By Christian Takushi, Macro Economist, 17 Sep 2015, Switzerland.
The FED decision this evening was a crucial one and its implications go beyond monetary policy and the economy. As I have said before the USA has been effectively using her energy & monetary police as subsidiary geopolitical tools to advance US geostrategic interests. The pressure to give up “zero rates” was so big in recent days across the USA though, that I believe the FED chairperson stayed her course in order to preserve her credibility. If Mrs. Yellen had capitulated or yielded to the strong calls for normalization, she may have conceded a mistake and emboldened those in Washington requesting an overhaul of the FED system.
Nevertheless, we believe, a change of mind is taking place inside the FED. The FED of St Louis has already spoken out that FED policies have failed and are counterproductive.
The decision to keep policy rates at practically zero ..
- keeps up the pressure on US-rivals China, Russia, Brazil and other emerging markets that have challenged US supremacy one way or the other.
- puts a cap on China‘s ability to control capital flows and informal credit, leaving her only currency management to let up pressure
- means the FED, ECB and BOJ cannot cut interest rates to support the financial system and the economy in case of an external or systemic shock
- will put downward pressure on the USD, allowing imported inflation to recover and shift US CPI closer to 2%, allowing the FED to hike rates without losing face as soon as October this year
Point 4 was the main reason, why on August 1st we suggested our clients to reduce USD exposure in favor mainly of the Euro and partially the Swiss Franc. On the same day we suggested to reduce global equity exposure to zero in favor of cash.
Geopolitical Risks: Point 2 and 4 are key, because there is the risk that major Emerging Economies (China, Russia, Brazil etc) that have felt at the total discretion of the FED for years, may resolve to put additional pressure on the USD to signal to the US Government that they are not powerless. A weaker USD is what the FED now desires, but a USD sell-off would complicate the FED strategy. It could allow CPI to accelerate and US assets to be avoided or sold internationally. A risky act by Emerging Markets, but after what they have suffered in recent years, quite likely: “we are in a mess, let us at least get the USA into our boat”.
The world over investors and corporate leaders were eagerly awaiting the decision by the U.S. FED at their September FOMC meeting. Seldom before have investors been so torn apart and divided in their expectations. While some say the world is facing too many economic and political crises (too early for the FED to hike), others say the US economy is strong enough or as strong as it can probably get (the FED should hike). Millions of people around the world are bewildered at the magnitude of the discussion and apprehension among investors and economists given the fact that interest rates are practically zero and the FED will only raise them by a tiny bit, if at all. As we know, it is the inflection that investors are concerned about. With the FED failing to hike, the USD might weaken, but a sell off cannot be ruled out. For over three years banks and investors have been buying USD in expectation of the first rate hike. Probably the most crowded bet out there. We have been forecasting for over a year a major global stock market correction in August – October 2015 – it has already happened in Emerging Markets, not yet in Developed Markets. A badly taken FED decision could trigger stock and USD selling.
We have the impression the FED is becoming increasingly aware that it has manoeuvered itself into a corner, but conceding it now would weaken her tarnished credibility. We believe the FED is embracing these truths or facts and it will try to move in this direction cautiously:
- The FED should normalize interest rates as soon as possible – zero rates are not only keeping inflation and growth low, they have created a gigantic asset bubble
- The FED should shift focus away from inflation – it is rather driven by corporate behavior and demographics. The 2% target reflects the optimum over the past few decades, the new target (if indeed a target is needed) could be around 1% reflecting new realities like lower population growth.
- The FED has overestimated US Potential Growth and it may reduce it to 2% p.a. – this could be a reason to hike in case inflation fails to hit 2%
- The FED should gradually move away from its over-managed forward-guidance practice – the idea was good, but it has been taken to a dangerous extreme
- The FED should stop trying to fix the Labor Market by itself – structural reforms like tax reform, education reform etc are needed
In other words, US economic growth is as good as it can get given the structural issues in the US economy.
So far investors and economists have been focusing one-sidedly on the benefits of zero rates. And for sure in the first 12 to 24 months of the Great Financial Crisis the benefits clearly outpaced the negative side-effects. Since 2010 I’m trying to make decision makers aware of the grave danger of keeping rates too low for too long. The obstinate low inflation is partly home-made, actually FED-induced. Nevertheless, we should not put all blame on the U.S. Fed. In fact three major global forces are putting a cap on global growth and reinforcing deflation: a) Zero rates (FED policy), b) extreme low-cost thinking, c) demographics (explosion of the old-age dependency ratios).
As we have written in the past, there are moral, economic and systemic reasons for the FED to normalize interest rates. Still, we believe the broad consensus is missing a very important aspect of FED Policy. It is the negative effect of a multi-year zero rate policy in combination with over-managed forward-guidance on economic growth and on consumer inflation (it caps both of them). Thus, the FED is in a Liquidity Trap of her own making: The FED kept interest rates for too long at zero. Zero rates are an extraordinary measure that sends a tremendously strong message to economic agents. This negative effect of forward-guided zero rates converges with the negative effect from the extreme “Low Cost” drive in the overall economy (cost competitiveness driven to an extreme) in reinforcing deflation in the World Economy. These two man-made destructive forces only reinforce the already existing (third) deflationary force of demographics. You may say why is “extreme low-cost” negative? Well, low cost or cost competitiveness is a healthy concept when applied in a balanced way, thus watching all its positive and negative side-effects over time. Let me give you this example: The USA is driving the cost of energy to extreme lows mainly to boost US cost-competitiveness, but also to hurt Russia & Brazil and prepare for eventual war in the Middle East (self-sufficiency). Extremely low energy costs have boosted profits at US chemical firms just as zero rates benefitted bank profits, but how much of that profit has benefitted the US economy and society? Germany on the other hand decided to exit nuclear power after the Fukushima nuclear fallout to embrace Renewable Energy. This resulted in higher electricity costs. In my humble view the German approach is the more responsible long-term oriented one, thus also better for the economy. The US approach allows for an explosion of profits in the short term, but, is it really good for us to drive the cost of energy to zero? Is it morally right versus future generations and our environment? Now, we can ask, is it economically and morally good to tell corporations and banks “the price of money is going to be zero over the next 2-3 years, help yourself”. Too cheap energy and too cheap capital will lead to unsustainable conditions and misallocation of resources. Worse of all, those firms will be ill-prepared for competition once energy and capital costs normalize.
This FED-induced chain-reaction (here simplified) leads to a vicious circle: A macroeconomic Liquidity Trap
FED sets interest rates at zero => this “economy in danger” message of the FED is like a “brace – brace” on an airplane => economic agents react to FED’s alarm signal and paddle back on investments and shorten the length of their commitments => demand visibility suffers => forward-guided zero rates in combination with paper-money printed in gigantic amounts incentivize firms to borrow money to buy back their shares and their competitors rather than to invest (to grow organically and hire more people) => Earnings-per-share jump, accounting profits rise, jobs (income) are lost after cheaply funded takeovers => demand visibility fades further => firms react with measures to lower their costs further => short-sightedness increases => weak demand exacerbates deflationary pressures and incentivizes FED to prolong zero rate policy => worse even, zero rates create a bubble in financial assets that supports the economy artificially. This gives the FED another reason to avoid raising borrowing costs and debt service burdens (keep rates low)
On 11 Aug 2015 we wrote: on our Quarterly Outlook: Obsessed with CPI, FED creates financial bubbles and puts a cap on growth: As we have been saying since 2010 the zero rate policy of central banks is having the opposite desired effect: after the first 2-3 years it actually leads firms to stop investing and to rather produce artificial profits (EPS) by borrowing money to buy back shares and other financial transactions. Thus, the FED, ECB and BOJ are depressing economic growth and reinforcing deflation. Even the Vice President of the FED of St Louis, Stephen Williamson, has boldly stated the FED policies have failed and are counterproductive: http://www.cnbc.com/2015/08/18/st-louis-fed-official-no-evidence-qe-boosted-economy.html
Feel free to read our Quarterly Global Geopolitical-Economic-Investment Outlook from 11 August 2015: http://nuevo.geopoliticaleconomics.org/?p=1329
Christian Takushi, Macro Economist, 17 September 2015, Switzerland
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