Fed Has Lost Control Over Interest Rates

I found another article our optimistic homebuilder CEOs should read.  Jim Jubak, MSN Money Editor, in his latest article suggests that the Fed has lost control over interest rates.   

Jubak states, “The dollar’s tumble and Federal Reserve Chairman Ben Bernanke’s attempts to placate overseas investors are the clearest signs to date that the foreign investors who finance the huge U.S. trade deficit have gained significant control over the U.S. economy. A few more weeks like that, and it will be clear to everyone outside of Washington that the Fed has lost control over U.S. interest rates.”

I find it interesting that so many reports are starting to surface about the state of the dollar.  It is almost like it is become socially acceptable to write that a $750 billion trade deficit is not healthy.

He goes on to describe the recent action in the dollar.  “On Nov. 28, as the dollar edged toward free-fall against the euro, hitting a 20-month low against that currency and plunging below key support prices in the currency markets, Bernanke got up on the ol’ soapbox to say that inflation was still “uncomfortably high,” growth in the economy was solid and the Fed’s next decision would be whether to raise interest rates again. That came as a big surprise to financial markets that were anticipating a cut in interest rates, perhaps as early as the first half of 2007.”

Jubak then outlines three major problems: a global dollar glut, a slowing US economy and rising euro and yen yields are not likely to go away soon. 

  • There’s that whopping U.S. trade deficit. Even though lower oil prices led to a drop in the September trade deficit to a mere $64 billion from the August record of $69 billion, it is on track to break $750 billion this year. That deficit has to be balanced by cash flows from overseas investors who provide the extra money that we spend to buy foreign goods and services. This puts more dollars in the hands of overseas investors and central bankers who are already worried about what to do with the dollars they hold.
  • Second, there’s the slowing of the U.S. economy in 2007. Yes, the revised third-quarter GDP growth at 2.2% was good news, but the economy is still in slowdown mode — second-quarter growth was 2.6%, after all. There’s a good likelihood that U.S. growth will lag growth in Europe and Japan for at least the first half of 2007. 
  • Third, U.S. interest rates aren’t headed any higher at a time when the European Central Bank and the Bank of Japan are still raising rates. That will lower the yield gap between U.S. interest rates and those in Europe and Japan, and as a result, the price of U.S. notes and bonds is likely to fall, while those issued in euros and yen climb.

From my understanding, the Fed has two mandates – to manage inflation expectations and to spur economic growth.  According to Jubak, a third one is being adopted.  “Yes, fighting inflation remains important to the Fed, and, yes, the Fed would prefer not to tank the economy. But Bernanke and company know that the tough choice must be made: Managing the dollar is more important at this point than managing inflation or growth. That’s because the huge piles of dollars sitting in the vaults of the central banks of China, Russia, Japan, the OPEC countries and the European Union are large enough that they make overseas bankers nervous.  When you hold 700 billion U.S. dollars in reserve (out of a total $1 trillion in foreign-exchange reserves), as the Chinese do, for example, every penny decline in the value of the U.S. dollar makes you nervous.”

The Fed is adopting a third mandate, because it is afraid of the consequences of a free falling dollar – when selling begets more selling.  So to nip this now “in the bud” Jubak expects higher interest rates sooner than later. “If it takes stronger medicine — an actual increase in U.S. interest rates — to do the trick, I think the Federal Reserve will raise interest rates, even if the economy is weaker than it would like. The cost of letting a dollar decline turn into a run on the dollar is simply too high. To the Fed, the domestic and, indeed, global damage of a run on the dollar outweighs the purely domestic costs of a period of slow or no growth.”

I just can’t believe how he concludes the article.  “Better to raise rates a little now, even if it creates unemployment and takes a bite out of stock and bond prices, than to face the need to raise rates so high later that it risks sending the U.S. economy into a recession that could be deep enough to take the rest of the global economy with it.”

Stagflation – rising interest rates in a slowing economy and our homebuilder CEOs think that the real estate market is bottoming.  Right?

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