Why the Fed Will Not Raise Interest Rates

There are reasons why the Fed will not raise interest rates this year, at least, not until after the election. Here are some of them.

1. The energy price shock is not something that the Fed can control. The oil price depends on many factors, and monetary policy is not one of them. Those who allege the oil price is determined by the weakness of the dollar are ignoring history. There have been just as many periods when oil prices rose and the dollar was strong as there have been in the reverse. The direction of causality between oil and currency is not proven. Skeptics can look at the oil price in other currencies and see that it has also traced a parabolic curve.

Energy price inflation is a shock. It causes substitution wherein consumers spend on gasoline or other energy at the expense of spending on something else. It functions as a tax. The amount of energy price inflation tax has already exceeded the total federal rebates. Energy price taxes, just like other taxes, reduce economic activity and slow the economy. They are deflationary, not inflationary. In this case the tax collectors (recipients) are foreign governments, and so the US is transferring wealth to them. The Fed cannot control any of this economic transfer. It only exacerbates it by raising interest rates.

2. Food price inflation is another form of shock. We know the story on corn and flooding. Soybeans are also impacted. We have seen drought-induced rice shortages and higher rice prices. And we have already written about the new airborne fungus impacting wheat. The Fed can do nothing about the weather, nor can it alter the natural progression of a wheat disease. Monetary policy is not designed to handle these natural forms of shocks. Like energy, the higher food prices are altering the consumer's ability to spend elsewhere. Food prices force substitution just like energy prices.

The Fed can also do nothing about the stupid Congressional structure that has subsidized ethanol and caused higher food prices that now have a "pile-on" effect on the weather-induced food price problem. The United States national legislature has dealt a terrible blow to Americans and the world with its policy. Notice how silent the Senators and Representatives are about ethanol. Remember all the crowing about "energy independence." Now you hear nothing. How many journalists have probed the votes of those who gave us this policy? How many now editorialize against it? How many admitted that this massive subsidy at the federal level has been an enormous raid on the taxpayer and has diverted national resources to economically nonviable businesses? The Fed is powerless to do anything about this situation.

3. The housing situation is worsening. No bottom is in sight, as prices of housing continue to fall throughout the country. There are still millions of housing units in excess inventory that have to be absorbed. The Fed will only exacerbate this situation by raising rates. It took the Fed 6 months longer than needed to get the rate low enough so that resetting mortgages reached levels that did not raise the foreclosure, default, and delinquency rates. Now the Fed knows it must hold the short-term rate steady so that this situation can start to plateau. The lead time between monetary policy and impact on housing is nearly a year. The foreclosures we see now are a result of policy a year ago. The Fed knows this. Raising rates now only makes the housing situation worsen.

4. Wealth effects are harder to measure but are a real force in the economy. We have two at work, and housing is only one of them. The other is the negative psychological effect that impacts individuals when they see the declining values in their retirement plans (401k). This is the "flip side" of a rising stock market. The result is that individual investors retrench. We see that in mutual fund flows and in the choices investors make in asset allocation. We see that the stock market "labors" even as the Fed has lowered the policy interest rate to 2% and has extended massive liquidity to the banking and capital markets through the use of the many new tools and the redeployment of the Federal Reserve's balance sheet. The Fed has done about all that it can to offset any negative wealth effects. Rising interest rates would only worsen the present situation.

The housing negative wealth effect is becoming a record drop. Homeowners' equity dropped about $400 billion in the first quarter of this year. The year-over-year drop was nearly $900 billion. The total decline in US households net worth was $1.7 trillion in the first quarter of 2008. This is the largest quarterly decline in the post-WWII history. Falling housing prices are now raising the default and loss rates on the $600 billion home equity second mortgage sector. These have been securitized and are likely to trigger the next round of write-offs and loss reserves in the financial sector. The Fed has already dropped the reference rates to the level that will blunt the damage. Going lower will not do much more to improve things. Raising rates will certainly exacerbate this situation.

5. The Fed knows that it is under political attack. We have written several times about Senator Christopher Dodd's behavior with respect to Fed appointments. The Economist recently editorialized a view exactly consistent with ours. Dodd isn't even embarrassed by the revelation that he took a personal mortgage at a below-market rate from Countrywide under their "VIP" program. At least his colleague, Senator Conrad, admitted the error and contributed the difference to a charity and refinanced his mortgage. Dodd has done nothing but deny he took a subsidy, and claims he didn't know about it. The Fed is in its weakest political position since 1932, and the Board of Governors' appointments are the most impacted since the Depression era. The Fed normally does not raise interest rates preceding a national election. This time they are a beleaguered body and threatened by politics unlike in any recent period of history. Politics has injected a wild card into the Fed decision making. We expect that the Fed will stay on hold until after the election and keep its profile low in September and October. But the other forces at work are such that anything can happen.

We will stop here because of time. Our position is that the Federal funds rate will be unchanged for the rest of this year. We also expect the Fed to continue the use of its balance sheet in these newer forms as it tries to narrow credit spreads and restore dysfunctional financial markets to more normalcy. No one knows what the new normal will be. The situation is not healed and the Fed knows it. Before the Fed can resume a more normal policymaking stance it must have restored financial markets to a healthier condition. The Fed cannot apply policy to an injured financial system. The Fed knows it. That is why the Fed is unlikely to raise rates in 2008.

David Kotok is founder and Chief Investment Officer of Cumberland Advisors. He posts regular market commentary at Cumber.com.

Comments

[WorkingClass]

The Fed is a banking cartel. It will do whatever is in the best interest of its members.

[castlerider]

David, thanks for your post and for mentioning each of these epic transitions as a shock because that is precisely what they are- for the rich elite who are all gaga in love with Milton Friedman's syle of economics that prescribes shock as a means to impugn government and lay waste the economy for corporations to take hold after the groundfloor has been devastated and summarily wiped clean.

What about this idea, and why wouldn't it work? What if we froze interest rates for all property owners 3 to 5 years. Prior to setting this freeze we mark a day. Say, at the end of the year, or a certain month, when all purchases must be made by, and all loans are locked. After this day, rates are then set and allowed for all future purchases from that point to go up to 8%, to 10 %, where they should be... many will argue that such manipulation would be wrong, but think of how much money would move. The momentum would be incredible. Regulations could be set to guard against greedy speculators and investors, where everything must be transparent and available to review, but that could be done easily enough. This would bring EVERYONE down off the fence and make them buy. Then, when rates go up, it will bring in TONS of dollars and investment into our infrastructure. Again, the momentum would be extremely strong .. These are dire and extreme times, and such times call for very special

[themodernleader]

The Fed will raise interest rates when there is a crisis of confidence in our currency. It will happen when it happens. No one knows. The only certainty is that it will happen sooner than later. Governmental deadlock and the despicable Fed squanderers and special interest traitors have assured that certainty.

[avraamjack]

.
Elaboration on thr comment about the Board of Governors appointments would be nice.
.

[Rule Of Law]

Oh, and referring to the Sub Prime Mortgage Scam and Rip Off Crisis as "the housing situation," certainly avoids assessing responsibility to anyone in the Financial sector where this pump and dump originated. And talking about the homes of millions of Americans who were conned into those predatory loans as "housing units in excess inventory," further dehumanizes this fraud and it's far reaching human toll!

The FED, whose cheap money policies beginning in 2004 fueled most of the runup and speculation we have seen in these sectors, will continue that policy to feed the debt engine this country now runs on, increasing the wealth of the wealthy, while making the inflationary cost of living for the rest of us, ever more difficult

[Rule Of Law]

"Those who allege the oil price is determined by the weakness of the dollar are ignoring history."

AS someone who works in Finance, you should understand that when the dollar is low against the world's currencies, it makes Everything more expensive for us. Certainly it is just a part of the problem, but no where in your article do you mention Speculation or rampant market manipulation as possible additional causes for our current recession.

Speculators are now cashing in. There has been little reference here to what newspapers like Germany's Der Spiegel is reporting:

"After investing in high-tech stocks and real estate loans for years, legions of speculators have now discovered commodities like oil and gas, wheat and rice. Their billions are pushing prices up to astronomical levels -- with serious consequences for ordinary people's quality of life and the global economy."

They seem to get it in Germany and the rest of the world, including the Midwest here, that the commodities markets--everything from foods to energy--are being manipulated.

[Rule Of Law]

Here is the link for the farm speculation article:
http://www.signonsandiego.com/news/business/20080422-0715-foodprices-speculation.html

[elpollo]

So, Mr. Kotok. Do you see deflation kicking in, and if so, do you have a time idea?

[Rule Of Law]

"The Fed can also do nothing about the stupid Congressional structure that has subsidized ethanol and caused higher food prices..."

President Bush advocated for ethanol:

http://www.washingtonpost.com/wp-dyn/content/article/2007/01/24/AR2007012401869.html

And isn't it a convenient scapegoat for rising food prices--especially when:

"Farmers, ranchers and grain processors met with regulators in Washington to discuss the causes behind turbulent markets and historically high prices for wheat, corn and other foodstuffs. Food producers have complained in recent months that increased speculation by Wall Street investors has thrown off-balance the exchanges where they buy and sell crop futures."

Gee, but what do they know. They just grow and process it. No mention of ethanol, just good old fashioned speculation that the Commodity Futures Trading Commission refused to act against!