The Fed Delays Again

The Federal Open Market Committee (FOMC) met this week and announced on Wednesday that it would keep its target interest rate in a range between 0.25% and 0.5%.

While this lack of change was widely expected, the Fed is backing off its pace of raising the federal funds rate. The market is now expecting the Fed to raise its key rate just twice in 2016 instead of four times as previously expected.

This is due to lower-than-expected inflation and a slight decrease in projected growth. Or at least, that is what the Fed is saying. It probably also has something to do with the major scare in stocks at the beginning of 2016.

Based on the announcement and Janet Yellen’s press conference on Wednesday afternoon, stocks and commodities surged upward.

This whole saga is quickly becoming a repeat of 2015. It really started in 2014 when analysts began talking about rate hikes and what impact it would have on the economy and investors.

The market kept anticipating a rate hike throughout 2015, and every time it was another excuse on why the Fed should wait one more time. It finally happened in December 2015, when the Fed raised the range of its key rate by one-quarter of a percent.

It achieved this rate hike by paying banks a higher interest rate on their reserves. The Fed is paying the banks not to lend. It did not achieve this small rate hike by selling off assets.

Despite the Fed’s small hike in the federal funds rate, market interest rates have not gone up. In fact, longer-term yields have actually dropped since that time, as investors have a greater fear of an economic slowdown.

So it looks as though 2016 will start out with a similar story from the Fed, mainly that it wants to wait and see before hiking rates. We have quickly gone from expectations of four rate hikes down to two. If we have another downturn in stocks, is it inconceivable that all rate hikes for 2016 may be off the table by the Fed’s next official meeting?

Praying for Inflation

The Fed has a dual mandate of low unemployment and 2% inflation, or at least that is its stated mandate. Its actual dual mandate is to act as a backstop for the big banks and to help Congress fund deficits when needed.

But let’s get back to this 2% inflation mandate. Why 2% inflation? Why not 1% or 3%?

There really is no magic to that number. The Fed doesn’t want price inflation to go too high, or else it makes the masses restless. It is easier to lay the blame on the Fed when prices are rising quite noticeably.

But the Fed doesn’t want zero price inflation, either. It is made up of central planners. After all, that is what the Fed is supposed to do — centrally plan the economy by controlling the money supply and interest rates.

Central planners do not want zero price inflation. They believe we need positive inflation so that people will be encouraged to spend their money. Still, it is rather hard to believe that 2% price inflation will get people into spending mode when near-zero interest rates haven’t done the trick.

This idea that we need positive price inflation is a great economic myth, and it is one that does great damage to our economy and our living standards. There is nothing wrong with consumer spending, as it is a reward for previous production. But people do not need to be encouraged to spend. If they want to save some money, it is probably needed.

In fact, savings and investment are what ultimately lead to greater production and increased living standards. Saving money is beneficial for the individuals doing it. It is a sign of future orientation by delaying consumption. It is also beneficial for the economy in the long run.

There is this constant fear of price deflation because of its association with the Great Depression. But the early 1930s was a completely different world. There actually was monetary inflation by the Fed, but the overall picture was deflationary because of bank runs and a reversal of the fractional reserve lending process.

It is also important not to confuse cause and effect. When economic times are tough, people do tend to spend less money. The velocity of money falls and prices tend to fall. But it is the tough times that are leading to less consumer spending. It is not less consumer spending that is leading to tough times.

If the government and the Fed would allow these price adjustments to occur, we would see a new base of savings form and a reallocation of resources in line with consumer demand. This would set the stage for real productivity gains and better living conditions.

Politics at the Fed

Some people claim that the Fed is a private bank disguised as a public institution. If anything, it is probably the other way around. The Fed’s very existence depends on the government for its monopoly powers. The Federal Reserve Act of 1913 is what set up the Fed. We should also consider that the Fed chair is appointed by the president and approved by the Senate.

It is hard to say what the first priority of the Fed is. Unless Congress is threatening to revoke the Federal Reserve Act of 1913, the Fed will generally take care of the banks first and Congress second.

There is no question that the Fed is politically driven to some extent, but Fed officials are looking out for themselves, too.

There will be some accusations that the Fed will have an accommodative policy until the election in November. The biggest threat to Hillary Clinton right now — besides a possible indictment by the FBI — is a major economic downturn. If Janet Yellen wants to be re-nominated as Fed chair, her hopes would have to lie with Hillary Clinton at this point. She is probably not depending on being re-nominated by Donald Trump or whoever is on the Republican side.

Still, history shows that the Fed does not necessarily side with the sitting president. Bernanke had a tight policy until the fall of 2008, right before the election.

Perhaps the biggest case of a Fed chair turning on the president who appointed him was Paul Volcker. Jimmy Carter put Volcker in as Fed chair in 1979. Volcker slammed on the monetary brakes and let interest rates go sky high. It led to multiple recessions in the early 1980s, but the economy was already in the toilet during the 1980 election.

Volcker’s actions were correct. It was probably the last time a good cleansing of bad investment was allowed to happen. It set the stage for new prosperity, despite the short-term pain. It also contributed to Carter losing the election.

We don’t know if politics is going through Yellen’s head. But she is probably not calling all of the shots anyway. We also have to consider that the Fed ended QE3 in October 2014. So despite the low interest rates, the Fed has actually been in tight-money mode for well over a year now.

Investing in Chaos

Based on the previous easy monetary policy and the massive debts run up by Congress, I’m not really sure who would want to be president. There are a lot of promises that have been made by past politicians. Some of these promises will have to be broken at some point. I wouldn’t want to be the person to break the bad news to the American public that the Treasury is running out of money.

Janet Yellen may be a central planner, but she can’t be completely dumb. She may have an idea that the fiscal situation is not exactly sound right now. Maybe she wouldn’t care if Trump gets elected and she can ride off into the sunset and leave all of the problems for the next Fed chair. Then again, it is hard to give up power for most people.

With all of the built-up debt and unfunded liabilities, we are going to see trillion-dollar deficits again whenever the next recession hits. Congress will expect the Fed to help fund this deficit.

As long as price inflation remains relatively low, at least according to the government’s own statistics, then the Fed will likely accommodate Congress.

This means we should expect another round of quantitative easing (digital money printing) when any significant economic trouble hits. It doesn’t matter what the Fed does with interest rates at that point.

This is why commodities should be a part of your portfolio. This should include gold, silver, and even oil. These are hard assets that are likely to go up as the Fed seeks to inflate away our problems.

If the Fed can’t even hike its key rate above a half percent after talking about it for over a year, then it isn’t going to take much on the downside to get the Fed to start printing money again.

Until next time,

Geoffrey Pike for Wealth Daily