Cogito Ergo Non Serviam

Fed Should Leave Rates Alone

Central bankers, like old generals, tend to fight the last war. Thus, the chatter around the Fed's Jackson Hole meeting and the up-coming FOMC conclave focuses on increasing interest rates. In the minds of many, the issue is not so much if to raise them but when. The latest GDP revision has come in at 3.7%, while the number of jobs continue to increase. The standard model suggests that inflation is just around the corner, and inflation hawks are urging a pre-emptive strike, raising rates for the first time in a decade. In truth, an increase before the end of the year would probably weaken jobs and GDP while aggravating the real problem, which remains deflation. The key to understanding this is the US dollar.

The effects of an interest rate increase are exactly what the US economy does not need. Higher interest rates reduce investment by making it more expensive to borrow funds. At the same time, they draw more capital into the system because capital holders will receive a greater return. In addition, higher rates increase the value of the nation's currency because foreigners' desire to hold assets denominated in that currency increases due to the higher return possible. None of these is desirable in the US right now.

There is very little difference between an interest rate of zero and of 0.25%. However, when one borrows tens or hundreds of millions, that does start to add up. A rate increase will make big projects, the kind that can get the economy moving in ways that are felt by those outside the top 1%, less financially possible. Moreover, higher rates will eat into disposable income of wage earners that will depress demand for goods and services. This will put downward pressure on prices; that is, it will be deflationary.

At the same time, higher rates will pull in more capital to the US, and since rates are at zero now, that suggests there is a vast, unused pool of capital now. Higher rates will increase that pool, which is already not being utilized effectively (the definition of a zero rate). What the Fed needs to engineer is a decline in unused capital, not an increase.

The final issue is the US dollar. If the US were completely isolated from world trade, the Fed would probably be right to raise rates sooner rather than later. However, the US not only is an integral part of the global trading system, the US dollar is the currency most used in world trade. Higher rates make the dollar stronger, and it is already too strong for its own good. China has just devalued the yuan against the dollar, and the euro has dropped in large part thanks to the Greek drama. A stronger dollar will boost imports and reduce exports, increasing the trade deficit

The trade deficit is hugely important because of the way GDP is calculated. GDP is consumer spending plus business investment plus government outlays minus the deficit. A stronger dollar will increase the deficit which will weigh on GDP growth. While a 3.7% rate of growth is nice, it's not a level at which one needs to hit the brakes in the absence of inflation. And weakening GDP on the strength of a single data point is ridiculous.

The inflation hawks' argument for an increase is a simple one. A little increase now means a bigger increase down the line is unnecessary. However, if that is the wrong thing to do (as this journal believes), a rate hike will undermine the positive cycle that is developing and a cut will become necessary this winter or next spring. The Fed will look like it doesn't know what it is doing, and it won't know. It's credibility will be destroyed, and that is something no central bank can afford.

Keep the powder dry, and wait for real inflation to emerge. Economics knows how to fight that; deflation remains a mystery.

© Copyright 2015 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Ubuntu Linux.



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