Why US interest rates are really falling
You don’t often get a laugh out of central bankers, but last night’s Federal Reserve statement was a cracker.
Fed chief Ben Bernanke said he was a bit worried about inflation.
Pull the other one, Ben. The only part of the Fed that’s actually remotely worried about inflation is the single member of the ten-strong rate-setting committee who actually voted for a rate hike last night.
Because the truth is that by leaving rates on hold last night, the Fed actually cut them…
Interest rates in the US stayed on hold last night at 2%, which won’t come as a surprise to anyone. Because no doubt about it, the US economy is in trouble. House prices are plummeting (and remember, the vast majority of Americans have never ever actually seen their nominal house price fall before), unemployment is rising, and a recession is already here or on the way. Traditionally, that argues for lower interest rates to boost lending, and thus increase demand.
But as Warren Buffett puts it, there’s also the problem that “inflation is really picking up. Whether it’s steel or oil, we see it everyplace.” Official headline US inflation is at 4.2%. That argues for higher interest rates, to cut lending, and thus cut demand.
This is a tough choice for anyone. But the good thing is we don’t need to worry about what Mr Bernanke should do. We just need to worry about what he will actually do. And it’s pretty clear that Mr Bernanke has no appetite for raising interest rates. His view on the Depression is that it was largely caused by central bankers raising rates too early, and it’s the Depression that looms largest in the US psyche as the economic catastrophe to avoid.
Incidentally, this ‘group memory’ actually goes a long way to explaining the differing approaches of the US and European central banks. The US remembers the Depression; Germany (which basically defines ECB policy) remembers hyperinflation, which is why the ECB likes to at least talk a lot tougher on interest rates.
Anyway, Mr Bernanke’s focus is on growth at any cost. But the good news for Mr Bernanke is he doesn’t have to do anything as obvious as cut interest rates.
Rising inflation does the job for him. Interest rates are already negative – in other words, people are being penalised for holding onto their money. Mr Bernanke can pretend he’s fretting about inflation, when in fact, by just keeping rates on hold, he is allowing real rates to keep falling.
A good dose of inflation is just what the US consumer needs in fact. Debts are fixed. So if you owe a lot of money, inflation is great news. The higher it goes, the more worthless your debt becomes. That’s tough on your lenders of course, but then they agreed to lend you the money in the first place.
Sounds like a good solution to all of America’s problems. Unfortunately, it becomes a little harder to maintain at a country-wide level. It’s not just US consumers who owe a lot of money – it’s the US as a whole. And if the foreigners who own piles of US currency decide that they don’t want this depreciating paper anymore, then the dollar will run into even more trouble.
That day is edging closer. Inflation might be bad in the West, but it’s absolutely rampant in emerging markets. Vietnam has recently withdrawn licenses for further gold imports, after the country became the world’s largest gold importer, as its citizens rapidly lose faith in the dong, the Vietnamese currency.
The problem for the Vietnamese is that they pegged their currency to the dollar. As the dollar fell, so did the dong. That drives up the price of imports, especially the raw materials that low-cost manufacturers like Vietnam depend on.
And while the US is in a slump, and so inflation is to an extent hidden by the lack of wage growth, Vietnam was already red hot. Inflation is up to an official rate of more than 20% a year.
Is there a solution? Yes, but not a painless one. Emerging markets will have to wean themselves off the dollar. That will happen in time, and for every country that does so, the dollar will lose that bit more of its status as the world’s reserve currency.
In the meantime, Vietnam offers a lesson for all investors. When inflation comes knocking, your gold holdings aren’t safe. The US confiscated gold in 1933. Vietnam is interfering with the market now. How high would inflation have to get in this country before we saw something similar?
I don’t know. But maybe it’s worth buying some now, while it’s still legal.
Turning to the wider markets…
Falling oil prices and better news for financials buoyed the FTSE 100, which gained 31 points to 5,666 by the end of the session. Barclays was one major gainer as investors were reassured by plans to prop up its balance sheet with money from overseas investors.
Over in Europe, Germany’s Dax Xetra index climbed 81 points to close at 6,617, while the French Cac 40 gained 62 points to end at 4,536.
US stocks were little changed, despite an early triple-digit rally on the Fed’s interest rate decision. The Dow Jones Industrial Average was up just 4 points at 11,811. The wider S&P 500 rose 7 points to 1,321, while the tech-heavy Nasdaq Composite climbed 32 points to 2,401.
The Japanese market ended a little lower as falling oil prices hit commodities-trading stocks. The Nikkei 225 slipped 7 points to close at 13,822.
Brent spot was trading this morning at $133.48, while in New York, crude traded at $134.07. Spot gold was at $889. Silver was trading at $16.81 and Platinum was at $2,031.
In the forex markets this morning, sterling was trading against the US dollar at 1.9776 and against the euro at 1.2619. The dollar was trading at 0.6383 against the euro and 107.91 against the Japanese yen.
And this morning, DSG, owner of Dixons, has met lowered City forecasts for the year to May 3rd. Profit before tax and one-off items fell by 30% to £205.3m. Including restructuring and other exceptional charges, the group made a pre-tax loss of £192.8m. “The economic backdrop continues to be difficult and the group remains very cautious about consumer confidence in many of the markets in which it operates,” DSG added.