The real reason the federal reserve can't raise interest rates

Shah Gilani
0 Comments|July 23, 2008

A look at the central bank's hand.

Given that the U.S. Federal Reserve is the master of “Three-Card Monte,” can you tell what’s in the cards for short-term interest rates?

Three-Card Monte is a confidence game in which manipulation and misdirection are employed as the “mark” tries to guess where the “money card” is among the three facedown choices.

The Federal Reserve’s job is to masterfully manipulate the public’s perception of where interest rates are headed. And it runs this larger-than-life game with three specific face cards:

  • Inflation.
  • The U.S. dollar.
  • And the actual “money card,” which is interest rates.

For the Fed, the end game is public confidence itself. The central bank actually intended to gain and keep our confidence in its ability to stem inflation and strengthen the greenback. And it pursues these two objectives by simultaneously managing the direction of interest rates and working to keep the economy from dropping into a recession, or worse, a depression.

The Fed and the Global Game of Dealer’s Choice

First, ladies and gentlemen, please take a good look at the inflation card. What we have here is the Jack of Spades, the rising inflation card, and a devilish villain whose prospects instill fear in all the world’s central bankers – not to mention the public at large. But remember that real inflation is initially trumped by inflationary expectations. Here’s what that means: No matter how bad inflation gets when it rears up, this tsunami of swirling prices doesn’t really reach shore and inflict damage until there is a pervasive expectation of its arrival.

It’s here that the perception about the potential impact actually begins to take hold and starts changing our behavior.

If a loaf of bread costs $2.00 today and $2.50 tomorrow, is that a problem?  Let’s assume that prices for some other things are rising, too. That may or may not be a problem; it depends on what you are buying. But if you look at the increase in those items that have risen in price, you can raise the specter of impending inflation. The question to ask is this: Is it affecting you?

Prices rise and fall based not only on the supply and demand for our loaf of bread, but also on the same catalysts for the underlying ingredients and labor that go into that bread loaf.

If increases in those costs are passed along in the form of higher prices for the finished product, then we will pay more. But we may no longer have a need to purchase that loaf of bread, or we may have substitution possibilities that are not as costly. Inflation is only a problem if there are a lot of goods and services for which there are no substitutes, meaning that we have to pay those passed-along higher prices for such “essentials.”

It is therefore the expectation of inflation across a wide spectrum of mostly essential goods and services that begets real inflation. And as we’ll see shortly, it’s a viciously virulent circle. If prices rise and we cannot afford the goods and services we demand, we will seek higher wages to be able to finance this newfound higher cost-of-living. If we achieve higher wages to pay for the higher cost-of-living, our employers’ profit margins are crimped and they have to charge more for the goods and services we produce for them so that they can pay us.

Finally we have a “real” problem – “real” inflation. And it’s quite a hand to be dealt.

But beware of the trickery being played upon us. Let’s take a look to see what I mean.

Watch for the Fed’s One Hellacious Hole Card

The first card of the three to be played is the Jack of Spades – the card the Fed shows us when it acknowledges its own inflationary worries. Central Bank Chairman Ben S. Bernanke & Co. show us that card because it’s meant to tell us: “We have to raise interest rates to stamp out your expectation that inflation is taking root.”

That’s an important part of the central bank’s hand. But here’s a secret those of you who aren’t yet initiated in this confidence game probably aren’t aware of: The Fed doesn’t really have to actually raise interest rates, since the mere expectation the central bank is going to act is enough to change individual behaviors and alter market trends.

Second, ladies and gentlemen, we have the Jack of Clubs – the falling-dollar card, another devilish villain. Take a good look, folks: The prospect of a falling dollar means that – relative to other currencies and other economies (Europe, China, India, Japan and South America, to name just a few), America’s worth is declining.

The falling-dollar card also points to increased inflation. Why? Because the more the greenback declines, the more it costs us to buy the goods and services we get from all of our trading partners.

Additionally – and much more insidiously in nature – the value of all the dollars that our trading partners hold is falling, meaning that the buying power of their dollar reserves are in decline, as well. That’s a problem for many reasons, not the least of which is that their stronger currencies allow them to buy U.S. assets at bargain-basement prices. Indeed, it’s already happening, as we see from all the foreign takeovers of U.S. companies, and from Dubai’s recent buyout of New York’s Chrysler Building.

Moreover, since most of the world’s commodities – especially oil – are priced in dollars, it takes more and more dollars to pay for those commodities. And with oil, the producers are loath to see their petro-gusher revenue decline. So with every downward click in the dollar, there’s a corresponding upward click in the per-barrel price.

If that doesn’t represent inflation, nothing does.

For the Fed, then, the Jack of Clubs is the card the central bank is now waving to say: “We have let the greenback fall far enough and we are ready to support our dollar and strengthen it.”

At this point, the only real way to strengthen the dollar is to raise interest rates.

So, my good friends, just where is that third card, the Queen of Hearts, the interest rate card? In which direction are rates going?

The Queen of Hearts is nowhere in sight.

The confidence game now demands that the Fed take action against inflation and strengthen the dollar. The two Jacks are the cards central bank policymakers are energetically and enthusiastically waving in our faces. But it’s misdirection – that’s the game.

By waving those two cards, the Fed implies that interest rates must rise to stem inflation and support the dollar.

But rates cannot rise. The game is fixed. And most investors don’t even realize it.

The Fix Is In

The Fed is not really worried about inflation (on a relative basis). It’s true that inflation has reared its ugly head, and is inflicting both damage and pain on the U.S. economy. But the collective expectation for inflation and its resulting pressures are not here yet. The Fed knows that as we are falling deeper into recession, jobs will be lost, wages will not rise, consumers will not be buying. There’s no real need to raise rates. The central bank just needs to show us that it has that card; it’s part of the game. It’s about giving us confidence in its resolve to do battle with the evil forces of inflation.

The same is true of the Fed and the dollar. It’s only been in the past couple of weeks that the current “Bush-league” administration and the Fed have even acknowledged the dollar’s big swoon. Why the delay? Because they knew consumers were tapped out and that the only growth (which they point to as part of their confidence-building shell game) is being generated by exports. The dollar has fallen so far that our U.S.-made goods and services are essentially “on sale” when compared to wares made in countries whose currencies have zoomed to record highs against the greenback.

I hope I’m not confusing you. But if you are a bit bewildered, let me provide the “spoiler” here by telling you precisely why the “money card” stays face down: Interest rates cannot go higher.

The credit crisis has blown our banking system apart, and the fallout from that explosion has smashed our entire capital formation/borrowing & lending infrastructure. And the capital that formally emanated from that sophisticated system is what makes the merry go round.

Rates now have to stay low in order to jump-start these crucial liquidity flows and re-ignite demand. While it’s true that maintaining low interest rates will further fuel inflation, the Fed really has no choice. Or perhaps it’s a Hobson’s choice. You see, if the central bank actually raises rates to combat inflation, adjustable rates on mortgages will rise, setting in motion a whole new round of housing defaults, which will lead to an escalation of bank write-downs, which will torpedo stock prices, which will force institutional investors to liquidate holdings to raise capital. The same will happen out in the marketplace, where companies with debt coming due will find it impossible to refinance, touching off still another avenue of defaults, losses, and write-downs.

Better to keep rates low now – and believe that it can throttle back inflation later on.

Beware of the proverbial dead-cat bounce. Keep your eyes on the prize. There will be a market bottom. It’s not clear how long that will take. But keep this in mind: It won’t be a buying opportunity until the “shills” have been shaken out and “the game” the Fed is playing is no longer a confidence game, but instead is the kind of transparent, well-supervised marketplace that’s the hallmark of capitalism.

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