Surprise, surprise. Just as the market starts to look a little shaky, in comes the Fed with its reassuring rhetoric. Overnight, the US Federal Reserve concluded a two day interest rate meeting. Clearly, it used most of those two days to discuss how the market would respond to the language they used, rather than what was going on in the real economy.
After two days of central bank blabbering, here’s what they came up with…
The assorted PhDs removed the reference to keeping interest rates low for a ‘considerable time’ and replaced it with the need to be ‘patient’.
What does that mean?
I have no idea, so I turned to Fed watcher John Hilsennrath of the Wall Street Journal for enlightenment…
‘For weeks before the policy meeting, officials debated whether and how to drop an assurance that rates would stay near zero for a “considerable time.” That statement has been an important marker that officials have laid out for months to convince the public rates that aren’t going to rise soon or quickly.
‘Some officials worried that dropping that assurance would jar markets and inadvertently lead some investors to believe the Fed was moving toward rate increases sooner than planned. Rather than drop the much-watched “considerable time” assurance altogether, the Fed introduced the phrase about being patient and said it meant effectively the same thing.’
Right then — so weeks of deliberation results in a word swap that essentially means the same thing? It’s good to know these sharpshooters are in charge of an economic system that is much more fragile than people think. Heaven help us all when the next crisis hits.
Actually, it’s brewing right now, and the surging US dollar is an unlikely symptom of the problems the global financial system is facing.
The greenback surged again overnight. The Fed obviously did enough to convince the markets that, while they would no longer take ‘considerable time’ to raise interest rates and would remain ‘patient’ instead, it still means that interest rates will eventually go up.
But there’s more to this delightful central banking game than just playing verbiage. Consider this, from Mr Hilsenrath again:
‘Yet there are several wild cards that could alter the Fed’s course [to raise interest rates]. The most obvious is the path of inflation. Tumbling oil prices are pushing down consumer price inflation. The Labor Department reported Wednesday, hours before the Fed statement was released, that consumer prices dropped 0.3% in November from a month earlier, the largest one month drop since the 2008 financial crisis rocked the global economy.’
What do you think… are falling oil prices good or bad for an economy? There are winners and losers of course, but in heavy oil consuming societies like the US, lower prices are undoubtedly good for the household sector, and consumption accounts for around 70% of economic growth in the US.
So, falling oil prices are a form of stimulus for the household sector. It puts more discretionary income in their pockets and therefore boosts their spending power.
But is it stimulus in the eyes of the Federal Reserve? No, because their textbooks say that lower oil prices are deflationary…and deflation is bad. Let me try and join the dots for you.
‘Deflating’ oil prices means the narrowly defined measure of inflation, the ‘consumer price index’ falls, which means in real terms interest rates rise. (That’s because real interest rates = nominal rates minus inflation).
The Fed sees rising real rates as bad for the economy, even though the driver of the rise in real rates is the falling oil price, which is actually a stimulus.
Are you confused? Well, it’s meant to be confusing.
The point is that in a modern economy there are about a gazillion variables that go into making up prices. Unfortunately, academics and Fed officials (who are mostly academics) have a tendency to want to shove all this information into nice little models they use to fine tune things to get the desired result.
They can try to do it…but it will never work. Not consistently, anyway. The unintended consequences of the Fed’s past actions haven’t hit the US yet. But they are currently wreaking havoc with emerging market economies.
Who would have thought trillions of dollars of Fed QE over a period of six years would have ended in a US dollar bull market? Not many, that’s for sure. Such is the nature of unintended consequences. Stuff happens that you previously would have considered insane.
China is currently experiencing something similar. Having gone through a huge credit boom, its economy is slowing and officials are trying to manage the slowdown. Recently they reduced interest rates to try and take pressure off heavily indebted companies who got carried away during the boom.
But in China, which contains a large portion of savings (their credit boom was largely internally funded…as opposed to, say, the US housing boom, where foreign capital financed the boom) interest rate cuts aren’t quite as effective.
That’s because while they relieve pressure on debtors (China’s corporate sector), they take away from savers (China’s household sector). In China, the whole aim of recent reforms is to encourage household consumption at the expense of fixed asset investment.
How do you think this rebalancing will go if interest rates cuts reduce savers’ income and discourage consumption? Not particularly well. But if the central bank doesn’t cut enough, you could see increased bankruptcies which will effectively wipe some savings out…a potentially worse result.
This is just one reason why China’s rebalancing task is so difficult and why over the next few years, economic growth will be much lower than most people currently expect.
The bottom line is, when you fiddle with a price signal as important as an interest rate, things are going to happen that you can’t control. And if you do it for long enough, bad things will happen.
The problem we have is that the people doing the fiddling have such a huge level of intellectual arrogance that they will never view it this way. The problems they create are just another problem for them to solve.
And around and around we go…
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