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What the Fed Doesn't Know CAN Hurt You

The Fed Can't See the Future

Written by Geoffrey Pike
Posted May 29, 2015

The Federal Reserve continues to make headlines in the financial media. The big talk is still about interest rates and when the Fed will raise them.

We have to be clear that the Fed can’t directly raise interest rates. It can raise the federal funds rate, but even that is not so easy these days.

The federal funds rate is the overnight borrowing rate for banks. But since the big commercial banks are sitting atop a pile of excess reserves, they have no need for overnight borrowing because they already easily meet the reserve requirements.

Unless the Fed is going to sell off trillions of dollars in assets, it is not going to be able to raise the federal funds rate with its traditional method of selling assets. The only choice it has left is to raise the interest paid on bank reserves.

The Fed has been paying 0.25% interest on bank reserves for over six years now. If it raises this amount, it means it will cut into the Fed’s “profits.” It also means more unofficial bailout money for the banks.

The Fed collects interest on the assets it owns (the ones it owns from previously creating money out of thin air, but that is another subject). The interest comes from holding U.S. Treasuries and mortgage-backed securities.

Most of the Fed’s assets are U.S. Treasuries. It “earns” interest, which is paid by the Treasury. At the end of the year, the Fed takes the money it has received, less its operating expenses, and sends this “profit” back to the Treasury Department.

So the Fed creates money out of thin air to buy debt from the Treasury Department, which then pays interest to the Fed, which then returns most of this money back to the Treasury at the end of each year. We have all of this confusing accounting just to make it more complicated for the layman to understand.

If the Fed starts paying a higher interest rate on bank reserves, then this will eat into its so-called profits. It means there will be less money to remit back to the Treasury, and this will lead to a bigger budget deficit.

This may or may not lead to rising interest rates elsewhere and higher short-term rates. But with the Fed’s now-tight monetary policy and its threat of raising its key interest rate, it could lead to a downturn in the economy and lower long-term interest rates as people seek safety.

June is Off the Table, But Does it Matter?

The minutes from the FOMC meeting in April were released last week. The minutes indicated that many participants “thought it unlikely that the data available in June would provide sufficient confirmation that the conditions for raising the target range for the federal funds rate had been satisfied, although they generally did not rule out this possibility.”

To translate this from Fed-speak, it means the Fed is highly unlikely to raise the federal funds rate in its next meeting in June.

While everyone obsesses over the Fed raising interest rates, we have to ask ourselves whether it will even matter that much if it even does happen. If the economy continues on the same pace as the first quarter, the talk is going to change from when the Fed will raise rates to when the Fed will restart its quantitative easing (money creation).

We also have to ask ourselves why the Fed is setting interest rates. They call it a “policy tool.” But it is a tool for central planning. Interest rates are a price, like anything else in the marketplace. This just happens to be a particularly important price because it involves money, which makes up at least half of most transactions in our economy.

Interest rates, like any price, send signals to the marketplace. Higher interest rates send a signal for more savings and less borrowing, while lower interest rates give an incentive to save less and borrow more, at least under more normal circumstances.

The problem is that the Fed is distorting interest rates to a certain degree. It sends false signals throughout the economy. You end up with unsustainable bubbles and misallocated resources, including a lack of savings.

There is no reason the market cannot set interest rates. The Fed did not exist prior to 1913 and yet interest rates existed in the economy. Somehow the marketplace managed to function without FOMC meetings and speeches from Fed chairs.

Janet Yellen’s Admission

The release of the FOMC minutes wasn’t the only interesting Fed news last week. Janet Yellen gave a speech in Rhode Island, a place where she probably feels comfortable.

Yellen stated that most members of the FOMC see an approximate growth rate of 2.5% per year over the next couple of years, along with a continuing decrease in unemployment. She also said she expects inflation to move toward their 2% objective.

Then came the good part:

Of course, the outlook for the economy, as always, is highly uncertain. I am describing the outlook that I see as most likely, but based on many years of making economic projections, I can assure you that any specific projection I write down will turn out to be wrong, perhaps markedly so.

This is probably the most honest thing Janet Yellen, or any Fed chair, has ever said. She just admitted that her economic projections are usually wrong.

She is absolutely right, but it makes no sense in this context. She is the head of the Federal Reserve, which claims to know how to manage a $17 trillion economy. She claims to know how high interest rates should be and what the money supply should be. But she also says her projections will probably turn out to be wrong.

If she makes a mistake, then she can just say, “Oh well!” Her mistakes will affect over 300 million people (or more if you count all of the people outside of the U.S. using U.S. dollars). They will lead to massive dislocations in the economy.

But she will just take her best guess and live with it.

Nobody Can Predict the Future

The point here isn’t that Janet Yellen can’t predict the future well. No Fed chairman before her has done it well, either. The issue is that nobody can predict the future with any certainty.

The global economy is made up of billions of people making billions of transactions every single day. Every individual has his or her own goals and ideas on what they want and need. Nobody can successfully plan an economy that is made up of hundreds of millions of people, as in the United States.

The only way for the economy to function properly and according to people’s needs and wants is to let it happen voluntarily. You can’t have a dozen people in a conference room determining what the interest rates should be for 320 million people. They can try, and they can claim to have a successful policy, but the only thing that can happen is a distorted economy because of it.

While I am a critic of the Fed (and central banking in general), I have to pay close attention to what it is doing because its actions drastically affect our economy, our savings, and our investments.

Janet Yellen is right that she can’t predict the future. Nobody can. Nobody can predict what billions of people are going to do. We also can’t predict what the Fed is going to do in response to what everyone else does and vice versa.

All we can do is take educated guesses about what the Fed will do and how people will respond. For this reason, it is always good to diversify, at least to a certain extent, with stocks, bonds, gold, cash, real estate, etc. Since you can’t predict the future with any absolute certainty, you have to protect your wealth.

This means protecting your wealth from Janet Yellen, who now admits that she gets things wrong. Unfortunately, that is not stopping her from making decisions that affect hundreds of millions of people.

Until next time,

Geoffrey Pike for Wealth Daily

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