A Fed Rate Hike Won't Solve the Current Crisis

Money is already tight in virtually all areas. Trying to combat inflation by raising interest rates would only further tighten the money supply. Of course, the Fed can supply money in other ways, but that would not compensate for the contraction due to interest rate increases. The economy is on the verge of collapse. The huge oil price run up is reminiscent of the run up in the early 1970s that led to the last really bad recession. If the Fed could find a way to decrease the price of oil, the market might recover even with increasing interest rates.

I don't believe the Fed can do this. The price of oil may temporarily go down a little with lagging demand due to higher prices. However, the factors driving the oil price increase are too strong to go away. This means that the Fed has to do everything it can to stimulate the economy. This means in the short term it should not increase interest rates.

Inflation can actually act in your favor. In this case, inflation as seen in the weaker US dollar has led to increased US exports (because our goods are now cheaper internationally). This has not balanced the trade deficit. Still it has kept us from noticing how much the oil trade deficit has grown. In effect it has kept us out of a major recession so far. Low interest rates, which allow inflation, are also helping the banking industry. With the interest rates low (for banks), the banks can make a bigger profit on their outstanding loans. Specifically the interest rates banks give for home loans rarely sink below about 5.5%. If the banks borrow that money at 2%, they are making more money than if they borrow it at 3%. It is also easier on the homeowners to pay at 5.5% versus 6.5% or 7.5 %. Both need every cent at the moment.

Further inflation is actually helping the housing crisis, without hurting homeowners or banks too drastically. Their equity in dollar terms is staying the same if prices stop going down. They are of course losing money in "real" dollar terms, but this money doesn't have to be accounted as losses. You could look at this as perhaps the least painful rebalancing process. Inflation is making homes more affordable at their current prices. Ditto the low interest rates. This brings more buyers into the market. This causes the house prices to stop eroding (or even go up). This is again good for anyone who wants to sell or has to sell their house. The fact that these people can sell instead of default is good for the banks and the homeowners involved. Inflation (with low interest rates) is not a bad thing at the moment. It is much preferable to having everything crash down around our ears. Fortunately we are a food rich country, so the food price increases have not been nearly as bad as they would otherwise have been.

The biggest US problem at the moment is the trade deficit. We have been running negative for far too long. The other countries of the world are now realizing that the US is simply not as stable or as much of an economic leader as it was. They are likely not going to easily tolerate the US borrowing ways much longer. Further you are perpetually seeing US assets being sold to companies from other countries. We are the debtor!!! We need to change this.

With regard to exports, having a weaker dollar actually helps. It just hurts us on imports. We need to import less. We are not as rich as we once were when everyone had to buy the latest technology from the US. Now we invent, but China copies it in a year or two. Or sometimes other countries are the original leaders. The biggest factor in the trade deficit currently is oil. We need to use less of it. We definitely need to import less of it. We need to move to alternative energies, which are not imported. We need to produce more of our own oil. The total trade deficit so far this year is running at about a $720B/yr clip. The trade deficit for oil alone may be over $500B this year. I think you can see why this should be the highest economic priority for the US.

People who are advocating higher interest rates at this time are actually advocating stagflation. We have already had high inflation in place for a number of years. The dollar has been in steady decline for some time. In 2002 the Euro was only worth about $.85. Recently the Euro has been valued at about $1.57. If this is not inflation, nothing is. The Fed has kept interest rates low through much of this time. They are lying to you if they are trying to say we have not had high inflation all of this time. You are lying to yourselves if you think we have not had high inflation during this time. The Fed governors know this, or at least most of them seem to. The economy needs interest rates low in order to stimulate growth, which is anemic at best at the moment. We are the people with the overblown egos that the other countries are starting to laugh at. We need to grow economically to change that. Higher interest rates will kill growth.

If you want to control inflation, buy fewer imports. Use less oil. You should back incentives for the US companies to produce more oil. You should back incentives for the US to move to alternative energies.

I take exception to T. Boone Pickens statements about natural gas being an area the US should look at to replace oil. The natural gas market is already tight. Trying to use it for cars would no doubt make Mr. Pickens richer as the prices for it would certainly skyrocket. It might be a little cleaner. However, it would not be a long term solution to the US energy problem, or specifically to the US oil importation problem. We would just end up being short of natural gas, which would lead to importation of that commodity. Solar, wind, uranium, etc. are all parts of the solution. They are also all more environmentally friendly (less polluting in terms of green house gases). Offshore drilling is a part of the solution. Increased oil production by US oil companies is an important part of the solution. They must be US companies to subtract from the trade deficit the millions of barrels of oil per day imported by the US.

Windfall taxes on the oil companies are only likely to keep the oil companies from producing more oil. They will have less money to explore, if they pay it in taxes. They will be discouraged from trying to make bigger profits. Instead the "use it or lose it" proposal for oil leases as presented in Congress may have some validity as a spur to development. A tax break for oil exploration and production increases by US companies might be helpful. I think "increase in production (especially by US oil companies)" is the key concept.

The trade deficit (especially the oil trade deficit) is the exact reverse of the stimulus package. If you believe the stimulus package helped most Americans, you must see that a trade deficit, which has been running about $60B per month, is hurting the economy by many times the stimulus package's help. This money is flowing out of the economy. We need the money we pay for oil to flow back into the US economy to further stimulate other aspects of the US economy. This has to happen for the US economy to prosper. We cannot do this in a day. We cannot do this in a year. We can however start on the process now.

Every dollar that we don't pay out to other countries economies will recirculate to re-stimulate the US economy. If we could trim $180B from the trade deficit by this time next year, that would have the effect of the stimulus package, without further inflationary borrowing by the government. If we could do the same in the following year, the US economy might really start to shine. I think you get the idea. I am not suggesting that we can trim exactly $180B from the US oil trade deficit in the next year. In some ways you cannot even look at the results in dollar terms. You have to look at them in total barrels of oil imported and possibly in percentage terms of imported oil with respect to the total oil use by the US.

T. Boone Pickens is definitely right that this problem is a critical one to US economic health. Please do not confuse this "real" problem with a trumped up "inflation" problem, which is not new at all. In fact going by the Euro valuation versus the dollar, the US has had 10%+ inflation per year since 2002. If we had had high interest rates all of that time (as many people seem to be saying we now need "in order to fight inflation"), the US economy would likely be in a very deep recession right now. Mr. Bernanke seems to understand this.

Some other people are calling for a strong dollar (via higher interest rates) thinking this will solve the oil importation crisis. It will not. The main factor driving the price of oil up is the increased demand by the quickly growing economies in the world (the BRIC countries especially). A temporarily strong dollar propped up by interest rate increases may be a political expedient and a temporary curb to higher oil prices. It is not a solution though. Instead we need a strong dollar propped up by a strong economy.

The path to this is generally thought to be through low interest rates. The complication is the oil problem. This needs to be addressed as expeditiously as possible, but not by the Fed. The Congress probably has to take the lead on this. It has to take action to stimulate US oil exploration and production increases. It has to take action to curb US oil use. It has to take action to encourage the quick adoption of alternative energies. State governments can lead also.

Disclosure: None

Comments

[Brian in Mo...:]

I don't agree that the dollar is moving oil, heggies maybe, however the FED can talk about raising interest all they want. Up here in Canada the banks seem to have more control, we didn't drop interest rates much, and mortages still went up. Maybe the U.S. banks like that idea. Let's raise rates and raise mortage rates even more, since they can now borrow for less than the price of inflation, (like drunks at an open bar so to speak).

By the way, comments on POT being cut were very interesting over on David Fry's Market outlook.

2008 Jul 24 08:50 AM

[Charlie Str...:]

Brian in Montreal, according to Bloomberg, the price of oil has moved inversely to the U.S. dollar 90% of the time over the past year.

Natural gas for the U.S. transportation fleet could last an estimated 20-30 years until we are ready for a new replacement technology.

Disclosure: Canada freakin rules because I have been long Canadian equities since the start of the Iraq War.

2008 Jul 24 09:02 AM

[redbaron:]

I agree, and would also add this. If the US had not of exported all our jobs to the BRIC countries, they would not be using all this oil, and this problem would be much easier to manage. I can't see how we can put the genie back in the bottle however, and the emerging countries are going to continue to emerge, i.e., use more oil.

The people trying to manage this problem with financial manipulations, may well fail. What then?

I think T. Boone Pickens has it exactly correct, as the recent natural gas discoveries in this country are enough to supply his proposals and bridge us to the next fuel, hydrogen.

2008 Jul 24 09:03 AM

[MarvinMBA:]

This author is right on...its domestic energy that will give a boost to M1 and start the economy moving again. This administration is wasting a lot of time. Call your representative and write the White House and tell them to get going with comprehensive DOMESTIC energy legislation...MarvinMB...

2008 Jul 24 10:16 AM

[Marshall Sohne:]

I hope that talk of raising interest rates by the fed by some of the fed governors is just a head fake.The economy is superleveraged as well as our government therefore us being deeply in debt. Our financial system our banks are contracting their balance sheets creating a deflating effect on various assets and industries. Presently we must recognize that the increase in the price of energy is causing a restructuring of society and business. We must for the forseeable future plan our strategies around higher energy prices. We have to use less import less which will require us to restructure how we think and live. Life will still be good. It seems like our government has been a little slow at coming up with the strategies I think the people of this country are waiting for thier leaders to lead. I think its time for the people to work their own strategies. We dont need a lot of the junk we buy to be happy. We dont need to import our way to bankruptcy. Weve got so much going for us in this great country of ours. We got food, we got clean water we got a beautiful land technoloy we got universities we got a diverse population living with a bill of rights and a constitution. We as a people can figure this one out. I think we need to show what we can do as consumers of imports lets cut back on our uses of hydrocarbons. Im sure we will eventually have electric cars. Our motor companies have to get on board before they go bankrupt enough with huge suvs that get minimum mpgs. They should assume gas will get more expensive and people here will become more frugal. They also have to have strategies or they will be bankrupt. Hoping that the price of oil will go back down to 30 a barrel is not a strategy. We must plan for the future. We have to look at ways to reduce our imports. If that means more people living in the cities and less suburban sprawl so be it. It if means more bicycles and less suvs so be it. If it means less materialism and more spiritualism. I think we can still be happy. I think the author is right we have inflation the government knows this because they help it along by printing the money. I think the government strategy is to slowly inflate its way out of this deflation bubble and thereby rescue the banks our economy and homeowners is a reasonable strategy certainly not perfect. Raising interest rates during this type of economic contraction will accelerate the liquidation phase and cause a lot of pain if we can avoid this with a measure of inflation and some leadership so we can restructure our economy we might get luckly. When I hear our government officials blaming this on the speculators either they dont have a clue or they as politicians prefer avoiding their responsibilites by scapegoatting the "evil speculators"

2008 Jul 24 11:05 AM

[kashirin:]

the article has the right idea - less import but solutions is wrong
low interest rates is a disaster

consumer must stop consuming to improve trade balance and this can be achieved or through dollar devaluation or through higher interest rates
both ways include deep recession
higher interest rates are healthier long term for the economy
but as US government doesn't want - dollar devaluation will happen

2008 Jul 24 11:05 AM

[mcadoo3312:]

T. Boone Pickens has emerged as the sole bi-partisan leader in 2008. Of course he has his own monetary interests in the outcome, but wouldn't you invest in a mutual fund in which the manager has millions of his own cash invested in it?

2008 Jul 24 11:06 AM

[Jason Rines...:]

Pickens is correct, but his hypocricy by going on national T.V. and saying he has changed when a few short months he was pumping oil irks me. But any good investor will go towards the money. If he helps change some minds in Washington, all the better. Dmitri is also correct. The Fed will raise rates creating a further inverted yield spread deepens the recession. If banks were lending that would be a different matter but they are shoring balance sheets. How does lowering the short-term rate from here help the 70% of the U.S. economy which is consumers? It doesn't. More firesales will happen and more private equity investors here in the States and abroad will gobble it up.

2008 Jul 24 11:46 AM

[Jason Rines...:]

Meant to put comma, but point is raise rates now lower because if lower, then increases inverted yield.

2008 Jul 24 11:48 AM

[Obama is Bu...:]

You are overlooking that many of the problems we face today are the direct result of interest rates being lowered too much for too long...

The argument for lowering rates is to stimulate the economy-- but you can't fix overleverage with more leverage

Meanwhile, interest rates that are markedly below the rise in the cost of living (not necessarily the textbook definition of inflation) means that you are taking money away from savers (aka the elderly and others on fixed incomes) and diverting that money to stupid bankers who shot themselves in the foot.

Punishing the prudent to reward the foolish is no way to fix anything

2008 Jul 24 06:09 PM

[Kunst:]

We always talk about the Fed and interest rates, but there is another tool that is far more effective: fiscal policy, i.e., tax rates.

A 1% income tax surcharge (about $28 billion) both dampens economic activity [maybe we should have done this a few years ago] and reduces the federal deficit, a KEY cause of the weak dollar. Likewise, when times are difficult, a 1% tax decrease puts more money into the economy right away. Tax changes, unlike interest rates, directly affect the average American and start working immediately.

While the Bush tax cuts might have made sense during the early-2000's economic downturn, they should have been reversed as the economy improved and then overheated. Then we could be cutting taxes now, much better than lowering interest rates. You can't have it both ways, stimulating the economy when it is hot and when it is cold.

For those who think taxes are always bad, how about we just cut them to zero and borrow the entire Federal budget? That OK with you?

2008 Jul 24 06:30 PM

[Joseph Cull...:]

Since we could not find a vehicle registered for T. Boone Pickens, the oil man on television, see what vehicle his wife drives

webofdeception.com/#pi...

2008 Jul 24 07:31 PM

[Jimmy Lathrop:]

I started reading this article until I got to the point where the author started speaking about how low rates and inflation stimulate home buying. I then checked the Fed Fund rate and saw that banks are borrowing for 2 percent and lending it out to prime rate customers at 6.74 percent - higher if your credit, income and teeth are not spotless. You would think that a bank could live on those kinds of spreads but they are not passing them along to the homebuyer, they are just hoarding and speculating. At that point the rest of the article degenerated into a discourse of T. Boone Pickens' wit and wisdom. Its sort of like calling up the fellow who won last weeks Mega Millions and asking him what he would do to save the economy. And this article is an editor's pick? Shame.

2008 Jul 24 08:43 PM

[truthisbest:]

Inflation is good??? This is insanity.

Inflation would effectively reduce fixed rate debt in real terms and similarly reduce savings in real terms.

This is tantamount to transfering money from savers to those that have demonstrated fiscal irresponsibility. It's wealth redistribution at its worst...thievery plain and simple. Shame on you for even suggesting the idea.

2008 Jul 24 11:10 PM

[E.D.Hart:]

I have to agree that inflation is what destroys wealth. Few benefit, most suffer, especially the poor and the struggling middle class. The wealthy are usually adept at avoiding the worst inflation better than the rest.

There are benefits to everything, including cancer and war. But that doesn't make them desirable or something we would hope for.

2008 Jul 24 11:41 PM

[John Lounsbury:]

I have to disagree with David White's opinion that inflation makes homes more affordable. That can happen under certain conditions with wage inflation; that is not the inflation we see right now and is not likely in America because we are still the highest paid workforce on the planet. Global competition will keep the lid on our wages.

Energy is the largest economic problem we face. It could also be our largest economic opportunity. I try to discuss this in the latest posting on my website.

2008 Jul 25 09:44 AM

[Austrian Sc...:]

This is an article that says you can help a drunk by keeping him in booze. You know, if you try to make him stop drinking he's likely to get very sick, so do the right thing and keep him drunk.

I agree with the previous poster in that inflation doesn't have to be in the form of higher wages. It could be that its just making everybody poorer (the money you have buys less of the things you need to live).

Low interest rates below what the level of savings would have naturally dictated is like taking human growth hormone. You can only get certain amoutn fo healthy growth, beyond that the HGH just creates tumors and other cancers. We've gotten to the point where the tumors have been able to buy enough influence in congress that they can keep the flow of HGH coming. Also, many people can no longer tell the difference between what is tumor and the original organism. So when the tumor shrinks they exclaim "our growth is stagnating, protect the growth"

Author lacks any sense of economic justice, all about how to keep a messed up system teetering along. I've venture to guess he doesn't know what a healthy system is supposed to look like, and just knows what he's experienced in his lifetime.

2008 Jul 25 11:39 AM

[flow5:]

The only way the US will curb the trade deficit is to sell higher quality, and lower cost, goods & services (like Hondas). GM, Ford, et al, have a long way to go.

2008 Jul 25 02:33 PM

[CaptBob:]

If inflation is beneficial Zimbabwe should be a garden spot of prosperity, in the midst of a housing boom, instead of starving to death.
It's a shame the citizens of same are 90% illiterate and can't read this article.

If D. White had done his homework and read--(or listened) to T.B. Pick's plan he would not have criticized it for using nat gas when it is "tight"--he would have noticed the nat gas being used for auto fuel was FIRST being freed up by using wind generation to produce electricity.

The Pick is a known success story/quantity who puts his -ample-money where his mouth is, and I'll listen to him any day over a Politician who puts his mouth where my money was.

I've learned more from Sponge Bob than jimmy Carter,--30 years ago--showing us how to deal with energy shortages! and every politician since--in whose capable hands--we left the problem.

2008 Jul 25 03:51 PM

[Pete Murphy:]

Your identification of the trade deficit as the root cause of our ills is right on. But you are wrong to believe that the falling dollar will have any significant impact. Yes, "exports" are up, due to the soaring price of grain but also due to the soaring price of oil, driving up the value of U.S. oil exports. (Yes, the U.S. does export some oil.) Our trade deficit in manufactured goods is as bad as ever. The demise of U.S. manufacturing has actually accelerated as the dollar has declined.

Rather, the trade deficit is due to granting free access to our healthy market to grossly overpopulated nations who are unable to offer access to equivalent markets in return. Their markets are emaciated by over-crowding and low per capita consumption.

A falling dollar won't help. Foreign exporters won't stand idly by and watch their share of the U.S. market evaporate just because their profits are down. They'll aggressively cut costs (and "dump" if they have to) to sustain and even grow their market share.

Pete Murphy
Author, "Five Short Blasts"

2008 Jul 27 10:14 AM