Tuesday, October 20, 2009

Don't Raise Rates Yet

The cover story of Barron's last week screamed it's time to raise rates. I feel for savers, but I still disagree. I believe that many in the financial press and punditry greatly misapprehend the current financial and economic situation in which we find ourselves.

This economic recovery and financial market improvement is far too fragile to be able to withstand a premature withdrawal of various support programs, or more importantly, a near-term increase in official interest rates.

Despite some return to normality in the credit and equity markets, consider the following headwinds facing the financial system:

# In the $6.5 trillion dollar market for commercial real-estate loans, The Wall Street Journal reports that $154.5 billion of such loans are coming due between now and 2012, some of which are having great difficulty getting "rolled over."

# It is estimated that as much as $1.3 trillion of CMBS need to be refinanced, leaving banks with the potential for further balance-sheet impairments. That doesn't even include those derivative contracts that have to be re-consolidated on bank balance sheets as of January 1, 2010. Estimates suggest another $900 billion of liabilities will hit the banks at the start of next year.

# Commercial real-estate values are plunging, office vacancies are rising and rents are down sharply.

# Credit-card delinquencies are reaching record levels and are likely to go higher until there is improvement on the employment front.

# Unemployment, itself, remains a problem for the economy and possibly a long-term chronic issue.

# The broadest measure of unemployment -- called U-6 by the Labor Department, which includes the unemployed, the under-employed and those who have abandoned all hope of getting a job -- currently tops 17%, higher than the peak in the 1980-82 recession. The Fed has rarely, if ever, raised interest rates before unemployment peaked.

# Factory usage rates, also known as capacity utilization in more econo-speak, are hovering around 70%. The Fed has never raised interest rates with so much unused capacity and rarely, if ever, raised rates before factory use topped 80%. (Usage rates are quite low globally, as well.)

The argument that the Fed should raise rates hinges on the possibility, not probability, that the Fed's accommodative stance on monetary policy is creating another bubble in financial and hard assets, like stock and commodity prices.

There are problems with this argument. Were it not for Treasury Secretary Hank Paulson's decision to let Lehman Brothers fail, we may have never endured a financial market crisis of the magnitude that we have suffered from the summer of 2007 to the spring of 2009 -- one accelerated greatly by Lehman's demise.

True, we were headed for an extreme makeover on the downside, regardless of Lehman's fate, but Lehman's failure brought us to the brink of systemic collapse. I believe we were much, much closer to complete collapse than most people realize, between September of 2008 and March of 2009.

The failure of Lehman Brothers, in my opinion, was one of the single biggest economic policy blunders of the modern economic era and created a crisis of historic proportion. Had the Fed not engaged in aggressive monetary policy accommodation, established a variety of financial market insurance programs and greatly expanded its balance sheet, we would, today, be enduring The Great Depression II.

Hence, it is possible that the Fed's overt actions have allowed markets to return to some semblance of normality and that the collapse that brought the Dow Jones Industrial Average to 6,500 on March 9 was an overshoot. The recent rebound we have enjoyed is part of an appropriate normalization process, not a financial market bubble.

Others, like David Einhorn at Greenlight Capital, who correctly identified Lehman as a candidate for failure, is now buying gold amid worries of a currency collapse that will end in a "death spiral" for the dollar.

He is not alone in his thinking that excess liquidity, large fiscal and current-account deficits and other global imbalances will bring about the dollar's demise unless some efforts are undertaken to correct global problems of this nature and magnitude.

Others argue that the Federal Reserve will need to raise rates to "defend the dollar". The problem with this reasoning is that no one says what we are defending the dollar from, in the literal sense.

There is an abstract theory that a falling dollar will cause U.S. creditors to dump their dollar-denominated securities, particularly U.S. Treasury bonds, thereby not only hastening the dollar's collapse, but also bringing about a massive and catastrophic spike in interest rates.

No one has remarked that the budget deficit for fiscal 2009 came in at $1.4 trillion, a record, but also $400 billion below prior estimates. It is possible that as the economy recovers and tax revenues rebound from the record contractions experienced in the last fiscal year, the budget deficit will likely continue to shrink as a percentage of GDP.

Expenditures for financial rescue programs will fall as the need for them abates. This is a phenomenon we have already witnessed, as the $700 billion in TARP funds available to aid troubled banks was never fully deployed.

This interest-rate spike that everyone foresees should be taking place right at this moment, if the thesis of unsustainable deficits is to be the driving force behind the dollar's imminent demise and an associated interest-rate spiral.

Instead, overseas investors continue to purchase U.S. Treasuries for reasons of enlightened self-interest. In order to keep their own currencies from appreciating too rapidly against the dollar, thereby reducing their pricing advantage in world export markets, our trading partners buy dollars and park the proceeds in the U.S. bond market, keeping our rates low and their exports competitively priced.

Despite the constant calls among our trading partners for more sound fiscal policies that would presumably strengthen the dollar, they will spend whatever it takes to keep their own currencies weak as a means of competitively pricing their exports bound for our consumers.

This is a process that our trading partners would abandon at their own peril. Purposefully abandoning the dollar and allowing that dreaded spike in interest rates would destroy the U.S. market in which foreign goods are bought in the U.S. This is the economic equivalent of the Cold War's nuclear deterrent, known as mutually assured destruction (MAD).

Without a functioning U.S. economy and consumer, the rest of the world is, crudely put, screwed. As we witnessed at the depths of our financial market and economic crisis, exports from our trading partners from Berlin to Beijing plunged by double digits, on a monthly basis! We caught cold and the rest of the world got pneumonia, as has been the case for decades.

Defending the dollar with higher rates, or having our trading partners abandon the dollar are perils unlikely to be realized any time soon.

Finally, there are the "gold bugs", who claim that the message of gold's recent and only nominal new high is one of incipient inflation in the U.S. This, they say, can only be cured by an immediate hike in official interest rates and draining excess liquidity, which has the potential to create hyperinflation.

What the gold bugs also fail to mention is that gold has not reached an inflation-adjusted high, which would require the barbarous relic to climb above $2,000 an ounce. That may happen, but it hasn't happened yet.

Citing monetary theory as their intellectually solid reasoning, they claim that inflation is the result of "too much money chasing too few goods."

As I have pointed out, we arguably have too much money, but we also have too many goods! That does not meet the monetarist's definition of inflation. Indeed, given all I have written thus far, deflation remains the larger of the two risks.

The Fed's printing press has, indeed, been running overtime. But it has merely replaced the $2 trillion in lost capital from the financial crisis and has yet to find its way into the real economy.

Unless and until those dollars begin to circulate in the real economy, the danger of "overheating" is illusory, as the velocity, or turnover of money is of greater significance to economic growth than simply the supply of money.

There is no demand-pull inflation taking place from an over-levered consumer, nor is that happening anywhere else in the world, except in China. China's government is mandating the purchase of raw materials. Chinese consumers are not the drivers of domestic demand, which, again, is not the ingredient for generalized inflation abroad, or at home.

Gold's message is not one of inflation, but of concern about all manner of currency risk around the world, and not just in dollar terms. The price of gold is rising in other currencies as well, as competitive currency devaluations take place all over the globe.

There is a preference for gold in lieu of paper of all kinds.

While I may be whistling past the dollar's graveyard here and missing a key element of our economic future that demands that domestic interest rates be raised, history teaches us a few important lessons about the specious arguments being laid out in favor of higher rates or a "strong dollar policy."

First, it is far too early to declare victory over deflation by prematurely raising interest rates to counteract phantom inflation. Second, a "strong dollar policy" despite the required rhetoric from politicians and policy-makers is not always "in the best interest of the United States."

We are fighting deflation still. The combination of higher rates and a stronger dollar would kill this economy before it ever had a chance to fully recover. Quantitative easing and a zero-interest-rate policy are the proper cures for what ails our economy and will likely remain so, as the Fed says, "for an extended period of time."

I believe the Fed can let expire the various insurance programs that backstop money-market mutual funds, commercial paper issuance, sales of bank debt and the like with little impact on the markets or economy. And, they are already doing that.

By letting those programs expire, it would also put to rest the inaccurate claims that the bailout is costing the U.S. over $11 trillion! That figure includes the nominal price of insurance programs, but not the true liabilities taken on by the Fed and Treasury. In truth, very little of that money has actually been used.

As we learned in the U.S. in the 1930s, or as the Japanese have learned over the last 20 years, policy mistakes have consequences, and they can be severe.

In 1937, a premature withdrawal of support and a hike in rates by the Fed touched off a second depression. In Japan, a series of policy mistakes over the last 20 years has left that country's economy in recession for 50% of the last two decades and the Nikkei still 75% below its all-time high scored on December 31, 1989.

Does anyone want to repeat the mistakes of both ancient and modern economic history over a faulty assumption that we are entirely out of the woods? I, for one, most certainly do not...

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