The Peril of the US Federal Reserve’s ‘tightening’

Yesterday we discussed the view of the markets from the perspective of Austrian economics, quoting from Austrian heavyweight Ludwig von Mises. He reckons that there’s no escape from a credit expansion driven by the deliberate suppression of interest rates below their ‘natural rate’.

What does that mean? We’ll explain it, and why the idea is so important for long term investors.

But before we do, yesterday’s final quote left out a vital segment (our apologies). Here it is again, in full, with the missing bit in bold. 

‘The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.’

We’ll explain why that bit is so important in a moment (hint: the US Federal Reserve meets tomorrow). But first, let’s go back to the natural rate of interest. This is essentially the market rate of interest that seeks to balance out the needs of savers and investors.

Here’s how it works. High levels of REAL savings flow into the banking system and push down the market rate. This is simply a form of excess supply pushing down the cost of money (the interest rate). When real savings are scarce, the natural rate of interest will rise…a case of low supply pushing up the cost.

Savings represent deferred consumption, so high savings and a low interest rate encourage capital investment to take advantage of higher expected future consumption. And when interest rates are low it discourages savings and encourages consumption. This means investment will be lower because entrepreneurs are not expecting a big increase in future consumption.

Thus the natural rate of interest constantly changes to balance out the needs of savers and investors.

But the real world doesn’t work like that because central banks around the world have taken the natural rate of interest out the back and beaten it senseless.

For example, after the tech boom turned to bust in the early 2000s the US Federal Reserve lowered interest rates to 1%, well below the natural rate. This set off a housing and general credit boom which the Fed then tried to gain control of by increasing rates, or as Mises would have put it, by voluntarily abandoning further credit expansion.

It began raising rates in 2004 and continued doing so in 2005 and 2006. In doing so it popped the credit bubble and brought about a collapse that had its origins in 2007 and picked up force in 2008.

Fast forward to today, and now the US Federal Reserve has elected to abandon further credit expansion again. They began tapering their QE policy in December, cutting their monthly debt monetisation program by US$10 billion. They did so again in January and March, and are expected to announce another US$10 billion reduction in the next few days.

This is monetary tightening. You’re already starting to see the effects of it in the most speculative parts of the US stock market. The NASDAQ index, for example, is starting to look vulnerable:

COMQ Nasdaq Composite INDX
click to enlarge

Emerging markets are feeling the greatest effects of the US Federal Reserve’s nascent tightening. Speculative capital is now starting to migrate back to the US, putting emerging market credit systems under great pressure. Capital is seeking refuge in US large caps, which is why the S&P500 is at record highs.

The question is, at what point does this round of tightening set off another collapse, and can the Feds resort to another round of inflation to prop the system up again?

No one knows the answer to that question. But we do know that very few are actually thinking about it, and even fewer are prepared for its inevitability.


Greg Canavan+
for The Markets and Money Australia

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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