Sprott Money

 

November 17, 2015

 

Five reasons the Fed can’t raise rates

Markets are currently pricing in a Fed rate hike in December. This has been putting downside pressure on gold prices. However there are at least five major obstacles to US central bank tightening.

 

In recent weeks the US Federal Reserve has been increasingly hinting that is would raise its policy rate at its next meeting, which is scheduled for December. In recent testimony before Congress, Janet Yellen the central bank’s chairman described such a move as a “live possibility.” This of course would be bad for gold, because higher interest rates increase the opportunity cost of holding the yellow metal.

 

However the US central bank’s communications strategy has been sloppy, erratic and contradictory to say the least. That means to get a sense of the Fed might go, it pays to take a closer look at some of the key underlying economic forces. If you do that it quickly becomes clear that there are five key reasons that the Fed is unlikely to raise rights anytime soon.

 

A weak economy

Eight years after the start of the financial crisis and ensuing recession, the US economy struggles to achieve breakout speed. While US job creation surged by 271,000 posts last month, over the past three months that total look less impressive. Furthermore, the quality of the jobs being created is poor and labor force participation remains at near 30 year lows.

 

Inflation numbers continue to run below Fed targets

The Federal Reserve claims that any timing of future moves will be “data dependent,” and one of its key targets has been an inflation rate that runs near 2 two percent over the medium term. However the Fed is nowhere near that target even over the short term. That’s important because inflation targets are at least as important as the more widely-followed employment numbers, to government and central bank planning models.

 

The Fed can’t risk blowing its credibility

The US economy is now in its seventh year of expansion, which means that the odds of it slipping into recession again, increase every year.  If the Fed raises rates in December, it risks accelerating the process, and would quickly find itself needing to reverse course. This would be a huge blow to the central bank’s credibility, which is a key pillar of the fiat money system.

 

US election next year

While the US central bank is nominally independent it is in fact a political body, as former Fed Chairman Alan Greenspan recently acknowledged. Any Fed moves would thus be interpreted in light of the upcoming November 2016 Presidential election. Central banks have traditionally avoided raising rates in an election year. As such December will represent one of Yellen’s last chances to influence events, without appearing blatantly political. As an Obama appointee, she will want a strong economy next year, and that implies she will want to keep interest rates low.

 

A balance sheet wind-down would be a better way to tighten

If the Fed really wanted to tighten up the economy, a better and more consistent way to do so, would be in reverse order to the way it tightened things. For that to occur, the Fed would need to start by unwinding its controversial Quantitative Easing asset purchases, which have bloated the Fed’s balance sheet to nearly $4.5 trillion. This would increase longer-term interest rates first, as opposed to short-term rates, a far more prudent course, as it would steepen the yield curve an increase the incentive to invest for the long-term.

 

Anything could happen

With all of these pressures and data points mitigating against a December rate hike, if the Federal Reserve does act, it will likely be due to developments that are not readily understood by the general public. Possibilities include fragility in the derivatives market, bond fund outflows, which hamper the financing of US debt, or other information which the Fed has access to but does not make public. 

 

Of course that would provide another signal that the Fed needs some real help with its communications strategy.

 

For artwork: please use a picture of Janet Yellen.

 

Peter@peterdiekmeyer.com

 

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