The Fallacy Of The Fed's Proposed Rate Raise Policy

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Includes: DIA, IWM, QQQ, SPY
by: David White

Summary

There is no inflation (+0.1% for 12 months) according to the US government.

The US's biggest trading partners are exporting deflation. Their QE and easing programs make their relative Fed Funds rates -3%+. Japan's is -15%+.

The US is already losing jobs to overseas companies. Why make this situation worse?

The "Old Fed" used to decide policy based solely on US needs. Perhaps they considered Europe and Japan a little in making their decisions. However, those days are gone; or they should be. China is now the second largest economy in the world. In 1980 when Volcker was Fed Chairman, the economy of the US in "current US dollars" was about $2.86T; and the economy of China was $189.6B. The European Union did not exist. Russia, although a world power, was a lesser player economically. Germany's GDP was only $947B. The US was clearly the "big economic dog" in the world.

One could argue that Volcker could afford to be cavalier. However, the world economic landscape has changed. The number of major players has grown. The EU led in GDP in 2014 with a GDP of $18.46T. The US was second with a GDP of $17.42T. China was third with a GDP of $10.36T. Japan and Germany were a distant fourth and fifth with respective GDP's of $4.6T (estimated for FY2015) and $3.85T. The point here is that there are now a lot of other "big" factors and players that can significantly affect the US economy.

One of these factors is the ECB (the central bank of the European Union). It announced a €1.1T QE program in late January 2015. Since that time it has been buying assets at a rate of €60B per month. This will amount to about €600B for the year. That's about 3.3% of the European Union's GDP for FY2015. They say this QE program will end in September 2016; but many question that date. That's another +€540B in 2016 for a total of €1.14T. The total represents about 6.2% of the EU GDP. Since this is the opposite of tightening (what the US Fed is proposing to do), it adds to liquidity. It tends to decrease the value of the EU countries' currency -- the Euro. One could view this as reverse tightening (or a negative interest rate) of -3% to -4% per year for the EU.

Japan's QE program amounts to $712B per year. This is over 15% of Japan's estimated FY2015 GDP. One could view this as a negative interest rate of -15%+. Japan is effectively printing that much money.

China is in a different situation with its supposedly +7% GDP Growth. However, its economy has been slowing. To counteract this the Chinese government has cut its main one year benchmark lending rate from 6.00% on November 20, 2014 to 4.85% as of June 29, 2015. Many think that more cuts are coming. On top of that China has also devalued the yuan recently by about -3%. Since this number is tied directly to the USD (and China is one of the US' biggest trading partners), this has a virtual direct impact on the value of the USD and on US businesses' ability to compete against Chinese products.

I could go on. On February 28, 2015 ZeroHedge said there were 21 central banks around the world doing QE. I have covered the biggest ones above. Given those actions, having no QE and approximately a 0% Fed Funds rate essentially means that the US Fed is by comparison tightening by at least +3%, if not much more. The fact that the USD Index has risen dramatically in the last year is no accident (see chart below).

At its recent high, the USD Index was more than 25% higher than it had been at its lows a year earlier. It has fallen back a bit from its peak; but it is still over 20% higher. That means the US can on average pay 20%+ less for foreign goods; and foreign countries have to pay 20%+ more for US goods. This last is a huge headwind for the US businesses that are big exporters. The former is a big indicator that more US jobs are likely to make their way offshore. Bernanke understood this. It is unclear that either Obama or Janet Yellen (or Fisher) does.

They seem to think they are back in 1980 with Volcker; and I believe even then his policies led directly to a faster loss of US jobs to overseas competitors. With the current landscape, the effects should be far more obvious even to someone with the US national pride/conceit of a Paul Volcker. The idea that the US Fed has to raise its Fed Funds rate in order to be able to lower rates at a later date is a fallacy. The idea that the US Fed has to raise rates to tighten to avoid inflation is a fallacy. What is instead true is that such raises would likely cause inflation themselves. Yet they would still slow the economy as they normally would. Such a strategy would almost certainly lead to STAGFLATION (no or negative growth with inflation). That is an extremely unpleasant economic condition to live in. US citizens will not thank Obama and/or the US Fed for getting them into such a situation.

In addition the above data, while not the whole world, indicate that the US has no need to tighten rates in order to avoid inflation. All of its major competitors are "exporting deflation". The numbers suggest that that deflation amounts to -3% to -4% for the EU, -15%+ for Japan, and at least -3% for China. If the US holds its Fed Funds rate at 0% (and it has no QE program), it is allowing virtually all other countries to undercut its prices on a continuous basis by an increasing amount. That is an unsustainable monetary policy for any government that wants to grow its economy. If the Fed raises its Fed Funds rate in this environment it is worsening an already bad situation for US businesses. Americans should make their voices heard. They should tell their government officials that they do not want to lose more jobs to overseas competitors.

If the above situation was not bad enough, many countries, especially those in Central and South America use the USD as a secondary currency (effectively their major trading currency). They sell their products mostly in USDs. They use USDs to buy foreign goods and services. Many shops accept USDs more easily than the home country's currency. If the USD rises further, it will buy more of those countries' products for less. The USD will cost more for those countries to buy in order to buy imports with. The GDP of those Central and South American countries will fall. Many of those GDP's fell from 2013 to 2014. These include such countries as Argentina, Brazil, Chile, Columbia, Uruguay, Panama, etc. For FY2015 the GDP losses will probably be even greater. Those figures just aren't out yet. Does the US want to bankrupt its closest neighbors?

Aside from Central and South America, there are many other countries that trade based largely on the value of the USD. US companies are not the only ones that will be hurt by a stronger USD policy. The US Fed raising rates is unwarranted on a relative basis when you account for the QE policies of its biggest trading partners. One could argue effectively that the US Fed Funds rates are already over +3% on a relative basis. With a GDP of +2.3% in Q2 2015 and +0.6% in Q1 2015 (after much tinkering with the data), the average US GDP growth so far in 2015 is only about 1.45%. I am not sure how government economists believe this meager growth can support relative Fed Funds rates even greater than 3%+; but it appears to be faulty syllogistic reasoning to me.

In high school we used to have a favorite syllogism that showed the huge flaws possible with this type of reasoning. Keep in mind we were high school students. It went:

Nothing is better than sex.

A ham sandwich is better than nothing.

Ergo a ham sandwich is better than sex.

Of course, no high school student at an affluent prep school is going to agree with this conclusion; and they shouldn't from their perspective. Yellen, Fisher, etc. have been indulging in the same sort of faulty syllogistic reasoning. If all of their major trading partners are exporting deflation, there virtually cannot be inflation. Instead it is more likely that imports would increase in response to any increase in US domestic prices (inflation). That would mean the US would lose more jobs to competing businesses in other countries. How can the Fed believe a policy engendering inflation (higher domestic prices) would be good for US businesses? Such a policy would be contrived inflation arrived at in the worst way. Prices would go up; and the economy would slow. It would be inflation that would generate STAGFLATION.

The Fed normally raises Fed Funds rates to combat inflation. The relative inflation compared to its major trading partners is not there. The actual US inflation released by the US government on July 17, 2015 was +0.1% through the 12 months ended June 2015. This doesn't warrant a Fed Funds raise to counteract it. Yellen and Fisher need to get out of their traditional Fed behavior rut. They need to deal with the changed world economic dynamics and the real inflation scenario that exists today.

This is not the 1980's world of Paul Volcker. His policy was flawed then. It would be disastrous now. Even IMF Head, Christine Lagarde, has asked the US Fed not to raise its Fed Funds rate until at least 2016. She believes such a raise(s) would hurt the US economy. More than that, she believes a still stronger USD would crush a lot of small countries' economies, which use the USD as a secondary currency.

Get a clue US Fed! Don't take actions because they are the "traditional actions". Look at the world's reality. Do you folks want the US to lose more jobs? Do you want to crush the economies of many small countries? Do you want to throw the US into STAGFLATION?

The Fed may insist that it has to get out of the QE game eventually. However, it should take the path that is the least damaging to the US economy and to other economies. A long term 0% Fed Funds rate is a good exit strategy when the US' major economic counterparts are following huge QE programs. A fall back into QE would not be a disaster. It is a mistake for people like Fisher to say that it would be. Yes, we need to avoid a bubble; but we already seem to be doing that. Or did I imagine that commodities prices have fallen dramatically? Why overreact?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.