When it Comes to Interest Rates, Economists are Stupid

Stocks had a wild night last night. The Dow was travelling along nicely. Then along came the Fed. Their statement put an interest rate rise back on the agenda. The Dow suddenly tanked 100 points.

But before you could say, ‘sell stocks’, the punters decided it was good news and ramped prices higher. After the dust had settled, the Dow finished up nearly 200 points, or over 1%.

In case you had any doubt about the Fed’s influence on the market, overnight events should dispel that notion. The question is: how long will this ‘interest rate rises are good’ vibe last?

Don’t forget, it was the prospect of rising rates in the US that forced China to devalue its currency. This in turn caused global instability and saw markets fall substantially.

It was this financial market instability that led the Fed to talk about holding off on interest rate rises. Markets loved that and started to rally again.

And this is where it gets really funny. The Fed obviously views calmer financial markets as a reason to put the rate rise back on the table. They don’t seem to consider that calmer financial markets are the result of them taking the rate rise off the table last month!

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Here’s the Financial Review’s take:

The US Federal Reserve’s switch to a more relaxed stance on risks from the global economic ructions has been interpreted by financial markets as the Fed becoming slightly more hawkish and keeping alive the chances of a December rate rise.

The Fed’s communication turnaround is a tacit admission that the central bank, in the midst of global choppiness in China and emerging markets last month, may have got carried away in overstating the dangers to the US from the international turmoil.

The Fed statement on Wednesday said the central bank was simply ‘monitoring’ global economic and financial developments, in contrast to last month when it issued a surprise warning that events abroad may ‘restrain’ the US economy and put extra downward pressure on inflation.

What a global farce. The Fed’s show is a comedy, but the world’s economists think they’re reading a suspenseful drama.

But let’s be clear here. The global instability the Fed was worried about last month was a direct result of the Fed’s intention to raise rates. They took the rate rise off the table and the global instability magically disappeared. Now it’s back on the table, what do you think is going to happen next!

Here’s the money chart. It shows the US dollar index…

Source: StockCharts

As you can see, the US dollar is rallying again as capital flows back into the US on the prospect of higher interest rates.

You might recall that it was the strength of the US dollar that caused major problems for highly indebted emerging nations. If the US dollar goes on to new highs, you’re going to see all those emerging market problems again.

So what effect will this have on Australia? The dollar is the obvious casualty. It fell 1.2% in US trade overnight and is now back down to 71 cents. This is a good thing if you think a lower dollar will save us from a resource investment bust, an overvalued housing market and lack of discernible future growth options — apart from coffee shop growth.

But in reality, a lower dollar simply reflects a relative fall in the value of Aussie dollar assets. That is, our weaker dollar is a reflection of a weaker economy and falling living standards.

You saw evidence of this weakness in yesterday’s inflation data. The ‘core’ inflation measure came in at 2.1%, which is apparently so weak that the odds of an RBA rate cut next week instantly doubled.

Calling for an immediate rate cut is more bank economist insanity. Has anyone stopped to ask what got us into this hole in the first place? Low interest rates! They encouraged the accumulation of massive amounts of debt, and a huge misallocation of capital.

That misallocation of capital is now coming back to bite us through low productivity. That is, we’re not producing enough growth to comfortably service the build-up in debt. A greater and greater proportion of our earnings go towards debt service and repayment.

That means weaker demand, which in turn means downward pressure on inflation.

And what do the geniuses prescribe to get us out of this hole? Why, lower interest rates of course!

It’s stupid policy making and stupid thinking.

By some miracle, the RBA will hopefully resist the urge to follow the advice of Australia’s economists (all employed by the banks, who love lower interest rates) and keep rates on hold next Tuesday.

But I’m not holding my breath. As I said, the odds of a rate cut doubled following the release of the inflation data yesterday. Financial markets are usually pretty good judges of upcoming decisions. The ASX has a ‘RBA rate indicator’ page which tracks the market’s odds of a rate cut or rise. You can follow it here.

As of yesterday, the odds of a cut were 67%, up from 31% the day before. Going against the market is usually futile, but in this case, I’ll bet against the stupidity of the market’s knee jerk reaction. I assume the RBA will keep rates on hold for at least another month.


Greg Canavan
For Markets and Money

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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