What's Behind the Interest Rate Conundrum?

Before we can even begin to discuss Interest rates intelligently, we must first define what it is that we are actually talking about since it appears that all the talking Media Heads and Wall Street analysts haven't a clue as to how interest rates work or even what their primary functions are supposed to be.

WHAT ARE INTEREST RATES?

#1 Interest rate is just another word for price. It is the price for money and it is determined exactly the same way as the price of any other commodity, product or service - through the interaction of supply and demand.

#2 However, unlike every other product, commodity or service, interest rates and money do not operate in a Free Market. Interest rates and the supply of money are greatly influenced and manipulated (controlled) by the Fed. They do this by controlling the amount of money that is available in the banking system through their Open Market Operations (buying & selling treasury Bonds in the open market) and by changing their deposits that they have with their individual members (Banks).

WHAT ARE THE FUNCTIONS OF INTEREST RATES?

# 1 Interest rates determine the propensity of people to either Save or Consume: When interest rates are manipulated (by the Fed), it influences the degree that people are willing to defer present consumption in favor of savings. If interest rates are manipulated too low, like they are now, people are no longer willing to save. When the interest rate is so low that it becomes negative (the interest rate is lower than the inflation rate) as they are today people, since they are now being paid to go into debt, take on excessive risk by investing and borrowing because that is exactly what they are being paid to do.

# 2 Interest rates also determine which investments should or should not be made, by their expected rates of return. When interest rates are manipulated too low, a great many investments and risks are undertaken that should not have been, because they will fail at the first signs of weakness in the economy or with rising interest rates. This is the main underlying cause for the business cycle. The imbalances (wasted resources) in the economy must be liquidated before the economy can stabilize enough so that the next growth phase can begin.

# 3 A Neutral Rate of Interest is the rate that neither stimulates nor restricts the economy. Greenspan is in a conundrum as to what that rate is or should be. Previously, that rate was thought to be 1.5% to 3% over the inflation rate. In the past, when the Fed did not manipulate the rates except at the extremes, the market was able to determine what that rate should be through the interactions of the Free Market. But today with US savings nearly zero, the Fed is unable to measure the Velocity of Money and with negative interest rates, the Fed does not have a clue as what the neutral rate should be.

# 4 The Discount Rate is the rate that the Fed charges the banks who want to borrow money from the Fed. They FED used to be referred to as the Lender of Last Resort. The interest rate charged used to be a Punitive Rate; A rate that was somewhat above the Fed Funds Rates (the rate at which Banks lend to each other in order to meet their overnight reserve requirements). But today, the discount rate is below the Fed Funds rate, drastically lowering their cost of money and reducing the amount of interest they are willing to pay for deposits) so that now massive amounts of money are being borrowed from the FED without having to worry about excess demand increasing interest rates, greatly increasing the banks' ability to create money out of thin air. (completely negating the supply/demand function in setting interest rates) This beak down in the function of a free market has led to the creation of "The Carry Trade." In so doing, the Fed has completely lost control over the banks and near banks' (FNM, FRE etc.) ability to create money and have therefore lost control over the money supply: This has led directly to the creation of both the Stock and Bond Market Bubbles and more recently, to the ever expanding Real Estate Bubble. Regardless of the ever increasing demand for loans interest rates continued to decline.

Fed Chairman Greenspan once again raised the conundrum of the divergence between short term and long-term rates during his recent testimony before the Joint Economic Committee of the US Congress. At the end of May, the yield on the 10-year Treasury-Note stood at 4%-well below the 4.6% rate in June of last year when the Fed funds rate was only 1%. Greenspan blames some mysterious 'pressures' for the divergence between the Federal funds rate and long-term rates. Careful examination shows that there is no mystery. The so called mysterious pressure is in fact the natural outcome of the Fed's own policies.

When it comes to interest rates, what matters most is the availability of money and not the purported interest rate stance of the Fed. For example, in order to maintain a given interest rate target in the midst of a strong economy, the Fed is forced to push more and more money into the system to prevent the Fed funds rate from rising above their target rate. This in turn causes long term rates to fall. The opposite will happen should the economy go through a period of weakness. Since they are always behind the curve, they end up accentuating the problem Since June 2004, despite raising the Fed-funds rate target, the Fed has actually hiked the pace of pumping money into the system. In short, the Fed has been talking tough while acting loose.

TIME LAGS: Nobody seems to realize that there are always time lags whenever there are any changes in money supply or oil prices or ??? . It takes time for the Free Market to send its signals through to every participant. The estimated average time lag between changes in the Fed Funds policies and the growth momentum of industrial production is on average 9 to 12 months. Hence, at the same time as the FED"S attempted tighter stance ( June 2004) the effect of the previous easy interest rate stance was still in force and continuing its influence for the following nine to twelve months. So in spite of their regular ¼ % increases, it kept the yearly rate of growth of industrial production around 4 to 4.5% in the first half of 2005. However strong economic activity has made the Fed targets unsustainable-so the Fed had to lift its monetary pumping to prevent the Fed Funds rate from overshooting their target. This monetary pumping has in turn prevented the growth momentum of liquidity from falling, thereby preventing a rise in long-term interest rates.

INFLATION: Everybody knows that inflation is a monetary phenomenon. If you keep printing money (beginning in 1994) at a rate that is 10% a year above the economy's rate real rate of growth, inflation must eventually ensue; It first showed up in the stock market, then found its way into the Bond market and eventually into Real Estate. Although the government has thus far managed to convince everyone (through their ingenious manipulation of the CPI) that there was and is no inflation, Nevertheless inflation has already begun to show its face and it won't be much longer before we see just how high inflation really is. Greenspan to his credit is looking to the Future while the rest of out esteemed analysts are still concentrating in their rear view mirror.

Conclusion

It is probable that the Fed has decided to push the Fed funds rate even higher in order for liquidity growth momentum to start trending down. But by doing this, with out taking into account the lagg effect of their last 12 months of interest rate hikes, the Fed has set in motion a depressing effect on economic activity which will take effect more than likely within the next 3 to 6 months. In the meantime, the lag effect of the tighter interest since June 2004 will also start to undermine the stock, bond and real estate booms that sprang up on the back of the past ultra loose period of liquidity, setting in motion the next economic bust. What To DO Now?

Liquidate all your short term Debt. Build up your cash position by selling most of your stock and long term bonds. (begin by liquidating all your loosing positions immediately) Buy Gold and if you know how look to finding short selling opportunities. If you don't know how look to find someone who does and is attune with your level of risk tolerance.

GOOD LUCK

Aubie Baltin CFA, CTA, CFP, Phd. (retired)

Palm Beach Gardens, FL

[email protected]

561-840-9767

11 October 2005