The Real Reason Yellen Is Raising The Federal Funds Rate

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Investment U

By Alexander Green, Chief Investment Strategist, The Oxford Club

Last week, Federal Reserve Chairwoman Janet Yellen announced that the central bank would continue raising short-term rates. No surprise there. The Fed has lifted rates four times already - and made clear its intention to continue tightening.

What is surprising, however, is that Fed officials resolutely refuse to state the real reason they're doing this.

So let's take a closer look...

The central bank purportedly exists to maintain stable prices and create full employment. Full employment is a squishy term. Historically, it has meant an unemployment rate of less than 5%. We've been there for over a year now.

However, the current unemployment rate of 4.1% fails to take into account all the employable men and women who have given up looking for a job.

Yet, with economic growth hitting 3%-plus for two straight quarters - and hiring up - even these folks are being pulled off the sidelines.

As for stable prices, that hasn't been a problem lately either. Yes, the cost of healthcare and college tuition is rising faster than most prices. But the core inflation rate is just 1.8%.

Yellen claims she can't understand why it's not higher with economic growth and job creation strong. But what's more bewildering is why the Fed wants higher inflation. After all, that benefits no one. Even a 2% inflation rate cuts consumer purchasing power in half over 36 years.

So let's consider the real reason the Fed wants to raise rates. Is it to tamp down the stock and bond markets? Absolutely not.

Falling asset prices undermine consumer confidence and cause households to slam shut their wallets, undermining economic growth. Is it to benefit savers? Hardly.

Over the last nine years, ZIRP - the Fed's Zero Interest Rate Policy - has hurt no one more than savers. Consumers who have set aside safe money to reach short-term goals - like raising a down payment for a house or paying next term's tuition - have earned essentially nothing.

So why is the Federal Reserve really raising rates? For one simple reason: to put the arrows back in its quiver.

If we started sliding back into a recession, the traditional monetary response would be to slash interest rates. But when the benchmark is at 1%, there isn't much to cut.

Moreover, investors are hardly in the mood for Quantitative Easing IV, V or VI. (Especially since the Fed is trying to unload its multitrillion-dollar bond portfolio, not build it up.)

There isn't much to hope for on the fiscal side either. Having run massive deficits under former Presidents Bush and Obama, the national debt now stands at $20.57 trillion.

We've already had the fiscal stimulus (for what it was worth). Piling on more debt in the next recession would only put us in the same league as Greece and Venezuela.

The central bank's real desire is to slowly raise interest rates - without rattling consumers, investors or business owners - to a level where it can once again stimulate the economy (at least theoretically) by bringing them down again.

So, instead of letting everyone scratch their heads, why doesn't the Fed simply say so?

Perhaps it's because when investors realize how little both Congress and the central bank could do to bail us out of the next recession, it would undermine consumer confidence and spook financial markets.

Let's hope the Fed doesn't need to cut rates soon, especially since it can't do much anyway.

But let's also recognize that a lack of effective policy options is one of the greatest risks facing investors today - and we should govern our portfolios accordingly.

Good investing,


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