Letter: Professor Preponomics on Yellen’s Rate Hike

I have long been of the opinion that the Fed has backed itself into a corner with interest rates near 0%. Such low interest rates only serve to encourage the borrowing, adding to the unwieldy national debt. With the interest rates so low, the debt may be currently serviceable, but if the rates are raised, I question whether or not the debt load can be serviced at all. After Yellen announced a 0.25% rate hike, I queried Professor Preponomics on what in the world Yellen was thinking. I believe SurvivalBlog readers will be very interested in the answer. – HJL

JWR’s recent post with a warning about the risk of a liquidity crisis was SPOT ON. In my view, it was so right (and so timely) that it’s worthy of a reposting to the blog such that it captures the attention of as many readers as possible. His recommendations for diversification were very much like those that govern my own beliefs and strategies: cash, precious metals, survival stash, means of production, and goods for barter. I also suggest advance payment of property taxes.

JWR and Hugh are so right to raise the question and concern with regard to that nasty four letter word: debt. I’m sure you’ve noticed that I post often on this subject and the spendthrift nature of Congress. Many of the programs they fund are so absurd that I shake my head in disbelief and disgust. An example: We’re spending a cool $5M to help hipsters quit smoking alongside $119M to prop up the tobacco industry. One analysis suggests that interest on the national debt will shortly triple and will become the 3rd largest budget item on the books. …and yet we continue to borrow. …and spend. …and borrow even more. The midnight passage of this latest spending bill was an outrage, and a total failure of fiscal policy.

I am deeply concerned about whether or not the debt could ever be repaid. I believe that neither the momentum nor the mathematics are favorable to this outcome, but perhaps as worrisome (maybe more so) is the lack of any political will to have an honest conversation about the state of our national finances. Politicians avoid the subject and so do most Main Street Americans. Many simply believe that we can simply outrun our obligations by spending ever more and devaluing our currency by way of targeted inflation rates. …and why address the painful reality of repayment for as long as we can remain in denial? There simply is no will to reduce the debt, we’re not even trying, and we are in very real trouble. The United States is, and has been for some time, insolvent.

Unfortunately, our refusal to face the facts will not relieve us from realizing harsh economic consequences, and those consequences may be quite severe as conditions unravel. In point of fact, it’s possible we are already seeing the signs of such an unraveling in various forms of economic malaise (or non-responsiveness to stimuli) punctuated by points of significant volatility. The swings may be warning signals with an important message: Danger Ahead.

Our fiscal policy (which includes no apparent form of spending restraint) is most assuredly complicating our monetary policy – and our monetary policy has exhausted most of its traditional options designed to promote increased production, maximum employment, stable prices, and moderate interest rates.

Now here comes the rate hike – and economic hysteria ensues. What in the world was Janet Yellen thinking?

  • She is trying to recover some degree of credibility, having backed herself into a corner with lots of talk and no action over too extended a period of time. She may also be trying to preserve some degree of political maneuvering room, and she’ll need it if things don’t go according to the Fed plan.
  • She is probably also trying to ease into a rate hike to signal (or telegraph) confidence in the economy, and perhaps she hopes this will stimulate the velocity of money or what I call the “wind tunnel” with the stated goal of 2% annualized inflation.
  • At the same time, she is trying to prevent the kind of runaway inflation that can easily arise from the extraordinary levels of QE; surely Yellen recognizes the signals that bubbles are forming (even as some sectors of the economy struggle along).
  • In order to accomplish this goal, she knows she must reach beyond the banks. Yellen’s efforts to expand influence in the financial decision making of non-bank financial institutions through the use of reverse repos is, in my opinion, a real sign of risk recognition. …and since she has effectively uncapped the reverse repo ceiling, it seems reasonable to assume she views the systemic risks coming from non-bank financial institutions as significant.
  • She may as well be trying to curb the risk taking behaviors of banks (and other financial institutions), but I do not believe she will succeed in this regard given the evidence of the past as well as the nature and character of bankers. Derivatives are an excellent example.
  • Of course she must also counter balance the need to manage the risk of inflation with the risk that Fed policy could ignite a liquidity crisis, especially since she may have to pull back quite severely on the money supply in order to accomplish the real effects of a quarter point rate push.
  • Does she hope that the relatively strong U.S. dollar will do some of the work by holding economic activity in restraint? Maybe. This is certainly a possibility. If this works, she may believe that while the rate decision will capture most of the headline news, the real economic work will come from the reverse repos and the relative strength of the dollar.
  • While Yellen is considering all of this, she must weigh as well the risk of emerging market debt defaults that might follow from the increased costs of servicing huge debt loads. Economies are so intertwined that it would be impossible for her not to consider global implications.
  • …but none of this mentions the implications for municipalities, which also service debt, or for pension programs that are starved for returns and facing their own insolvency issues. None of this mentions the U.S. national debt or the ever-escalating cost of servicing that debt let alone the possibility that the debt might ever be retired.

No doubt about it… Yellen is navigating a narrow tight rope across a very deep canyon where one misstep (or unanticipated gust of wind) could spell disaster. Unfortunately, the chances she can traverse the distance to a safe landing are not good.

Missteps and gusting winds could come from just about any direction:

  • A misunderstanding of the underlying cause of the problems we face and the misapplication of any solution or combination of solutions.
  • Errors with regard to the timing of any form of intervention – too early or too late.
  • Attempts to solve problems that are beyond the limits of monetary policy – including out of control fiscal policy and climate change. No, Janet; climate change is not part of the Fed Reserve’s mandate nor (in my view) should it be.
  • The challenges of evaluating the effectiveness of any policy measure given lag-time effects.
  • The necessary and unavoidable reliance on the cooperation and good will of other nations, whose interests (domestic or foreign) may diverge from our own (and sometimes unexpectedly).
  • The risks of unexpected events where economics are overly leveraged and there is no room left within them to absorb shocks. These can come from the natural phenomena of a solar flare or an earthquake to acts of man, including those tied to terrorism.

We are all watching closely. With level heads, it’s wise to continue to prepare ourselves in earnest.