fed needs to lower rates back down to near zero and start the monetary printing presses again. They will also be claiming that the reason for the economic downturn was because the Fed was too “hawkish” and should not have been so “quick” to raise rates (seven years after the fact).

But there is a different perspective in all of this. What if a correction is already baked in the cake?

The Fed is good at blowing up bubbles, whether it is in stocks, oil, real estate, bonds, or anything else that easy money will pour into. But it always ends the same way: The bubbles eventually burst — some worse than others.

The Fed has quintupled the adjusted monetary base since late 2008. This is unprecedented in the Fed’s 100-year history. Fortunately, the banks piled up this money into reserves and did not lend most of it out, or else we would have seen high consumer price inflation to go along with it.

But all of this newly created money has had its effects. It misallocates resources. We have already seen the oil boom go bust. Stocks are near all-time nominal highs, and it is not justified based on economic growth (or lack thereof). At some point, we should expect a correction. It is just a question of when and how much.

Finding Safety

If you invested in stocks in the spring of 2009 and held until now, you have done really well. But these things don’t last forever.

Even with low interest rates, the Fed is technically in a tightening mode. It stopped QE3 late last year. It has stabilized the money supply.

When someone is addicted to something and you take that something away, there tends to be a crash. It doesn’t matter if it is drugs, sugar, or easy money.

I recommend that stock investors be very cautious at this time. There is nothing wrong with cashing out a portion of your stock holdings and going to cash until a better time presents itself. You can still hold your favorite stocks that you think are going to do well. It’s just that some diversification into other assets — particularly cash or cash equivalents — seems to be a wise strategy at this time.

If we do see a major correction in stocks, it won’t be because of the Fed raising interest rates; it will be because of past Fed policies that blew up the bubble in the first place.

When we do see a downturn, there will be calls for the Fed to start another round of QE (money creation). If the Fed goes this route again, then it will be time to get out of cash again. It will also be time to buy more gold.

Until next time,

Geoffrey Pike for Wealth Daily

Comments

Buffett's Envy: 50% Annual Returns, Guaranteed