Fed Will Leave Rates at Zero Until Inflation Shows Up

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


The Federal Reserve left the fed funds rate in the zero to 0.25% range at its April meeting. This is the 16th month that the Fed has maintained rates at an all-time low. While the Fed was a bit more upbeat about the economy than it has been at recent meetings, it still pledged to keep rates near zero "for an extended period of time".

When it comes to the Fed and other government representatives, investors would be best off by paying attention to what they do and not to what they say. The Fed was certainly more upbeat in its statement from the April meeting than it was in previous meetings. It noted that "economic activity has continued to strengthen and that the labor market is beginning to improve","growth in household spending has picked up recently" and  "business spending on equipment and software has risen significantly". You would think happy days were here again and short-term rates will be 5% before you know it. Well maybe not, it turns out.

While strong economic growth leads to inflation, apparantly there is no risk of that (inflation that is) as far as the Fed is concerned. The Fed went on to say that "with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time". So the Fed seems to be talking out of both sides of its mouth. Either growth is not sustainable in the long-run and it thinks this will keep inflation subdued or the Fed has pumped so much money into the financial system that this is creating economic expansion (at least for the moment) and inflation will follow.

The first scenario was seen in Japan during the last two decades, especially after its two-year recession in the early 1990s. The economy was supposedly recovering nicely without inflation for a few years. Instead, it gradually fell into the abyss and a deflationary spiral. In the second case, uncontrollable inflation is possible - and this can take place with a great deal of resource slack. Rapidly declining and eventual collapse of resource utilization is the marker of hyperinflation. Fed chair Bernanke should tell Zimbabwe that it couldn't have possibly had the second highest inflation rate in world history, sextillion percent, because it had an unemployment rate of 94%. Weimar Germany, with a mere 100 trillion percent inflation rate, had unemployment that reached almost 25%.

The Fed statement also had two telling comments that provide significant insight in the Fed's thinking. These were, "financial market conditions remain supportive of economic growth" and "bank lending continues to contract". Taken together these indicate that the financial conditions that are supportive are the Fed's low interest rates and the high prices of stocks - the paper economy. While the paper economy is going great, as indeed it was before the Credit Crisis and during every other bubble in history, the real economy is struggling. It can't function well without adequate credit from banks. In other words, the Fed's positive view of the economy is based on economic make believe.

If the Fed really believed the economy was improving, it would be raising rates or at least getting ready to do so and not say it was maintaining its ZIRP (zero interest rate policy) for a long time. As I have documented in previous articles, there is usually a two to three year lag from the end of a recession until the Fed starts raising rates. If we assume optimistically that the recession ended in July 2009, that would take us until at least July 2011 before rates went up. Any rate rise before that date would indicate significant inflation risk and a rate rise after July 2012 would indicate a serious deflation problem.  In either case, the Fed's response will be too little, too late.

Disclosure: None Relevant

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.