When Will the Fed Stop?

April 17, 2006 – When will the Federal Reserve stop raising interest rates? It is the question everyone is asking these days.

The federal funds rate, which is the rate at which banks lend and borrow money for short-term needs, is now 4.75%. As recently as June 2004 the rate was 1%. It seems inevitable that the Fed will take fed funds to 5% when the FOMC meets on May 10th, but will the Fed stop there?

This question is interesting, but another question is more important. What will happen to real interest rates, i.e., interest rates adjusted for inflation? It is real interest rates that will determine the dollar’s future.

For months formidable forces of inflation and other forms of monetary debasement have been gathering at a frightening pace. Rising energy prices, out-of-control federal spending, and a growing mountain of debt are just some of the more visible problems. So how does the Federal Reserve – the guardian of the US dollar – respond to this threat?

Not to worry. We have been told that the Federal Reserve will continue to raise interest rates at a “measured pace”. It is really silly that so many commentators make a big deal of this inane statement. Would the Fed actually come out and say anything else? Would it be honest with the American people and say that the threat of inflation is not only real, but also growing? Will the Fed state that it is going to raise interest rates at a ‘rapid pace’ in order to prevent more inflation?

Of course not, but in reality that is exactly what the Federal Reserve should be doing. It should be raising interest rates at a ‘rapid pace’ if it intends to conquer today’s monetary problems and save the dollar from a total collapse. Ben Bernanke should be taking direction from Paul Volcker, who raised interest rates at a ‘rapid pace’ after he was appointed chairman of the Federal Reserve in 1979.

Mr. Volcker understood that meaningful actions were necessary to save the dollar from a total inflationary collapse. So he did what he had to do. He raised dollar interest rates at a rapid pace because he understood that only high interest rates would save the dollar. Look at it this way.

Consumers have a choice – to hold dollars (which represent just some uncertain, intangible promise) or to hold gold (which is a real and tangible asset). Gold is money that is not contingent upon some central bank or Fed chairman’s promise. The trade-off is that you do not earn any interest on your gold because you are not taking the risk of someone’s promise. But when monetary problems grow, consumers increasingly doubt central bank promises and as a result, choose to forego interest income they could earn on dollars. They opt out of a troubled dollar by converting their purchasing power into the safety and security of gold. Importantly, once this trend to move out from the dollar starts, it is hard to stop, which was the situation faced by Mr. Volcker when he became Fed chairman.

He used the only tool available to him to re-establish confidence in the dollar. He started raising interest rates as soon as he assumed office and kept on raising them. He needed to get people to move their wealth out from their gold and back into dollars, and he knew the only way to do this (without imposing capital controls) was to raise dollar interest rates high enough in order to entice – i.e., essentially bribe – consumers back into the dollar.

Mr. Volcker kept raising interest rates until they were much higher than the rate of inflation. In other words, real dollar interest rates (i.e., dollar interest rates less the rate of inflation) soared to record highs – to levels that had been unimaginable only a few years before and have never been seen since.

These record high real interest rates did the job intended. They enticed a lot of people out of gold and other tangible assets, and moved them back into dollars to earn the interest income from the high real interest rates Mr. Volcker created. But Ben Bernanke is not doing this, nor did his predecessor, Alan Greenspan. Even though nominal interest rates have been climbing under their watch, real interest rates remain low, and probably negative depending upon how one measures the true rate of inflation.

Real interest rates are calculated by subtracting the inflation rate from the federal funds rate. If the difference is positive, dollar holders are earning a rate of return greater than the rate of inflation, i.e., their purchasing power is increasing. Conversely, their purchasing power is decreasing if real interest rates are negative because in this case, inflation more than erodes what dollar holders gain in interest income.

Generally, a positive return is necessary to keep consumers in dollars. In other words, to entice consumers to hold dollars and avoid gold, real dollar interest rates should be positive. When real rates are negative, the gold price climbs, as consumers flee the dollar and demand gold instead, which explains exactly what happened in the 1970’s.

Conversely, when real dollar interest rates soar, as they did under Mr. Volcker, the price of gold falls. Look at what happened in the early 1980’s. It was the unprecedented climb in real interest rates that stopped gold’s meteoric advance back then.

Since the late 1990’s real rates have been falling. What’s more, real rates have been negative for much of this time, so is it any surprise that the gold price is rising? Of course not.

Consumers are not dumb. They look through the nonsense of the “core” CPI, and their decisions are not affected by the mindless jawboning from the Federal Reserve. Consumers understand that the purchasing power of their dollars is being inflated away. The true rate of inflation is explained by economist John Williams proprietor of  www.shadowstats.com  as follows: “Real CPI right now is running about 8 percent…If you were to peel back changes that were made in the CPI going back to the Carter years, you’d see that [the yearly rise in] the CPI would now be 3.5-4 percent higher [than reported].”

By this estimate, the rate of inflation is well above the 4.75% fed funds rate. So the Fed is way behind the curve because real interest rates are negative. There is in effect no cost to borrowing fed funds, which is very inflationary. Consequently, consumers understand that one is better off owning gold, and will continue to be better off until the Fed chairman does what Mr. Volcker did – raise dollar interest rates at a ‘rapid pace’. Will it happen?

No, it won’t, and the reason is simple. The US today cannot afford to pay the bill of high real interest rates.

When Mr. Volcker became Fed chairman, the US was the largest creditor nation in the world. There was no mountain of debt, no derivatives bubble, no stock market bubble, and the US savings rate was positive. What’s more the federal government’s budget deficit was relatively tame compared to the big spending under the Bush administration, and the US was not fighting any foreign war – it was the Soviets who were bogged down in Afghanistan.

Today’s circumstances are the exact opposite. So Mr. Bernanke cannot raise interest rates to achieve the positive real interest rates that Mr. Volcker needed to save the dollar. If it were tried, the Fed would destroy what remains of US economic activity. The growing interest expense burden would kill the federal government’s ability to maintain the illusion that it is solvent and can repay its debts. In other words, raising interest rates today like Mr. Volcker did would sink the economy.

So Mr. Bernanke – just like Mr. Greenspan before him – is left to using the only tool available, namely, jawboning, which is the politically correct term for propaganda. There is of course another tool – capital controls. They will come when jawboning no longer does the job, which means soon – possibly as early as next year. But neither jawboning nor the threat of capital controls will stop the gold price from rising.