Is a Patient Fed a Good Thing?

Written By Geoffrey Pike

Posted February 27, 2015

Federal Reserve Chair Janet Yellen spent two days on Capitol Hill this week testifying before Congress. While many topics were discussed, the financial media is talking most about her remarks on interest rates.

Yellen cautioned that the word “patient” could be removed in the FOMC’s next statement on monetary policy. But she assured everyone that just because the word “patient” may not appear, it doesn’t mean an increase in interest rates is imminent.

Many have speculated that the Fed will raise interest rates in its June meeting, but Yellen is more open at this point, saying it could happen at any time depending on conditions.

This is what monetary policy has come to… this is what we have in a $17 trillion economy: We are worried about whether the word “patient” will appear and how the Fed chair defines the term.

I believe this whole discussion of interest rates is overrated in the first place. It is important to understand that the Fed only directly controls the overnight borrowing rate for banks — also known as the federal funds rate. This rate has been targeted between zero and a quarter of a percent since late 2008.

The only way the Fed can raise this rate now is by selling off a lot of assets (massive monetary deflation) or by increasing the interest rate paid on bank reserves. We all know the first option is not on the table, as this would quickly crash stocks and the broader economy.

Since the banks have massive excess reserves, the overnight borrowing rate is near zero. The Fed’s increasing or decreasing of the money supply, as measured by the adjusted monetary base, is having no effect on the federal funds rate.

The other interesting thing is that long-term yields have gone down, despite the market’s expectations that the Fed will raise rates later this year. In other words, investors don’t really care what the Fed is saying about interest rates because people keep buying bonds to drive down yields.

A Strong Dollar… For Now

So what does Yellen’s testimony tell us? It tells us the Fed is going to keep a tight monetary stance, at least for now.

It sounds kind of crazy to say this after the Fed has nearly quintupled the monetary base in the last six years. It just finished its latest round of quantitative easing a few months ago, which was the biggest round of money injection in the Fed’s history.

But the U.S. dollar has been strengthening, at least compared to other currencies. But I see this as more of a reflection of how bad the other currencies are. While the Fed is currently tightening, the Bank of Japan is creating new money like crazy. It is unprecedented for a country of its size and economy.

The European Central Bank is also getting set to engage in massive monetary inflation. With that and the weak European economy, the euro is appearing very weak.

You could say the dollar is strong by default. The Swiss franc is holding up well after breaking its ties to the euro, but Switzerland is a very small country by comparison.

Out of the major currencies, the U.S. dollar is the least bad at this point, and it looks like it may stay that way for the near term, especially if the Fed holds firm on its tighter monetary stance.

Effects of a Strong Dollar

This week, Hewlett Packard reported lower revenues and forecasted earnings below what analysts had expected. Its stock price tumbled on the news.

The most interesting aspect of this story was that Hewlett Packard is blaming some of its problems on a strong dollar, since it derives much of its revenue from outside the U.S.

While it is certainly true that some companies suffer more than others with a strong currency (and most will benefit in the long run), it seems that HP is making excuses for its poor performance. It is hard to feel too sorry for a company that makes tens of billions of dollars per year.

If the dollar is such a huge issue for its business, why doesn’t the company buy some insurance in the form of hedging against a strong dollar? It could easily enter the futures or options market and go long on the dollar to protect itself from currency fluctuations. It would be no different from a major airline buying call options on oil so that a spike in oil prices doesn’t increase costs too dramatically.

While I am a huge critic of the Fed and central banking in general, I think HP is stretching it a bit here in blaming the Fed for its problems. Does the company expect another round of quantitative easing just to accommodate its export business?

There are many effects of a stronger currency, and supposedly hurting exporters is just one of many. We must also consider the benefits.

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A Subsidy for Americans

American consumers don’t realize just how much they are subsidized by foreign central banks. The central banks of China and Japan buy up U.S. debt, which actually makes consumer goods cheaper for Americans.

A strong U.S. dollar also benefits the American consumer. We can buy foreign products that are cheaper — and we know Americans buy a lot of foreign consumer goods.

Interestingly, many American companies also buy materials from outside the United States, which can lower their costs. So companies such as HP that rely on foreign customers can see at least some of this loss offset by the cheaper materials used to make their products.

Unfortunately, the reason for the strong dollar right now is just the comparative advantage over other countries that are engaging in monetary inflation and that have weak economies. So just because the dollar is strong relative to other currencies doesn’t mean we can’t have price inflation here.

Investing in Currencies

It is always important to hedge against the currency of your own country. It doesn’t matter where you live or what the current environment looks like — you have to protect yourself against the potential of a depreciating currency, especially when that currency can be created out of thin air on a printing press or a computer screen.

This can present a problem for Americans, because the other currencies aren’t all that attractive.

Since the Swiss franc dropped its artificial peg to the euro, investing in francs looks a lot better than it did a few months ago. The Singapore dollar also seems to be a fairly stable currency in a prosperous country.

The good news is that you really don’t have to invest in any currencies if that is not your cup of tea. You just have to protect yourself against a declining dollar. While the Fed has a tight money policy right now, this could change quickly if the overall economic environment changes.

To protect yourself, you should allocate a certain percentage of your portfolio (at least 25%) to investments in hard assets. This can include oil, gold, silver, real estate, and even collectibles.

Stocks can be considered a hard asset in the sense that you are buying ownership in a company, but conventional stocks should not really be counted for this purpose because you are subjecting yourself to the earnings and profitability of the companies you buy.

Invest in currencies for speculative play. They are investments that you should be prepared to get in and out of quickly.

For a longer-term hedge against the U.S. dollar — and despite its current strength — invest in hard assets.

Until next time,

Geoffrey Pike for Wealth Daily

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