The Everyman Economist

In case the Everyman hasn’t noticed, medium term and long term interest rates have been skyrocketing for the last few weeks. Ever since the day the Fed announced that they would enter the market to buy securities and rates dipped briefly, they have reversed course. The rate on 10 year US government securities is nearly 4%, which is up from 2.25% earlier in the year and even 5 year securities which were as low as 1.38% earlier in the year, have now climbed to almost 3%. These are massive moves, especially without any real changes in the economy, so why has it happened? And will the impact on mortgage rates, which have also risen by about 1%, hurt an economic recovery?

First, a little background information. We’ve probably seen the worst of the downturn in the economy, so it’s no surprise that most markets are in the process of consolidating their huge declines. Stocks are up, oil is up, commodities are up and the dollar is down. This is all part of the normal process that markets should go through after the recent global financial meltdown. But make no mistake about it, many markets are now in the process of believing their own baloney. After the Dow bottomed at about 6500 and now has climbed to 8500, there are lofty predictions of a new bull market. The same is true of oil, metals, and many other markets. Unfortunately, the big picture scenario does not support this thinking. The economy is just too far from health and is very susceptible to aftershocks from every direction. Whether it’s the auto industry, consumer debt, private and commercial real estate or interest rates, the economy needs a lot of good things to fall into place and they are just not happening yet. The markets may wish it to be, but wishing and hoping does not make for sound investing.

And that brings us to interest rates. The securities markets are about to be overrun by new supply. All of the government spending that we’ve seen over the last several months will get paid for by issuing securities. With a deficit the size of the Grand Canyon, that means there are a lot of securities in the pipeline. The more securities, the more upward pressure on interest rates, as they seek a price level where the supply can be absorbed by investors, traders and foreign governments. You can throw in predictions of runaway inflation and a collapsing dollar, and interest rates have a steady stream of bad news to deal with. In all likelihood, rates will top out for the short term near their current levels. Any more climbing and whatever plans the Obama administration has for an economic victory celebration will have to be put on hold. So the environment will take care of itself and rates should settle down soon. They will not likely fall too far, however, and they will continue to be plagued by supply and demand issues, but the economy will be the big determining factor. Choke off a recovery and we will see lower rates again and quickly. The recovery is not yet guaranteed and even if it was, it would be feeble at best, so don’t expect rates to soar much more.    

We were On The Brink…and now we’re Back From The Brink…But…We are not alone. The financial crisis is not just a problem on our shores, it’s a problem on European and Asian shores as well. We were first to deal with the problem and now it’s their turn. Fortunately, we showed our friends and enemies what democaracy is all about, warts and all, and Europe and Asia will follow. But this is not going to be a pretty picture. Markets will fall, rise and fall again, and economies will be hurt badly. The credit squeeze will ease back from the brink of despair, but economic conditions will remain weak. This week the world will need even more encouragement and bold initiatives and I believe the Fed will supply some help. Interest rates will be lowered, but now is the time for some VERY bold action. With US interest rates already at 2%, what can the Fed do? What they MUST do now is remove the guesswork from the markets and stop pegging the Fed Funds rate to a specific target. Instead of lowering rates by 1/4 point or 1/2 point or even a full point, the Fed should formally announce that they will allow the Fed Funds rate to float freely, which is approximately what’s already happening in the markets anyway. Let natural market forces continue to dictate the overnight Fed Funds rate and let the pundits all go home. After all, they are no help with their predictions that often leave the markets disappointed, even when the policy is right. In addition, the Fed should officially lower bank reserve requirements and ease some more of the pressure that’s built up in the financial system. Now that we have $810 billion of fiscal policy relief on the way, we need to adjust the monetary policy spigot so that market psychology begins to believe that this is all for real. We all need to know that the financial system will not be abandoned and we need to be sure that it will get through this incredible mess. When we have a crisis of such immense proportion, leadership is the most important component to getting us back on track. That’s what FDR did in the 30s and 40s, that’s what JFK did in the 60s and that’s what Rudy did on 9/11, and we now need that same kind of bold leadership. We may be Back From The Brink…But…It’s Now Time To Reverse Course.

If the Everyman is wondering whether the Federal Reserve is about to raise interest rates, we believe strongly that it won’t happen any time soon. In fact, there is a greater likelihood that rates will have to go down again before they go up. We are in the midst of a severe credit crisis in the United States and that is not the time to be worrying about inflation and higher rates. Congress and the Fed will be facing tough issues and the printing presses will be running overtime. The deficit will continue in its complete runaway mode and we are likely to see $500 billion dollar red ink this year and closer to $700 billion dollar red ink in 2009. The US dollar is in a temporary recovery mode, oil is shedding some of its molten luster and Gold and Silver are looking ugly, but BEWARE! Although we would never predict oil prices with any degree of comfort, we continue to expect global surprises and that could mean jumps in prices when you least expect it. The dollar is recovering right now because the rest of the world is catching up to us and experiencing their own severe economic conditions. But don’t mistake that for a strong dollar. Once this temporary phase plays out, the US dollar will be back to its nasty ways. After all, we have a government in limbo and neither candidate is sounding very encouraging with their lack of expertise in dealing with these problems. And that brings us to Gold and Silver. With the latest steep declines, Gold is now below $800 and Silver is below $13. This is one heck of a buying opportunity and we urge the Everyman to consider buying soon. Markets have a funny way of lulling us all into complacency, but this isn’t the time for it. Put on your buying shoes and don’t worry too much about price. When the dust clears, these prices will be long gone.    

The Federal Reserve Bank is the most powerful force behind the US economy. The Fed is primarily the “lender of last resort” to the US banking system and pretends to control inflation, which is more a psychological reality than a practical one. On a daily basis, however, the Fed does much more. It orchestrates the nation’s monetary policy and therefore manipulates the amount of money in America, as well as the growth rate of the bundles of all that money. However, don’t confuse that last tidbit with controlling inflation because it’s an imperfect relationship at best.

The Fed is actually a group of regional Federal Reserve Banks and their leaderships who meet periodically to discuss, debate and vote on how it will conduct monetary policy in the immediate future. Most of the time the votes simply maintain the status quo, but every so often they rock the boat. For example, since ending their quest to raise interest rates last year, the Fed is now engaged in a policy of lowering interest rates in response to a deepening credit crisis brought on by overzealous mortgage lenders and worsened by creative bankers who devised products that ultimately became worthless. By the way, that’s the reason you’re reading about losses in the billions - that’s billions with a “B” - at many major financial institutions. As you might imagine, it’s quite a task for a governmental body to reverse these problems, but the Fed is busy as a bee attempting to pollinate the dying flowers with small doses of lower interest rates. I’d like to say “so far, so good,” but I have to “say so far, no good.”

So how does the Fed actually do all this cool stuff every day of the Everyman’s work week? For starters, the Fed controls the Fed Funds rate, which is the rate at which banks lend to one another. In addition, the Fed controls the Discount Rate, another bank lending rate, as well as Bank Reserve Requirements, which are the monetary reserves that banks are required to maintain against their balance sheets. Finally, the Fed conducts daily operations in the money markets known as “Repos” and “Reverse Repos” which help to fine tune all of the the above. If it’s starting to get confusing, it is, so let’s hold up on any more techno-bull.

And that folks brings us to the “Power of the Fed” which is actually the “Power of the Head of the Fed.” That’s because no matter what the Fed finally does with interest rates, it’s the Paul Volckers, the Alan Greenspans and the Ben Bernankes that are truly making the decisions. These men set the tone and for the most part, the group plays follow the leader. And remember folks, these are not elected officials. These are appointed officials, approved by Congress (whoop-de-do), who make the most important financial decisions in America. Let’s hope they’re all good at it. Time will tell.