Interest Rate Rise NOW!

I have been doing some thinking lately and analyzing the Fed's rate action since 2000 and have decided the biggest problem created by the Fed was not bring rates to historic lows after the 9/11 terrorist attacks. The problem began when the jacked up rates in early 2000. Then after realizing they “goofed” dramatically reversed course in 2001 only to overshoot to the down side where they left rates to low for to long. When realizing this, the Fed followed with a draconian attempt to return the rates back to "normal" beginning in 2004, which wrecked havoc with the credit markets and economy.

It takes a while for the markets (and the economy) to react to both lower interest rates and higher interest rates. This is Econ 101 stuff. If rates are set at an abnormal level either on the high side or low side, the market will adapt, create all kinds of products and strategies to "deal" with the rates as they are and make money. The financial markets will make money, lots of it, any time official rates are out of sync with market realities, unfortunately with sometimes disastrous effect. This happened when rates were kept artificially low for to long. The markets were then shocked when rates were raised so quickly. The real question is, "Why does it seem the Fed is always lagging the markets so much, failing to see obvious signs of bubbles or crises?"

Rates were raised 17 (yes 17) consecutive times beginning June 2004. The rates had remained at 1% (fed funds rate) for the prior year and were 1.25% from November 2002.

Part of the reason the Fed had to lower rates so much in 2001 were the Fed's mistaken rate rises in 2000 of a full 1%. In only four months (Feb - May) rates were raised from 5.5% to 6.5%. The Fed then had unnecessarily choked the financial system and exaggerated the stock market bubble burst with this draconian rise. It is as if the Fed was (late to the party as usual) trying to "pop the Dotcom Bubble" right at the wrong time. The bubble was already deflating. Then, within 9 months of it's last rate increase, the Fed reversed course in dramatic fashion lowering rates a whopping 4.76% inside of 12 months so by the end of 2001 rates stood at 1.75%.

The reason the batch of rate increases in early 2000 were unnecessary was obvious at the time and is more so looking back. The Dotcom rally in the markets had begun to play itself out. Moreover, the overall economy at that time had not experienced any real underlying inflation in the consumer sector. Commodity prices were tame and Oil had bottomed out only two years earlier. There were hints of inflation in housing at the time but after the housing and real estate bust of the late 1980's which lasted well into the mid 1990's the revival in the housing and commercial real estate prices were welcome and at that time not over heated.

Note: I will paraphrase the comment about housing in 2000 by saying, there were some exceptional housing price increases around 1999-2001 fueled mostly by Dotcom employees and executives cashing out options and buying "trophy" real estate; basically real estate in resort oriented areas or "desirable" urban centers. However the overall economy did not participate in the Dotcom surge in wealth. There were some sorely needed rises in average wages and incomes, which had stagnated for some 30 years. In fact, as we can see in hindsight, the crazy options grants to executives, exploding pay and bonuses to CEO's of NON-Dotcom companies were nothing more than attempts for those guys to play the same game financially as Dotcom companies were. For boards of companies they bought in with the excuse they had to in order to "keep their CEO's from bolting to the hot Dotcom sector". Legacy industries in the US were not growing or profiting anywhere near the level of the Dotcom startups. Yes, the dramatic disparity in wages between executives and salary earners was exasperated by these phenomena. For example when you look back on deals like AOL buying Time Warner and the churning of assets in telecom and energy where executives were trying to get as much cash from these cash generating companies as possible to play the Dotcom "I want mine to" game, it is obvious the influence the Dotcom bubble had on legacy companies and the economy. Hence there was some spill over in "luxury" and "resort" real estate areas but like I said, there was no overheating of the general economy or real estate assets in general by early 2000. In fact it was obvious the Dotcom phenomena had been played out.

So the Fed drops rates in dramatic fashion throughout 2001 (not just after 9/11 as many remember, by then rates had already been slashed by 3%). The Fed obviously did not grasp the state of the markets in 2000 and was "shocked" at the dramatic drop in stocks and subsequent affect on the economy after their 2000 rate rise.

My guess looking back is had the Fed kept rates at 5.5% through 2000 we would have had a softer landing of the Dotcom bubble. Easing rates would not have had to be so dramatic in 2001. The 9/11 effect would have only had to be short lived (lowering rates and adding liquidity only in the months after the terrorist attacks). Rates should have averaged around 3.5% from late 2001 forward before being raised again beginning around mid 2003 to closer to the 5.5-6% range (nearer a historical average).

If one looks at the European lending rates this is exactly what one would find. The EU started in the fall of 1999 at 5.5% raising them only to 5.75% in late 1999 before beginning to actually LOWER them again by May 2000. Their rates reached a low point of 3% not until June 2003 before they began to raise them slowly to peak in July 2007, just before markets reached an all time high in October of the same year.

Basically, the EU Central Bank was “Right on the Money” with monetary rates from 2000 forward. So why was the US so drastic in it’s moves? Why did the US find it necessary to jack up rates in 2000? Why did the US find it necessary to drop rates to 1% so quickly through 2001? Why did the US find it necessary to keep rates so low for so long? Why is it that the entire credit crises had its roots in the US and the “financial shenanigans” undertaken by Wall Street?

What had already started happening years earlier in the US was a consolidation of the financial sector. This began in the mid 1990's and was formalized in 1999 by financial deregulation legislation. I hold the position that Washington simply bent over after the Fed had turned a blind eye to banking sector consolidation and movement into alternative areas of finance and signed off on a deregulation bill largely written by the financial industry and celebrated as a nearly ¾ century battle to undue the regulations put in place in the early 1930’s. Hedge funds, debt backed securities, off balance sheet finance (made legend by the collapse of Enron) all had gotten off the ground in style. Deregulation was all that was needed to get the wheels of pre-depression risky finance and leverage going again. Cheap money was icing on the cake.

I don't know if the Fed has an office where folks simply follow the markets day in and day out, watch for what new financing schemes have been created, keep a finger on the emergence of new money flows and "emerging" companies and markets. Is there a team of people who attend the seminars and investment strategy sessions hosted by the big money center banks and investment firms? Does the fed have a bunch of folks who watch unregulated players in unregulated markets, stay on top of their strategies, see what "products" they are trading, study the leverage they employ, find out who is lending them the capital they need for this leverage? I wonder.

Anyway, from the outside it seems the answer would be "no" because the Fed obviously was hit blind sided again by the credit bubble that emerged very rapidly from the end of 2001 to 2004 and continued as long as through the end of 2006. Either way, the Fed is making the same mistake right now as it is obvious to anyone here on the "outside" that a bubble is being created on the back of cheap money and liquidity that they are pouring into the financial system.

Right now it does not matter if unemployment rises to 10%, 12% or 14%, and sales at major companies shrink by 5-30% from 2008 because for anyone reading the daily and quarterly reports of companies that function on a national and international level in industries dominated by a hand full of players knows, these guys are still scraping out profits and decent cash flows albeit on the backs of firing as many workers as feasible and shutting down excess capacity as fast as they can. They see no reason to "invest" this money in their businesses and are dramatically scaling back growth plans to conserve even more cash. While it is obvious the economic outlook is pale, they are either 1) paying down debt 2) starting to employ it in buyouts of their nearest competitors or in other areas 3) putting it to conservative "investment" use like treasuries or 4) hedging the value of their "assets" buy "investing" in commodities. I think the smartest thing they can do is "spend" it whether it be by buying another company or buying overseas growth because there is whole other potential problem with all this cash and "debt issuance" going around, the future of the dollar.

Time and time again this theme is played out, "The dollar is going to crash". Well whether or not the dollar really looses it's international attractiveness as a "store of wealth" is not the issue. The issue is the Fed needs to stop the cheap money wheel now and begin to allow the markets to price debt. In the US the Fed IS the mortgage securities market, consumer credit market, commercial mortgage backed debt market, funder of cheap money to banks so they can play the same old "borrow cheap lend long, keep the difference and leverage as much as you can doing it" game. The rest of the money is going right into the stock market, where an interesting article in January 2009 stated, "with the credit markets frozen the only place to put money is where liquidity is king". Well stock markets and treasuries are those 2 places and both have seen booms since early 2009, all liquidity driven by cheap money and Fed buying back its debt while allowing companies recently converted into "bank holding companies" to tap markets with Fed guarantees at abnormally low rates. Basically a stew of stimulating practices that is for the time being delaying the credit write downs that are sagging the books of many financial firms and buying time for companies to refinance short term debt, raise money from the cash driven markets and otherwise pad their books with stock market increases (esp. insurance companies).

The problem with all this stimulation is it was too much and to soon. It was a very dramatic knee jerk reaction by the Treasury and Fed when all hell broke loose in late 2008. Once again the Fed was "taken off guard" by the severity of the financial melt down. It was obvious by 2006 to people like me that a house of cards was being created, a pyramid scheme not unlike the Milken days of the 1980's. I wrote a long letter to Secretary Paulson, fairly new on the job, in early 2006 warning him to stop bashing Sarbanes-Oxley and start doing his job. There was a credit bubble out there and at that time about $50 Trillion worth of “insurance” that nobody would be able to pay off if the credit market crashed. There was no way the party could continue and unlike the 1980's the introduction of credit derivatives had driven the credit markets beyond anything imaginable in the history of capital markets. Tens of trillions of dollars in "insurance" products were being sold on every type of credit imaginable combined with off balance sheet entities and leverage and vast sums of money in unregulated markets being administered and financed by regulated banking entities... I mean one had to live in a closet not to see this thing happening. Well, the fed doesn't have enough windows I guess.

Anyway, the stimulation was way out of whack. I remember the markets in late 2008. A 300-point move in the DOW sent Paulson and Bernanke to their respective podiums to announce more stimulating efforts. This was almost a daily occurrence. For a pure economic minded person such as myself, I was in total disbelief. I was loosing money left and right because any decision I made to buy or sell securities was being whip-sawed by draconian government attempts to "correct" a market that was obviously "correcting itself". Once again, the Fed was late to the party, came with huge ammunition beyond what was required and blew everything to pieces. Now we are experiencing a dramatic run right to the edge of a cliff. The stock markets are reaching elevated levels with no cause, the corporate bond market has nearly completely recovered, commodities are priced way out of context with respect to underlying demand while the fundamental consumer driven economy is not nearing a recovery. So the basic message to the Fed is, STOP STIMULATING NOW! You are causing asset bubbles that are inconsistent with underlying economic fundamentals, creating liquidity that is only chasing these assets indiscriminately, risking the future value of the US Dollar with a potential hyper inflationary scenario unrelated to classic inflation causes in the economy but related to pure debt and liquidity creation by an IRRESPONSIBLE FED.

The time is now to bring up rates .25%. NOW. This will signal to the markets that they need to start thinking about functioning without $11 Trillion in Fed guarantees. Raise again in .25% in January / February, another .25% in May / June and another .25% in September / October and a further .25% in November / December 2010. These rate increases will only bring us to 1-1.25% Fed funds rate, still extremely low. These rate rises will NOT have ANY major effect on the economy today but are absolutely essential. They will need to be combined with a removal of the Fed from the Mortgage market, the termination of the TALF program the end of the Fed Reserve buybacks scheduled this month, the adjustment of interest paid on deposits held on reserve by banks etc. The market DESPERATELY needs to begin pricing credit again the sooner we get Fed lending rates back to the 3-3.5% range the better.

I have expressed concern many times until now that the Fed extending all this credit directly and indirectly at artificially low interest rates is doing more harm than good. The longer they do this the more harm it will do to the long term credit markets and the more time it will take for the massive credit bubble (worthless assets) to "wind down". This mess cannot be "earned" out by the banks. The American taxpayer has already expressed displeasure at the Fed tacitly letting the banks rake the American Consumer's pocketbook to pay for their risky mistakes and besides, there is not enough money there to do so. The longer all of this cheap credit with Fed backing is extended while risking further declines in the dollar and further increases in non-productive asset prices, the more painful the reconciliation will be when market rates take over.

Right now, without Fed backing, I would guess mortgage rates would be in the high single digits to around 10%, credit card rates would be in the high teens to low 20's, auto loans would be in the low to mid teens, highly rated corporate debt anywhere from mid single digits to mid teens etc. If the dollar continues to fall, non-productive asset prices to rise and the economy continue it's lackluster consumer driven flat line; bigger trouble ensues.

Market realities need to be realized soon so the "market" can go about creating new ways to profit from new realities and drive our economy back towards its economic norms NOW.