Should they? Will they?
The second question is much easier to answer, and we will start with that. Much like the September 18th, the US Fed will “most probably” deliver another 50bps cut on Nov 07th. Like the previous 50bps reduction, this will do nothing to alleviate the bursting of the multi-asset bubbles of stocks-bond-and-housing they have created, the ongoing unraveling of these malinvestments, or the collapsing employment market. The only way to shore up the sagging employment numbers would be to create massive “unproductive” government jobs, as was demonstrated in the October employment report.
After the Nov 07th cut, we could expect another 50 to 150bps cut in the Fed funds rate over the next few months before rising price inflation forces them to reverse course and start hiking amidst the scenario of the bubbles bursting. That, of course, would be the “moment of truth” for the free market economists. & hopefully, the beginning of the end for Keynesian Economics that has dominated the mainstream landscape for the last 4 decades. More importantly, it would signal the beginning of the return of the barbarous relic (for the uninitiated, John Maynard Keynes had referred to Gold as “A Barbarous Relic”) to monetary economics.
It amazes me that Central Banks continue operating according to the “Keynesian playbook” while buying/ holding Gold. Scott Fitzgerald observed, “The test of first-rate intelligence is the ability to hold two opposing ideas in the mind at the same time and still retain the ability to function.” Scott would undoubtedly disapprove of using his Meta-doublethink quotation in the context of Central Bankers, especially those at the US Federal Reserve.
So, what will the consequences of the November 07th cut be? Increasing commodity prices and perhaps a slight deferral of the bubble bursting by a few weeks. Whether a few additional weeks is worth the price inflation is something that only Powell can answer, but in his defense, this has been the playbook for decades, and he is just continuing in the same vein. The consequences mentioned above would essentially be the case for almost any “reasonable” action taken by the US Fed at this juncture. An Inflationary Depression for the US is cast in stone, and Powell cannot alter the outcomes for the next decade.
We will now focus on the first question, “Should they”?
An easy answer to the above question would be, “Of course Not”. They should be raising rates and not cutting them. If the objective of the rate increases was to curtain monetary inflation, the 500bps increase starting in 2022 hardly achieved that goal. The National debt increased at the fastest pace since the rate hiking cycle, so the correct policy step would have been to increase the Fed funds rate and not hold steady or, worse, decrease as the Fed has been doing since the last hike in July 2023.
If the 5.25% to 5.5% rate did not come even close to meeting the objective, what would the Fed Funds rate have to be to curtail the monetary inflation? My estimate would be it has to be close to 10%. Assuming for a moment it’s correct, why did Powell not stay the course on he was till July 2023 and increase the rates further? After all, the economy seemed to be doing fine, with positive GDP growth, low unemployment, and price inflation still well above the target of 2%.
At a 10% interest rate on National debt, the interest component alone would take up more than 70% of the Federal Revenues, assuming that the revenues do not collapse due to the recession. Even with a 20% reduction in revenues (for comparison, the Federal Revenue declined by more than 20% between 2007 and 2009), almost 90% would go only towards interest payments. So, as I have said earlier, it’s not the recessionary fears that are the primary guiding factor behind the rate reduction of the US Fed, but rather the fear of exposing the bankrupt nature of the Federal government finances. From this perspective, it is indeed clear why Powell had to do what he did.
However, let us step back a bit. The cardinal question to answer is NOT “Should they cut rates?” BUT “Should they even have the power to tinker with interest rates?”
To answer the question, we have to first understand what “interest rates” is. As I explain in my book “RIP USD: 1971-202X …and the Way Forward,” interest rates are the “Price of Borrowing Money.” It is the price that helps individuals choose between current consumption Vs. investments to enable greater consumption in the future. For the same reasons, we do not want governments to set the price of cars or tomatoes, we shouldn’t have the government determine the most important price in the market, i.e., interest rates. Let me explain further.
Market interest rates – The Holy Grail of Capitalism
I have used a very simple Demand-supply curve of tomatoes to explain how prices are set in the “Free Market”.
- The supply curve is the upward-sloping line in the figure above. As shown, at a price of $1, the supply would be just 5 tons, but for $3, it would increase to 17 tons. It is easy to understand why the supply is more at higher prices as marginal lands are brought under cultivation.
- The demand curve is a downward-sloping line. As prices increase, individuals cut back on consumption, so the desired quantity tends to decrease at higher prices. For example, for $3, the demand is only 7 tons, but for $1, the demand increases to 15 tons. We can all intuitively understand this.
- The market price (point A) is the price at which the quantity supplied by producers equals the quantity demanded by consumers. This price of $2 is brought about by the invisible hand of free markets to ensure an equilibrium between supply and demand.
What happens if the government steps in and fixes the price of tomatoes to $1? This will ensure that while the demand is 15 tons, the supply is just 5 tons. This leads to other sub-optimal solutions like rationing or worse, the development of black markets.
Now, just replace “Tomatoes” with “Money” in the figure above. The “Price” is the “Price of borrowing” or more commonly understood as “Interest Rates”. The quantity of tomatoes becomes the “Quantity of Money”. The way markets would work is as below:
- At the natural rate of interest determined by free markets (i.e. 2% in the figure above), the quantity of money from savings would equal the quantity demanded by borrowers for investments.
The above is a simplified explanation but still works for the specific purpose of this article. For scholars interested in understanding further, I would recommend my book or even better “The Theory of Money and Credit” by Von Mises.
Now, the question is, what happens when the Federal Reserve steps in and artificially reduces interest rates? Much like in the case of tomatoes, the supply will reduce, and the demand will increase. The Federal Reserve would then create this additional money/ credit out of thin air. The correct terminology to describe the action of the Federal Reserve in tinkering with interest rates is “Price Fixing Money”. It should also be clear why this “Price Fixing” is very constrained under a Gold Standard as the US Federal Reserve cannot create the required additional gold out of thin air.
Money is one-half of all monetary transactions we conduct, and by manipulating interest rates, the Federal Reserve is distorting capital allocation, which ought to be a core market function. As I explain in the book, the boom-bust cycle and the malinvestments happen ONLY because of this artificially low-interest rate regimen engineered by the US Federal Reserve.
We can see the pattern repeatedly in the post-1971 paper monetary system – First, the NASDAQ bubble in 2000, followed by the housing bubble in 2008, and now we have the “Dollar Bubble” (manifested through a stocks-bonds-housing bubble) that is in the process of unraveling.
The quantum of monetary inflation leading up to the current crisis is an order of magnitude higher than the one that caused the GFC in 2008. It stands to reason that the consequences of the burst will be proportional to the artificial boom. Therefore, we should forget all the soft landing—hard landing discussions; it will be evident that when the bubble bursts, the US economy has been flying on “empty” for a long time now.
Conclusions
To have a system where central banks manipulate the most critical price in a system (i.e. Interest rates) and then call it capitalism is a travesty of the truth. We need to establish a system of market-determined interest rates, and that will not be politically possible under the paper monetary system – the incentives to violate are unimaginably immense. The ONLY way to achieve that would be through a gold standard, which would also end the boom-bust cycles we have been subjected to during the last few decades.
The real tragedy is that all these crises are eventually blamed on capitalism, and the Federal Reserve has managed to avoid its role in fomenting these bubbles. How long will the media continue treating the Federal Reserve as Caesar’s Wife?
Note:
1. Text in Blue points to additional data on the topic.
2. The views expressed here are those of the author and do not necessarily represent or reflect the views of PGurus.
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2. Returned to India in 2005 and have been an investor ever
since
3. Focus on investing in precious metal equities, particularly Gold, Battery Metals and Uranium Juniors.
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