In his excellent (as always) article of 3/30/05, the Mogambo asked The Big Question - Will the next rate increase by the Federal Reserve be a quarter point or a half point? That very same Big Question was the subject of considerable speculation before the previous FED meeting. Not even the mighty Mogambo offered to answer The Big Question, but the Optimist will do so now. The Optimist is happy to advise that the next FED meeting will result in an interest rate increase of no more than a quarter point, and the meeting after that may well be a surprise reduction in interest rates! The Optimist is pleased to be the first to present this unexpected perspective!
Contrary to the derogatory comments made by others about the intellectual quality within the FED, and despite the continuing process of dollar destruction caused by massive printing of excess dollars, the Optimist is confident that the FED is composed of people who are of reasonable (maybe even above average) intelligence. As evidence of that well disguised level of intelligence, the Optimist points to the masterful way they camouflage their prolific printing of excess dollars with statements which are cryptic to the point where anyone can interpret them to mean anything! The Optimist therefore can make the leap of faith that the members of the FED will be smart enough to see the US economy as clearly as the average high school student.
Any recent graduate from high school can readily report that there is no longer an abundance of good manufacturing job opportunities available in the USA. Many high school grads will be grateful to just get a job as a sales clerk in a deep discount store (which sells products made by the many new manufacturing jobs in China, Japan, and India). The Optimist notes with despair that even the number of service sector job opportunities are already declining as a result of the recent fitness craze causing a reduction in the number of previously sought after jobs like Journeyman Hamburger Fabricator at McD's. The point is that there is no longer a strong backbone (or leg bones, or arm bones, or anything else resembling a structural skeleton) of jobs which can continue through increases in interest rates that have historically been applied to cool the fires of inflation. Instead of a strong supporting skeleton, the USA economy has a soft underbelly of jobs which depend on the consumer to find a little more monthly income with which to make an additional minimum monthly payment on yet another new widget. Consumers no longer ask how much the widget costs. They need only be assured that they can fit the minimum monthly payments into their already crowded credit card agenda.
The Optimist is confident that our members of the FED, who have average or possibly even higher levels of intelligence, will be smart enough to foresee that increases in interest rates will directly translate into consumers having less minimum monthly spending ability. If the deep discount stores don't have buyers for that huge warehouse full of widgets, then the stores will quickly cut back on the precious service sector jobs our economy depends on. The quick result of higher interest rates will be a substantial loss of real service sector jobs of a magnitude that is difficult to hide among the already massively adjusted statistics. The Optimist is confident that a policy which leads to obviously rising unemployment is not politically correct.
Even though inflation will be increasing at a rate which cannot be disguised by clever hedonic adjustments, the Optimist offers the positive view that interest rates will not be permitted to rise to the level where the few remaining USA jobs are threatened. Since jobs will be the limiting factor, the Optimist is happy to share the good news that interest rates will be kept well below the true rate of inflation for the foreseeable future, and that silver and gold investments will prosper greatly over the years ahead.
Relax, gentle reader, and buy as much silver and gold as you like, without fear of a repeat of the 1980 approach Paul Volcker used to fight inflation. This time, consumers don't have an abundance of savings to dip into for a cash flow problem, or an unused credit line available for them to meet additional needs. This time, home owners don't have a substantial amount of untapped equity built up in their home. This time, the USA economy is barely afloat in an endless sea of debt, and would quickly drown under the weight of high real interest rates. This time, there is no base of strong employment to act as a life preserver to ride out the storm. This time, there is no possibility to massively increase the amount we borrow from the rest of the world. This time, we cannot dramatically increase our budget deficit to offset the economic drag caused by high interest rates. This time, there is no political will to be the party responsible for pushing the USA economy into depression. The Optimist is honored that he can be the first to tell you that this time, it really is different!
4/09/05 Update with reader input:
An alert reader recognized that the Optimist is much too optimistic, and he challenged me to put my money where my mouth is. Specifically, he advised that if I really thought the FED would push short term interest rates lower, then I should buy long term bonds.
Comments by the Optimist:
The Optimist must confess that he uses his full share of literary license, and sometimes he says things which are not meant to be interpreted literally as an ultimate truth. Although it is possible that the FED would feel the need to reduce short term rates sometime this year, the Optimist would also be surprised to see it happen. It seems far more likely that short term rates will continue to be modestly raised sometimes and held steady at other times, but that short term rates will always be kept below the neutral rate* relative to the true rate of inflation.
The roman candle of inflation is ignited, and it will blast a rising arc of increasing prices for years. The FED is now able to spur economic activity by simply holding short term rates steady, or even by allowing them to slowly increase below the neutral rate*, as inflation continues to roar ahead at an ever increasing pace. There is almost no limit to how high short term rates can rise and still be positive for the economy, so long as they remain below the rate of inflation. Just as in the 1970's the economy can continue to expand with short term rates in the teens, while inflation rages in the higher teens. As rising inflation bullies its way into the economy, the Optimist would be surprised if short term rates do not tip toe higher, but at a discreet distance behind the growing inflation like a diminutive and passive bride following at a safe distance behind a blustering and overbearing husband.
Long term rates, in contrast, are not directly controlled by the FED, but are normally driven by expectations for inflation in the future. The Optimist anticipates that long term rates are likely to strut higher along with inflation, after initially rising faster than inflation to catch up from the compression caused by the carry trade.
The Optimist confesses to being overly optimistic about the future, but he hastens to assure all readers that his optimistic character flaw does not include being bullish about any financial instruments. For whatever it may be worth, the Optimist does put his money where his mouth is. The Optimist consistently praises silver and gold investments, and that is the arena in which his personal investments are focused. As you can well imagine, the Optimist wishes the very best of luck to those who follow his suggestion to buy silver and gold!
* The neutral real interest rate is not, as some have indicated, simply equal to the rate of inflation. Consider, for example what would happen if we could shut down the FED and return to the silver and gold standard as required by the Constitution, so that inflation would be eliminated. After the celebrations ended at a huge number (so many that even the Optimist might be invited to a few!) of parties, short term interest rates would not fall to zero. The Optimist estimates that short term rates would likely range between 1% and 2%, depending on the state of economic activity at any time. We can think of a neutral interest rate which neither speeds nor slows the economy as approximately 1.25% higher than the true rate of inflation. With the current true rate of inflation likely to be in the 4 - 8% range, we can conservatively estimate the current true rate of inflation at 5% and then say that short term interest rates will be expansionary for the economy until they are pushed above 6.25%. The FED's current mode of very small steps up in interest rates is like gently lifting one's foot a little from the accelerator as the car speeds downhill. In 1980, the FED led by Paul Volcker actually moved its foot to the brake pedal, and only that action reversed the rapid rise in silver and gold. As indicated in This Time It Really Is Different, the Optimist is confident that this FED, in this environment of infinite debt, will continuously apply variations of pressure on the accelerator, and will never consider using the brake. The Optimist is fearless in his silver and gold investments, and he invites the reader to look at his charts to see how well that approach has worked. A chart of real interest rates is provided at Real Interest Rates Control Gold & Silver.
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