The Fed’s Half-Hearted Attempt at Monetary Tightening
On 15 March, the Federal Reserve (Fed) raised the federal funds rate by 0.25 basis points, bringing the band of the official rate to 0.75 – 1.00 percent. The move was widely expected. However, the market seemed surprised when the Fed reaffirmed that it would stick to its plan to raise rates no more than three times this year because inflation has already taken off. In February, the consumer price index was up 2.7 percent compared to last year, while the “core inflation rate” stood at 2.2 percent — well above the 2 percent mark typically seen as the level of “targeted” inflation. As a result, the current short-term interest rate in the US, when adjusted for current inflation, stands at around minus 1.7 percent.
The slowness with which the Fed is bringing rates back up suggests that they are certainly not in a hurry to put an end to ongoing debasement of US-dollar money balances and US-dollar denominated debt. There is, however, a reason why the Fed might actually be quite keen to keep real interest rates into negative territory: If the interest rate borrowers have to pay on their debt is lower than the economy’s growth rate, the economy’s overall debt-to-GDP level comes down over time; or the debt-to-GDP ratio increases at a slower pace even if borrowers keep running into even higher debt.
In the US — as well as in basically every other industrialized country in the world — interest rates have been brought down by central bank policies over the last decades, while public debt has grown. At the same time, interest payments on public debt have come down thanks to central banks having pushed interest rates to ever lower levels. With US short-term interest rates having remained well into negative territory since around the start of 2008, the US debt burden has been eased considerably. Against this backdrop, it becomes apparent that the Fed’s room for maneuvering has been reduced substantially.
For if it brings interest rates back up (especially in real terms), the US budget would have to cope with increasing interest expenses — which is undesirable politically speaking. Furthermore, higher borrowing costs would almost certainly have an adverse impact on the business cycle, especially since the extended period of artificially lowered interest rates has made consumption and investment increasingly dependent on the continuation of the low interest rate policy. In fact, the production and employment structure that has been built up under artificially lowered interest rates would disintegrate once rates were to start hiking.
The ongoing regime of exceptionally low interest rates is accompanied by an expansion of the quantity of money through bank credit extension. This practice does not only debase the currency. It also increases overall indebtedness and thus the default risk in the international money and credit system. And here you go: If push comes to shove, central banks — under the leadership of the Fed — will do whatever is needed for preventing the debt pyramid from collapsing. In order to prevent such an event from occurring, central banks will keep interest rates low and churn out ever greater amounts of money to keep struggling borrowers afloat.
This is presumably the truth behind the Fed’s half-hearted attempt to increase interest rates in nominal and in particular in real terms. If and when the Fed wishes to continue the artificial boom fueled by the relentless issuance of fiat money, it is most likely that interest rates in nominal and real terms will have to remain at extraordinarily low levels; and that in particular short-term interest rates will have to remain in negative territory. This trickery with the interest rates may well go on for quite a while. That said, savers and investors should bear in mind what the Austrian school of economics has to say in this context.
It was Ludwig von Mises who pointed out that the fiat money system will most likely end up in inflation, for
In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.1
Holders of fiat currencies and fiat denominated bonds should therefor watch out. The signs are already on the wall: The Fed’s half-hearted attempt of monetary tightening appears to tie in nicely with Ludwig von Mises’s conclusion.