In the week that the Federal Reserve raised interest rates by 0.25%, we will examine and show you why it makes zero sense. Why it is more about saving face than the economy and how it will backfire within 6 months. Resulting in a cutting of the rate back and even more quantitative easing. That, or within 18 months there will be a big depression within the world economy.
Let us start with the fact that the Federal Reserve has been consistently wrong on every prediction it has made over the last seven years. Often claiming growth and employment figures that were miles out. One would forgive them for being wrong every so often if they were incorrect on the low side, but 100% of the misreporting was always on the optimistic side. It is quite clear they have been trying – but failing- to talk their way to recovery. The result is that they have little or no credibility left amongst people in finance.
We do have some sympathy for them however.
The FED are stuck between a rock and a hard place. Unfortunately for those people at the FED today, they aren’t the individuals who were the ones who chose to go to zero % rates 7 years ago. In our opinion they can’t be blamed for the problems – just the wrong diagnosis.
In a way, the damage was already done then. Instead of taking the medicine back in 2008-09. They kicked the can down the road and kept the zombie banks and institutions alive by lending them free money. This should never have been allowed to happen, these institutions should have gone bankrupt and new better institutions appeared to take their place, with better corporate Governance and more shareholder powers to hold Directors to account.
There would have been 1-2 years of pain for the world, but we would have been back to growth around 2012 and things would have been much brighter today.
With central banks lowering interest rates, introducing quantitative easing (printing cash) and even some banks going with negative rates, bubbles have now been created in stock prices as investors look to put their cash to work rather than earning almost zero interest from banks.
Over the last 6-7 years, some companies on the stock market have had inflated valuations because of these investors. The value in these companies goes up – on paper anyway. This means they are now worth more – on paper. If Company X was on the stock market and valued at £80M, They may now find themselves with a company valued on paper now at £100m simply because investors have bought shares to store their cash rather than use banks.
This £20m increase isn’t real money, there is no more stock or assets that there was the day before the investment poured in – it’s all on paper. Here is the dangerous bit though; these companies have been allowed to borrow more money that they should have been allowed to, from banks because on paper they are now worth more.
Now with interest rates rising, the investors pull their money out and the stock price falls. Some companies may now find themselves technically insolvent, will find it a lot harder to raise cash for future projects and the bubble bursts and a credit crunch forms as banks again begin to stop lending to them. We predict a number of very high profile companies go to the wall because of this.
As credit starts to dry up, so does the spending and capital investment. This means less jobs, less jobs means less public spending and the real danger - deflation.
Deflation is the killer
Deflation is why the FED will be forced to cut rates again within the next 6 months. Inflation is good for economies because it reduces the value of debts, Governments rely on inflation. If inflation ceases and deflation takes over, the whole financial system crashes because people will put off buying things until later. Wouldn’t you if prices were going to be cheaper next week.
Used cars have already seen a massive drop in value due to deflation. This is hugely important because people now need to find extra when trading in their used cars to buy new ones.
Deflation also increases the value of debt that Governments have. Increasing rates has now led to a stronger Dollar, that makes them less competitive and exports will suffer whilst imports become cheaper. This is bad news for US workers whose industrial sector has been decimated in recent decades.
The FED need to keep a very close eye on the value of the Dollar closely. All they have to do is look around, China is artificially weakening its currency to boost exports, the European Central bank is printing cash to deflate it, the UK has kept rates at almost zero to keep Sterling low.
The results of the FED doing this unilaterally could be disastrous for them. It could bring in huge job losses and more deflation unless most of the other countries around the world follow its example and we can’t see that happening.
One potentially crippling outcome of higher rates is of course the amount of interest the US Government pays on interest. Well it would be if anyone dared to actually count what the US really owed. To the US this doesn’t really matter because it is already bust, it’s just that nobody ever mentions it because of the global catastrophe that would follow and take everyone out. But they will now have to pay the FED another 0.25% on any new debt it takes on, and it takes on trillions each year just to refinance existing debt.
The raising of the rates
In our opinion the FED is trying to solve an inflationary problem when the threat is deflationary. It reminds us of the scene from the film Rogue Trader where Nick Leeson is trying to buy the market back up as it constantly falls all around him. Perhaps the FED should have listened to the advice given to Nick by one of his friends – “You can’t fight the market”.
It’s almost like the Fed has looked out of the window in the middle of winter, seen all the snow, chosen to ignore it, walked out into the middle of the street in speedo’s, sun glasses - all in the hope of convincing everyone it is summer.
Good luck but our guess is that within 20 minutes they’ll be back in doors putting on some warm clothes with the rest of us.
We honestly don’t know where this is going or how many more times the can will be allowed to be kicked down the road. It may have a few more years in it yet but when it does come to a halt, it will be a halt that will take us back to the 1930’s.
There is one final possibility though, maybe the FED knows that the whole thing is about to crash, knows that every year the pain / depression is delayed – kicked down the road – the bigger the crash will be. If that is the case, then we think it is brave to tackle now but ultimately the right decision.