What the Fed Should Do About Interest Rates

Bill Bonner - Wed 30 Apr, 2008

The Fed should raise rates and bring about a much needed correction.

Writing from Paris:

Today’s Daily Reckoning will be a bit light. First, we don’t have much to say…and second, because we have no time to say it anyway.

As to the first issue, nothing much happened yesterday. The Dow retreated only 39 points. Oil slid only $3 - $115. The dollar rose slightly – to $1.55 per euro. Only gold seemed to want to go somewhere – down $18.

As near as we can figure, most investors think the worst is over. After a correction, stocks are going back up. The dollar too. Gold, meanwhile, is going down. Bernanke, Bush and the whole company of angels and archangels who watch over our economy and our money are winning, they believe.

But the more they win…the more you lose, dear reader. Because there are mistakes that need to be corrected. There are errors that need to be punished. Truth needs to be discovered.

And the longer the correction is delayed…the more we live in darkness and error, and the more it costs to fix things. You don’t have to be an economist to figure this out. It’s just the way the world works.

We ended yesterday’s note by reminding ourselves what money really is. When a bank makes an electronic transfer, electrons are the only thing that crosses a street. But those electrons represent pieces of green paper…which, in turn, represent wealth. And what is wealth? It is limited resources…the potential to take up some of the world’s coal, iron, plastic…anything from a ton of wheat to a brand new Mercedes…to some working man’s time.

The problem, fundamentally, is that the credit expansion of the last 25 years gave too many people too many claims against those limited resources. Then, when they went to exercise those claims – against stock market earnings in the ‘90s…then against houses in the early ‘00s…and now against oil, rice and gold – prices rose. The rising prices sent a phoney signal. They convinced investors that there was more demand for dotcom stocks and houses than there really was. And today, they’re signalling an outsize demand for commodities and gold. As money pours into the bubble sector…more and more resources – time, capital, things – are misdirected away from things people really want and need and into the bubble. Eventually, the bubble pops…losses are taken…and rebuilding can begin a firmer foundation.

‘But wait,’ we anticipate your question, ‘are you saying that commodities are going to crash too?’

Yes…of course. Every farmer in the world is working hard to make it happen. Lured by high prices, they are bound to over-produce. They always do. Over-production is, by definition, a mistake. It will need to be corrected, eventually… just as over-building of new houses is being corrected…and just as over-investment in Nasdaq dot.coms needed to be corrected.

The correction in the housing market made its sharpest move ever in February, with houses nationwide down 12.7% from 12 months earlier. In Las Vegas, Miami and Phoenix prices were down 20%. Foreclosures doubled in the first quarter, with Nevada leading the way.

The fall off in housing has cast a shadow over the whole consumer economy. Consumer confidence is at a five-year low. The LA Times tells us that people who live on tips – such as waitresses and bellhops - report that clients are tighter with their money than they used to be. Even the big spenders are less willing to part with their money. Says the Rocky Mountain News: “millionaires are singing the recession blues too.”

But let’s go back to commodities, oil and gold. Just because there will eventually be a correction in these markets doesn’t mean it is going to happen tomorrow.

Let us turn to the case of gold, for example. Yesterday’s close left the price at $876. If we’re right, a lot of investors and speculators are beginning to worry. We bought most of our gold when the price was below $500. But many of these guys got into the gold market at $800 and above. Some have already lost money. Others are worried about preserving their gains. Even a few of the old-timers are recalling the terrible bear market in gold of ’80-’99. They lived through it; they won’t live through it again, they say to themselves.

But even at $900…or $1,000…gold has still not got to the silly stage of a bull market. That is, it is a bull market…but not a bubble. The charts show a steady rise in the price, but no vertical spike.

And, as we’ve pointed out many times, a lot has happened since ’80. Simply adjusting the ‘80 price to inflation, gold would have to sell for nearly $2,500 in today’s money to return to its previous high. But inflation of the dollar is only a part of the picture; a bubble in the credit markets has led to trillions of dollars worth of derivatives …trillions of dollars’ worth of new debt…trillions worth of dollar reserves in China, Japan and Russia…dizzy prices for “works of art”… madcap building projects in the Mideast…breathtaking growth in China…and more debt than the planet has ever seen. Many of these prices and projects must be mistakes. Many will have to be corrected.

The Fed should raise rates…and bring on the correction. But that’s not going to happen, because another very important difference between ’80 and ’08 is the difference between Paul Volcker and Ben Bernanke. Volcker protected the dollar – which is why gold entered a two decade long bear market. Bernanke has no interest in protecting the dollar – which is why this bull market in gold has a long way to go. Instead of correcting the mistakes of the last 20 years, the Bernanke Fed is determined to help people make more of them.

*** What the US lacks, Europe seems to have. A positive trade balance, for example. Savings too. A rising currency. And a central bank chief more like Volcker than Bernanke.

This from Der Spiegel:

“Never before have the central banks of the United States and Europe pursued such divergent strategies when it comes to dealing with a financial crisis. The increased value of the euro against the dollar reveals which strategy is working.”

“Jean-Claude Trichet, the president of the European Central Bank (ECB), has the bearing and style of a classic representative of Old Europe. He always wears the best suits, his grey hair is carefully parted and his voice is so unassuming that it sometimes comes across as more of a whisper. He is happy to swap the columns of numbers that are part of his job for a volume of modern French literature.

“Ben Bernanke, Trichet's counterpart at America's central bank, the Federal Reserve (Fed), is an economics professor by trade and makes no secret of his dislike for suits. He once joked: "My proposal that Fed governors should signal their commitment to public service by wearing Hawaiian shirts and Bermuda shorts has so far gone unheeded." In his private life, Bernanke is an avid baseball fan.

“The personalities of the two men are as different as their strategies and their approaches to their jobs. Trichet runs the ECB thoughtfully and with circumspection. The Fed, under Bernanke's leadership, is hands-on and decisive.

“The ECB remains calm - sometimes to the point of doing nothing. Since the turbulence in the financial markets began last summer, it has left European key interest rates unchanged. The Fed, on the other hand, seems to take action to show it is doing something, sometimes to the point of hysteria. Since August of 2007, it has brought down the key interest rate at record speed, from 5.25 percent to 2.25 percent, to avert a recession in the United States.

“But now it seems that all of the Fed's efforts have been in vain. Testifying before the US Congress, Bernanke was forced to admit that he expects the US economy to grow very little, if at all, in the first half of 2008. It "could even contract slightly," he said.

“If a currency's value is a measure of confidence in an economy and its central bank, then the Europeans and their ECB are clearly emerging as the winners in the current crisis. Last week the euro climbed to a new record high of $1.60.”

"Bernanke is making himself a slave to the stock markets," said Willem Buiter, a monetary policy expert at the London School of Economics. Trichet, on the other hand, has opted for a hands-off approach. Interest rates in the euro zone are still where they were before the crisis, despite a considerably worsened economic outlook for Europe.

“But the ECB did not remain completely inactive. It provided the shaky banking sector with low-interest cash, a form of bridge loan. The banks needed the money because a lack of confidence had made them reluctant to lend each other money.

“The ECB acted according to a clear maxim. It would help the banks, but there would be no financial injections for the economy as a whole. The fear was that this would only lead to inflation.

“Meanwhile, the keepers of the euro are watching the activities of their American counterparts with a mixture of suspicion and unease. Although they would not say it publicly, they consider Bernanke's moves to be both dangerous and incorrect.

“Trichet and his ECB have…only one goal: stable prices. This strategy is also the consequence of a trauma, namely the hyperinflation in Germany in the early 1920s and the collapse of the currency after World War II.

“For this reason, the ECB has followed the German Bundesbank's lead by holding back with rate cuts. With prices currently rising at a rate of 3 percent, ECB representatives, unlike their American counterparts, are already talking about raising interest rates to keep inflation under control. They argue that keeping prices stable is the best way to promote growth.

“So far, at least, their approach has been pretty successful.”

*** “The U.S. is doing most of what it told Asia not to,” writes Bloomberg columnist William Pesek. “It counselled higher interest rates, stronger currencies, fiscal belt-tightening, avoiding fresh asset bubbles and limits on bailing out investors. These days, the U.S. is reminding the world it's better at giving economic advice than taking it.”