Sunday, 12 June 2016

The Fed Needs To Raise Rates in June

A couple of weeks ago, it looked almost certain that the US Federal Reserve would raise official interest rates at its meeting on 14th - 15th June. After a shock jobs report, last month, showing that the US added only an additional 38,000 jobs, the prospects of a rate hike were slashed. Some of those who have been praying for no rate hikes at all, in order to keep financial asset prices inflated, began again to press for no rate hikes for the rest of the year. But, the Fed actually does need to raise rates.

The fact is that the last month's jobs figures were a bit of a fluke. As the US begins to approach full employment, adding further jobs will become harder. US wages are rising, so firms will begin to look to use existing workers more efficiently, causing productivity to rise. But, jobs growth has not slowed as much as these figures suggest. It has been growing at around 200,000 jobs per month, more than double what is required to accommodate the growth in the workforce, of around 90,000 per month. Even if the rate of jobs growth halved, it would still be enough to see the unemployment rate continue to fall.

Not only are wages in the US rising for that reason, after a very long period when they have been stagnant, but they are rising because minimum wage rates have been increased across the country. The US inflation data indicates that core inflation is starting to rise, and that is before the effect of a doubling in the oil price from its low of $26 per barrel starts to feed through, and the prices of other primary products begins to stabilise after a period of overproduction. There are other reasons inflation will be rising, and may rise much more sharply than is currently being accounted for.

Across the globe, it is being widely recognised that monetary policy has not caused economies to grow. In fact, it was never intended to do so. Its primary purpose, after 2008, was to reflate the prices of fictitious capital. Private capitalist wealth today is almost exclusively held in the form of fictitious capital, that is of essentially worthless bits of paper, such as shares, bonds, and other derivatives. Because these bits of paper are themselves worthless, the only way they have any value is if the state and central banks stand behind them.

The price of these bits of paper that have been blown up to astronomical levels is determined on the basis of a capitalisation of the revenues they provide. Those revenues, which depend on a growth of profits, have not been growing very rapidly over recent years, for the simple reason that companies have not been accumulating capital at a rapid rate, and so have not been expanding their production of profit. The only way that the prices of these paper assets can rise, therefore, is if interest rates are low. In 2008, the prices of these financial assets, and similar assets like property crashed, which made a considerable dent in the paper wealth of the private capitalists who owned them, and of the banks, which also own such assets. As soon as the actual crisis had been stabilised, therefore, the state and the central banks set about reversing that situation, by cutting official interest rates, and printing money to buy up the paper assets, thereby underpinning the speculation.

But, there comes a limit to how far that can be pushed. Eventually all bubbles burst, when inflated past a certain level. Around the globe today, the indication of just how far these asset prices have been over inflated is shown by the fact that $ 10 trillion in bonds now have negative interest rates. In other words, people are paying to lend money! It has led the former bond king, and head of the world's largest bond fund at PIMCO, Bill Gross to describe the situation as a bond supernova that must explode.

There has been a large rise in the number of domestic safes being sold, as people with money faced with negligible returns on savings, the danger of losing those savings if banks go bust, begin to hoard cash. Some banks faced with negative interest rates on their own deposits with central banks, are looking at simply warehousing their own cash. Some Exchange Traded Fund providers are even looking at offering cash ETF's, whereby units would be sold in an ETF that simply obtains cash in the form of bank notes, which the fund would then store in huge warehouses. The fund would pay no interest to anyone buying units in it, but it would provide protection against the kind of huge crash in the prices of bonds, shares and property that some of the smart investment money now sees as being inevitable at some point.

The policy of QE has worked to pump up asset prices until now, because consumer price inflation has been low. In fact, as I've argued previously, QE, by sucking liquidity into these financial assets, and thereby causing a speculative hyper inflation of those prices, has at the same time drained liquidity from general circulation, thereby leading to that consumer price disinflation and deflation. But, with negative yields on many financial assets, there is not much more that that process can go. At the same time, as the price of oil and other primary products begins to rise, commodity price inflation begins to rise with it, and there are vast oceans of liquidity sitting in those financial assets that can quickly facilitate rising commodity prices and wages, fuelling a price-wage spiral.

Given that many of the sources of low commodity values, over the last 30 years, for example China, are now seeing higher wages and slowing productivity growth, the sources of higher prices are easy to see. At the same time, with monetary policy having reached its limits there is only one possible means now of raising economic growth, and that is via fiscal stimulus. In fact, many of the current problems could have been avoided had governments in the UK, and across the EU adopted policies of fiscal stimulus, even just like those adopted in the US, rather than applying crazy policies of austerity.

Now all of the major economic organisations from the OECD to the IMF and World Bank are arguing for fiscal stimulus. Even the representatives of the owners of fictitious capital have been increasingly recognising that you can't squeeze blood out of a stone. Without capital being accumulated, there is no basis for expanding profits, and so no basis for paying dividends and others forms of interest. But, if everyone and their dog thinks that being a speculator or buy to let landlord is the only rational solution, then any available money, plus any money that can be begged, stolen or borrowed will go into such speculation, and not into consumption - neither personal consumption nor productive consumption. At the same time, many millions of workers in the UK and EU, suffering as a result of slow growth, and low wages when they can get jobs, find themselves not with money to spend or to speculate with, but increasingly in debt, and paying high rates of interest on that debt. Without the prospect of rising demand for commodities, firms themselves, therefore, have no reason to use their profits to expand, and instead use those profits to boost share prices by buying back their own shares and so on.

This is a crazy and unsustainable situation. The longer it goes on, the more the forces of the supernova that Bill Gross describes will build up to cause an even larger explosion. It may even now be beyond the power of central banks like the Federal Reserve to control, but they should begin to try to let some of the hydrogen out of the potential explosion. The way to do that is to stop pumping liquidity into capital markets, and to begin to raise official interest rates. The US Federal Reserve began that process two years ago, but it has been more than cautious in applying the policy, pulling back whenever the stock market has taken fright. But, falls in stock, bond and property markets are the only way of resolving the situation. In short, large amounts of debt has to be written off, and much of the huge rise in fictitious wealth that has arisen in the last thirty years has to be destroyed. No one should feel too sorry for the world's multi-billionaires who will suffer in that process. They will still be billionaires at the end of it.

But, there are other immediate reasons why the Fed needs to raise rates. The week after it meets, Britain will vote in the EU Referendum. As things currently stand, a vote to Leave seems inevitable. Billions of pounds have apparently already left the country over the last three months, but if it continues to look like “Leave” will win, that will accelerate massively in the week ahead of the vote. If the vote is for Brexit, even more will flood out in the days after the vote. That will cause the Pound to tank, by around 20%. It will also cause share and bond markets to fall sharply. There are estimates of a 24% drop in EU stock markets in the event of Brexit.

A sharp drop in the pound will push up inflation sharply, because the UK imports a lot of necessary items that are priced in dollars. Some of those things, like oil, are already rising in price. A rise in the price of energy, and of things like iron ore will kill off the steel industry in short order. Patrick Minford, one of the economists supporting Brexit, is at least honest, unlike many in the Brexit camp, in that he admits that Brexit would probably mean that what is left of British manufacturing industry would be destroyed.

The first reaction of central banks facing a collapse of the currency is to raise interest rates. That is what happened in the early 1990's, when a weak UK economy faced an attack on the Pound, which had entered the European Exchange Rate Mechanism at a ridiculously high level. The Bank of England tried to defend the Pound, raising interest rates in successive stages to 15%. It didn't work. Moreover, recent experience shows that raising interest rates does not necessarily strengthen the currency, and lowering interest rates does not necessarily weaken it, as was once taken for granted. The Bank of Japan lowered interest rates, in the hope of weakening the Yen, but instead the Yen strengthened. The same thing has happened with the Euro.

I've set out the reason for that elsewhere. Because, there are now these huge speculative money flows into financial assets, the determining factor has become the potential to make capital gains, or at least not to suffer large capital losses. A state that lowers official interest rates, or prints money, which it then uses to buy its own bonds, thereby guarantees the security of the funds invested in them. That is all the more an inducement to keep money or to invest additional money in such bonds, when the state taking such action is a large state such as the US, UK, Japan, or the EU, because no one believes that the state will ever default on its own bonds in these economies.

So, when interest rates are raised, or the state stops engaging in QE in any of these economies that means that the underpinning of the bonds has been weakened. The holders of such bonds worry when the next such move will be. So, they look for some other economy where the central bank is moving in the other direction, and providing support. When the BoJ, or the ECB cuts official rates, or starts buying bonds, therefore, that is a signal for speculators to buy those bonds, and that flows over into Japanese or European shares, and other financial assets too. But, that means that these speculators buy Yen or Euros, and sell Dollars. Then instead of the Yen or the Euro falling as would previously have been expected, those currencies rise, and the Dollar falls.

So, a sharp drop in the Pound will cause the Bank of England to intervene to support it, and to take preemptive action against a sharp rise in inflation, by raising interest rates, but the immediate consequence of that will be to cause the Pound to drop further. The Bank of England could not cut rates, or engage in QE, because for one thing UK rates are still near zero, but also the problem will be sharply rising inflation.

The Fed, needs to raise rates ahead of the EU referendum, therefore, in order to provide space for the Bank of England to also raise rates in the event of a sterling crisis. Its unlikely that the Fed can let sufficient air out of the financial bubble ahead of any global financial panic resulting from Brexit, but it is better to go into such a global crisis with higher rates, than to go into it with rates already at zero.
Unless the Fed raises rates this week, it is likely to be too late. That is not just because of what might transpire with the EU referendum, but also because of what may transpire in coming months.

Whether the EU vote is to Remain or Leave, then as I suggested a few years ago, the right-wing of the Tory Party are likely to ditch Cameron in the days after it, and to install the Bonapartist Boris Johnson. The Tory Party is irrevocably split, and that will have consequences in the weeks and months to come. The internecine struggle so far will be mild compared to what is to come. And, that is being mirrored in the United States, where Bojo's doppelgänger, Trump, has the potential to become US President, with severe dangers for humanity.

The Democrats appear to have made a serious mistake in selecting the fundamentally flawed Hillary Clinton as their establishment figure to challenge Trump. Not only is their still the potential that she might be facing criminal proceedings before the vote, or before she could take office, but, at a time when there is a clear global movement against the establishment by large sections of populations that have grown tired of being screwed by austerity for years, whilst the super rich have become even richer, Trump has – however incredible that a billionaire could achieve such a feat – placed himself in the position of populist, anti-establishment figure.

Bernie Sanders is not what most European socialists would consider even to be a social-democrat let alone a socialist, but all of the polling shows that he stood a far better chance of beating Trump than Clinton does. If the Fed does not raise interest rates in June, the window for rate rises will begin to close as the election campaign gets under way, and it will not want to be seen to be intervening.

The Fed, therefore, should probably raise rates by 0.5 points in June, with further rises in July and August. It should, but it probably won't.

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