Wednesday, January 23, 2008

Expect U.S. Interest Rates To Collapse

While I did expect a large cut from the Fed (in the order of 75 to 100 basis points), I sure didn't expect them to cut already this week. Well, I guess this again illustrates why one should never underestimate the inflationary bias of the Fed. This cut will probably be followed by another cut at the meeting next week, probably by another 50 basis points.

What was interesting was that although the cut did lift stock prices, considering that the actual stock market decline was much smaller than the decline in futures before the opening, it lifted it by a surprisingly small amount. And today it seems stock prices might fall again in the wake of Apple Computer's latest report and general realization of the fact that the U.S. economy is in a recession. This indicates that confidence is declining so rapidly that the Fed is losing its power to lift stock prices.

That in turn will probably create even more panic at the Fed and get them to accelerate their rate cutting pace. It seems likely that interest rates will fall below 2% this year (perhaps as low as 1%) as the Fed cuts and cuts in increasingly desperate attempts to get the economy out of the recession. In the past I thought the high level of inflation would stop them, but that was because I underestimated just the extent of their inflationary bias. It is now clear that they want more inflation so as to inflate highly indebted U.S. households, companies and governments out of their debts. Officially they wont put it that way, of course, but instead claim that they expect inflation to fall because of the recession. What is remarkable is how easily bond investors are fooled by this.

This will ensure a new wave of dollar selling once the currency markets, like the stock market, snaps out of its current Wile E. Coyote mentality and realizes that there is no solid ground supporting the dollar.


Anonymous Flavian said...

It seems to me as i f the US could get into an uncontrolled inflation and that every attempt to control it will result in a new financial crisis with the result that inflation will at least be established on a new and higher level.

8:43 PM  
Anonymous Anonymous said...

"Inflating highly indebted households out of debt", will bring high nominal interest rates, right? So while the real present value of the debt might fall, the duration of the debt might shorten too, creating severe cash flow problems for the indebted.

Consider what happens if inflation increases to 10%, and nominal interest rates lag by increasing to say 9%. That would give 1% profit from holding the debt, great news! However, can you afford paying 9% of your nominal debt in interest this year? Even if your salary increases with 10%, if your debt is several times larger than your salary, that doesn't help much..

If the higher inflationary interest rate can be afforded, those payments will come from lowered consumption and hence recession.

3:33 AM  
Blogger stefankarlsson said...

Why would nominal interest rates rise? Nominal interest rates are determined by the Fed and the only thing that would make them raise interest rates is if they fear inflation. But assuming they don't fear inflation, they wont raise interest rates.

11:11 AM  
Anonymous Flavian said...

It is of course true that the Fed decides the fed funds rate and that the fed in principle could decide anything about the level of fed funds rates.

Still, if inflation soars market interest rates will, all other things being equal, soar and actually depress the economy.

If market interest rates drop I believe that the fall in market interest rates is related to a drop in the real exchange rate.

5:29 PM  
Anonymous Flavian said...

What I meant in my previous message was that if the Fed is succesful in lowering market interest rates by means of inflationary monetary policies, that is because the inflationary monetary policies lower the real exchange rate so much that the level of risk associated with holding dollars falls more than enough to offset the fact that higher inflation, all other things being equal, ought to bring about higher nominal interest rates.

Let me give an example.

In 1992 the Swedish krona was left to float or rather drop freely and the Riksbank lowered official interest rates.

Since such measures can be presumed to fuel inflation, it might seem confusing that long term interest rates fell as the Riksbank eased monetary policies considerably.

However; due to the fact that at the same time an enormous drop in the real, purchasing power adjusted, exchange rate took place the level of risk associated with holding kronor fell sharply in relation to other currencies, with the result that inflationary monetary policies brought about lower market interest rates.

This phenomenon is my opinion the only reason for lower nominal market interest rates in the US.

If the entire world were united in a global single paper currency union, I believe that the opportunities of the Global Central Bank to lower market interest rates by means of lower Global Central Bank lending rates would be more limited. The reason for that belief is that in that case, there would be much more limited opportunities to lower the real exchange rate by means of inflationary monetary policies because of the non-existence of other currencies.

Still gold and silver would probably be used along with the Global Currency Unit and in the sense that the price of gold and silver could increase the real exchange rate of the GCU (Global Currency Unit) could drop.

Still; I believe that, although the idea is of course perfectly absurd, it would be theoretically possible to create a global currency unit and a succesful Global Central Bank.

The GCB could be obliged by law to LOWER it's lending rates as long as AAA+++ bonds on average would yield LESS than 4% and to RAISE them as long as AAA+++ bonds on average would yield MORE than 4%.

In case nominal bond yields would drop that ought to be considered a deflationary signal causing the GCB to inflate and in case nominal bond yields would increase, that ought to considered an inflationary signal causing the GCB to raise it's lending rate in order to deflate.

9:02 AM  
Blogger Celal Birader said...

Hello Stefan...Perhaps the Fed also wants to inflate away the large pile of Dollars the Chinese are unwilling or unable to spend.

What do you think ?

BTW, i just love your Wile E. Coyote illustration -- it's so funny because it's so true.

Thanks again.

3:47 PM  

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