The Fed is raising interest rates but continues an easy Monetary Policy. How can this be? How can the nominal level of interest rate for Fed Funds be raised from 1 percent to 1.25 percent while Greenspan is still considered "easy"? The reason is this policy lives in a land of "Inflation and Money Illusion". Money illusion occurs when you give the consumer more money to spend, when it actually buys less. The consumer is left thinking they still got something for their new money because they are still thinking about yesterday's prices. Because most people, including investors, can be fooled this way year in and year out, inflation can continue to be used by the world's central banks to cheat savers and subsidize borrowers.
Here's how it works. There are really two interest rates - the reported interest rate and the "real interest rate". The interest rate on Fed Funds has been raised but to understand what the actual policy is, the Fed Funds rate needs to be adjusted for Inflation. This inflation adjusted interest rate is what economic scholars call the "real rate of interest". After inflation, an investor would like to see if he really made or lost money.
Now, if the Fed keeps the interest rate on Fed Funds below the level of inflation, as they do now, anyone who can borrow will actually owe less in real terms at the end of the year. If a speculator can borrow at 2 percent, when inflation is actually 5 percent, the speculator's real rate of interest is a negative 3 percent! In this Money Illusion world, institutions such as banks, Wall Street broker dealers and Hedge Funds, are stepping up and borrowing and will increase their holdings in commodities and precious metals that do well in inflation.
Since the Federal Reserve is in the business of providing all the money anyone wants at the interest rate they fix, there is no actual limit to how much money might be borrowed or how high the resulting money growth might be.
To accurately gauge the Fed's policy with respect to interest rates, it is important to understand that if the real Fed Funds rate is positive, savers are getting something on their money and borrowers actually have to pay something for it. If the real Fed Funds Rate is negative, savers are getting robbed and borrowers are getting subsidized. Investors should note that the Real Fed Funds rate started the year at -0.93 percent in January and has dropped to an even easier -2.01 percent in May! Surprise; the Federal Reserve has been easing the first six months of 2004!
Recent data of the Consumer Price Index (CPI) is showing inflation; a lot of it! The year over year CPI is up 3.1 percent and the CPI for the three months ending in May, was 5.5 percent at an annual rate.
Given the timing of inflation flowing into the United States, the rise in the CPI on a year over year basis, is back loaded into the end of 2004. The following chart is a highly likely projected reading for the Real Fed Funds rate assuming: 1) for the remainder of 2004, the monthly CPI fluctuates between 0.3 percent and 0.4 percent (which is less than the current monthly rate of increase; and 2) the Federal Reserve raises the interest rate on Fed Funds by 0.25 percent at its scheduled FOMC meetings in August, September, November and December.
|Month||June '04||July '04||Aug '04||Sept '04||Oct '04||Nov '04||Dec '04|
|Fed Funds Rate||1.0%||1.25%||1.5%||1.75%||1.75%||2.0%||2.25%|
|Year Over Year CPI||3.25%||3.55%||3.47%||3.54%||3.97%||4.67%||5.1%|
|Real Interest Rates||-2.2%||-2.3%||-1.9%||-1.8%||-2..2%||-2.7%||-2.8%|
Looking through this Money Illusion, "Easy Al" can clearly continue to live up to his name. Raising interest rates to a level lower than increased inflation means that businesses, households and the speculative community, will undoubtedly wake up to the fact that not only will money remain free, but it is still being subsidized big time.
When a consumer receives a "gift" by simply borrowing money, it's hard to turn down the present. This gift of subsidized borrowing will effectively drive up prices by encouraging these same consumers and businesses to borrow, create new money, and spend. The broad measure of M3 is rising at a 10+ percent rate so far in 2004 and money growth and inflation are expected to continue on the upside.
Money is created when borrowing takes place. Pay people to borrow and, abracadabra, money growth and inflation pop out of the Fed's magic hat. What a neat trick!
By the end of this year with year over year inflation at 5 percent, consumers who owe about $9 Trillion on mortgages and consumer credit can borrow and spend $450 billion just to keep their real level of debt, adjusted for inflation, the same. (Inflation forgives old debt.) Buying a house at ridiculously high prices might work in the long run if the buyer locked in a record low long-term fixed interest rate. Inflation will slowly but surely forgive the mortgage on the house.
For the economy, current debt burdens have now reached levels so high they can't be paid back from current cash flows in real dollars. The Fed can only choose between system-wide bankruptcy of debtors or a "measured debasement" of the U.S. currency, allowing inflation to forgive old debt and raise wages, salaries, corporate revenues and tax receipts. The money spigot is wide open and not only is money free, but the Fed will actually pay anyone who wants to take a drink of this free money!