U.S. Fed Must Continue to Cut Interest Rates to Keep Bubble Going

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Wham! Pow! Biff!

Shares, property, and income. They are the three pillars of personal wealth. And in the Western world, they are all taking a beating, especially in America. Is it true in Australia as well? We’ll get to that in a moment.

But first, just how desperate is the U.S. Federal Reserve? For the first time since 1974, all three components of household wealth (shares, income, housing) are falling in real terms. This may push the Fed to repeat the policy that kicked off the credit boom: cut interest rates below the rate of inflation. Why? And what does it mean for resource and share prices?

When real interest rates are negative, there is absolutely no incentive for anyone to save or invest in fixed income instruments (bonds). By pushing interest rates below the rate of inflation, the Fed creates a massive incentive for Americans to spend cash rather than save it, where its purchasing power will be eaten away by inflation.

Yes, yes, it sounds crazy. But the Fed is convinced that the only way to save an economy driven by consumption rather than production (and by spending rather than savings and investment) is to punish people for doing anything but spending. The Fed fears Japanese style deflation, in which asset prices like stocks and real estate go into decade-long slumps.

Japan, at least, had a high savings rate when its household wealth was pummeled by falling stock and real estate prices. Japanese wages have held up well owing to the countries high-tech, export-driven economy. By contrast, American wages (and Australian wages to some extent) are under assault from globalization, which has exercised a deflationary influence on world wide manufacturing wages.

So the Fed will fight the trifecta of declining real wealth by cutting interest rates to accelerate its pace. To save the American consumer it was first necessary to bankrupt him, apparently. “The Federal Reserve may push interest rates below the pace of inflation this year to avert the first simultaneous decline in U.S. household wealth and income since 1974,” reports Craig Torres at Bloomberg.

All of this means that the Fed will not just cut interest rates tomorrow; it will keep on cutting them. It will be one last attempt to keep the bubble going. But we think it will be better for gold than stock prices. It will also increase the yield differential between the U.S. and Australian dollars. That explains why the Aussie touched .89 in overnight trading. Also, if the Fed creates negative real interest rates, we may have to reconsider our forecast for oil prices. Stay tuned.

A number is beginning to surface about the cost of a collapse in the bond insurers. It’s a big one. “Banks that raised US$72 billion to shore up capital depleted by subprime-related losses may require US$143 billion more if bond insurers are cut, according to analysts at Barclays Capital,” reports John Glover at Bloomberg. This is why we are not convinced financial stocks are worth buying today.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. don’t know how you aussies are going to fend for yourselves ?

    but, what dan says about america makes perfect sense to me.

    i have $29 cash in hand and no place to dump it today.

    oh, forgot! off to ebay time to buy some time….

    Reply
  2. If we were fending for ourselves we would not be more heavily indebted (relative to national income) than Americans. One day we will be ‘foreclosed’ through a massive subversion of our sovreignty – quite possibly via importation of cheap labour (like america), or massive foreign investment.

    Reply
  3. While the USD is falling, it is not falling by as much as my old economics texts would have predicted. Why?

    • Firstly the velocity of the new money being pumped into the traditional banking system may be much lower on its previous path through CDO, CDS and subordinated debt agreements. If this is so, the inflationary impact will certainly be less.

    • Secondly there is both momentum and inertia in the existing money flows (like a charging bull elephant, the market can’t speed up, slow down or change directions very quickly).

    • Thirdly, the Asian central banks are indeed still tied to the US economy by the naval. While they would love to dump the USD, to do so would not be in their own short to medium term interests.

    So what does this mean for Australia? If Asian and European export to the US slow down, and they will, resource prices must take a significant hit. The relationship between supply volume and price is not defined by a straight line graph. Say if demand for a product falls by say 5% the market could respond with a price drop of 10% or more. Profit margins of some resource operations could evaporate that easily. However in the short (1 year) to medium term (2 years), Australia is protected by forward contracts and a lot of underlying economic momentum. Existing infrastructure cannot satisfy demand and an unsatisfied demand for skilled workers is putting significant upward pressure on prices. Even commercial and residential property predicted to be in undersupply (although I can’t understand why). And in 3 years time, international economic conditions may or may not have improved – I really don’t know. While I expect some minor interest rate rises – the Australian Government cannot raise rates my the amount required to keep a lid on inflation and protect the currency. This is because Australian voters are (like their American cousins) in far too much debt to tolerate a significant rise. It would be politically easier to follow the Americans into a cycle of inflation – but unlike America there is enough underlying pressure on wages to trigger a 1970’s style wages price spiral that will by itself push interest rates up. To sum up – inflation, uncertainty, a relatively weak currency (against everything but the greenback) and continued export strength for the next year or so..

    Coffee Addict
    January 31, 2008
    Reply

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