Here’s the real reason why US Federal Reserve did not raise interest rates

yellen_janet_040512_8x10
The Federal Open Market Committee (FOMC) of the Federal Reserve of the United States, the American central bank, has decided to stay put and not raise the federal funds rate for the time being, as it has for a very long time now.

The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

The market was split down the middle on what they expected the Federal Reserve to do. The Federal Reserve has maintained the federal funds rate in the range of zero to 0.25% in the aftermath of the financial crisis which started in September 2008. This has been done in the hope of supporting an American economic recovery.

One view was that the Federal Reserve should start raising the federal funds rate now and get done with it. The other view was that the American economy is still in a fragile state and hence, the federal funds rate should not be raised. Also, any increase in the federal funds rate would have a bad impact on financial and asset markets all over the world, this school of thought held. And that couldn’t possibly be good for the American economy.

The FOMC led by the Federal Reserve Chairperson Janet Yellen chose to go with the latter view.  There are several reasons for the same.
The unemployment rate in the United States fell to 5.1% of the civilian labour force in August 2015. Nonetheless, this number does not take into account those who are working part-time even though they want to work full time. It also does not take into account those who want to work but haven’t actively searched for a job recently.

In fact, the number to look at is the labour force participation ratio. The World Bank defines this as: “the proportion of the population ages 15 and older that is economically active: all people who supply labour for the production of goods and services during a specified period.”

The number had stood at 66% in January 2008 before the start of the financial crisis. As of August 2015 it stands at 62.6%. In August 2014 the number was at 62.9%. Hence, the labour force participation ratio has fallen over the last one year, despite the unemployment rate going down. This means that people have been dropping out of the workforce as they get discouraged at not finding a job and then stop looking for it.

Further, the Federal Reserve has been aiming for an inflation of 2%. As yesterday’s FOMC statement said: “the Committee expects inflation to rise gradually toward 2 percent over the medium term.”

The measure of inflation that the Federal Reserve likes to look at is the core personal consumption expenditure (PCE) deflator. The core PCE deflator is at 1.24%, which is nowhere near 2% that the Federal Reserve is aiming for. A stronger dollar which has made imports into America cheaper as well as lower oil prices are the major reasons for the same.

Interestingly, the FOMC in its statement yesterday said: “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” This is the first time this line has made it into the FOMC statement.

What does it mean by this? As Yellen said in a press conference that followed the release of the FOMC statement: “The outlook abroad appears to have become more uncertain of late. And…heightened concerns about growth in China and other emerging market economies have led to volatility in financial markets.”

In the press conference that nobody asked Yellen about what did she really mean by this. Chinese economic growth has been slowing down. Many analysts have argued that China is not growing at the 7% growth rate that it claims to be.

In this scenario it is likely that China might devalue the yuan against the dollar further in order to push up its exports. If China devalues the yuan, Chinese exports will become more competitive as Chinese exporters are likely to cut prices. In this scenario the value of imports coming into the United States will fall further, as exporters from other countries will also have to cut prices in order to compete with the Chinese. This will mean inflation falling further. In my opinion, this is what Yellen and the FOMC really meant.

In the press conference Yellen said that she expects that the FOMC will raise the federal funds rate before the end of this year. The direction in which the Chinese economic growth will unravel is unlikely to become clear so soon.

What this means is that the era of easy money unleashed by the Federal Reserve in late 2008, is likely to continue in the months to come. The Federal Reserve is unlikely to raise the federal funds rate this year. Not surprisingly the stock market in India is having a good day, with the BSE Sensex having rallied by more 470 points or 1.8%, as I write this.

Also, now that the FOMC hasn’t raised interest rates, calls for the RBI governor Raghuram Rajan to cut the repo rate are going to get louder.

The column originally appeared on Firstpost on Sep 18, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Coming up: The $9 trillion problem of global finance

3D chrome Dollar symbolThat global finance has been in a mess since the start of the global financial crisis in September 2008, is old news now. But the fact that a bigger mess might be awaiting it, should still make for news.
A January 2015 research paper titled
Global dollar credit: links to US monetary policy and leverage authored by Robert N McCauley, Patrick McGuire and Vladyslav Sushko who belong to the Monetary and Economic Department at the Bank for International Settlements (BIS), has been doing the rounds in the recent past.
As per this paper : “Since the global financial crisis, banks and bond investors have increased the outstanding US dollar credit to non-bank borrowers outside the United States from $6 trillion to $9 trillion.” In 2000, the number had stood at $2 trillion.
What this clearly tells us is that over the years there has been a huge jump in the total amount of borrowing that has happened in dollars, outside the United States. Hence, more and more foreigners(to the United States) have been borrowing in dollars.
A similar trend has not be seen in case of other major currencies like the euro and the yen. In case of the euro the number stands at $2.5 trillion. For the yen, the number is at just $0.6 trillion. “Moreover, euro credit is quite concentrated in the euro area’s neighbours,” the BIS report points out. Hence, a major part of the world continues to borrow in dollars.
The question is which countries have borrowed all this money that has been lent? As the BIS report points out: “Dollar credit to Brazilian, Chinese and Indian borrowers has grown rapidly since the global financial crisis…Dollar borrowing has reached more than $300 billion in Brazil, $1.1 trillion in China, and $125 billion in India. The rapid growth of bonds relative to loans is more evident in Brazil and India than in China.”
This is happening primarily because domestic interest rates in these countries are on the higher side in comparison to the interest rates being charged on borrowing in dollars. Further, in the aftermath of the financial crisis, the Federal Reserve of the United States, initiated a huge money printing programme and at the same time decided to maintain the federal funds rate between 0-0.25%. This led to more and more borrowers deciding to borrow in US dollars.
“A low level of the federal funds rate…is associated with higher growth of dollar loans to borrowers outside the US…A 1 percentage point widening in a country’s policy rate relative to the federal funds rate is, on average, associated with 0.03% more dollar bank loans relative to GDP in the following quarter ,” the BIS paper points out. And that explains the rapid expansion of dollar loans.
The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.
Interestingly, countries which are referred to as emerging market countries have borrowed close to $4.5 trillion of the total $9 trillion. “The emerging market share – mostly Asian – has doubled to $4.5 trillion since the Lehman crisis, including camouflaged lending through banks registered in London, Zurich or the Cayman Islands,” points out Ambrose Evans-Pritchard
in a recent piece in The Telegraph.
So what are the implications of this? First and foremost the world is now more closely connected to the monetary policy practised by the Federal Reserve of the United States. As the BIS paper points out: “Changes in the short-term policy rate are promptly reflected in the cost of $5 trillion in US dollar bank loans.” What this basically means is that if the Federal Reserve chooses to raise the federal funds rate any time in the future, the interest that needs to be paid on the dollar debt will also go up. And with the huge amount of money that has been borrowed, this could precipitate the next level of the crisis, if the borrowers are unable to pay up on the higher interest. One of the dangers that can arise is “if borrowers need to substitute domestic debt for dollar debt in adverse circumstances, then the exchange rate would come under pressure.”
There are other risks as well that need to be highlighted. There is a growing concern that companies in emerging markets have borrowed in dollars to essentially fund carry trades, where they are borrowing in dollars at low interest rates and then lending out that money at higher interest rates in their own country. Hence, nothing constructive is happening with the money that is being borrowed. It is simply being used for speculation.
Many of the companies borrowing in dollars are essentially borrowing for the first time in dollars. And this leads to the question whether the lenders have carried out an adequate amount of due diligence. Further, some of this borrowing may not have been captured in domestic debt statistics of countries. This means that countries may have actually borrowed more than their numbers suggest. Hence, when the time comes to repay this can put pressure on foreign exchange reserves. Lastly, with firms borrowing in dollars, the domestic policy-makers like central banks and finance ministries, may be misled “by the slower pace of domestic bank credit expansion”. This could mean lower interest rates when they should actually be raised. Lower interest rates can lead to more asset bubbles in financial markets.
What is not helping the cause is the fact that the dollar has appreciated rapidly against other major currencies. It has appreciated by around 25% since June 2014 against other major currencies. This means in order to repay the dollar loans or even to pay interest on it, the borrowers need a greater amount of local currency to buy dollars.
To conclude, it is worth repeating what I often say: before things get better, they might just get worse. Keep watching.

(Vivek Kaul is the author of Easy Money. He tweets @kaul_vivek)

The column originally appeared on Firstpost on Mar 25, 2015 

Janet Yellen’s excuses for not raising interest rates will keep coming

yellen_janet_040512_8x10
The Federal Open Market Committee(FOMC) of the Federal Reserve of the United States, which is mandated to decide on the federal funds rate, met on March 17-18, 2015.
The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.
In the meeting the FOMC decided to keep the federal funds rate in the range of 0-0.25%, as has been in the case in the aftermath of the financial crisis which broke out in September 2008. Janet Yellen, the chairperson of the Federal Reserve also clarified that “an increase in the target range for the federal funds rate remains unlikely at our next meeting in April.” The next meeting of the FOMC is scheduled on April 27-28, 2015.
The question is when will the Federal Reserve start raising the federal funds rate? As the FOMC statement released on March 18 points out: “In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 % inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”
Other than a clear inflation target of 2%, this is as vague as it can get. The inflation number in January 2015 came in at 1.3%, well below the Fed’s 2% target. The Fed’s forecast for inflation for 2015 is between 0.6% to 0.8%. At such low inflation levels, the interest rates cannot be raised.
But the Federal Reserve wasn’t as vague in the past as it is now. In December 2012, the Federal Reserve decided to follow the Evans rule (named after Charles Evans, who is the President of the Federal Reserve Bank of Chicago and also a part of the FOMC). As per the Evans rule, the Federal Reserve would keep interest rates low till the rate of unemployment fell below 6.5 % or the rate of inflation went above 2.5 %.
As the FOMC statement released on December 12, 2012 said: “ the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 % and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2% longer-run goal, and longer-term inflation expectations continue to be well anchored.”
This is how things continued until March 2014, when the Federal Reserve dropped the Evans rule. In a statement released on March 19, 2014, one year back, the FOMC said: “In determining how long to maintain the current 0 to 1/4 % target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 % inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.” In fact, this is exactly the wording the FOMC has used in the statement released on March 18, 2015.
What the FOMC meant in the March 2014 statement was that instead of just looking at the rate of unemployment and the rate of inflation, the Federal Reserve would also take into account other factors before deciding to raise the federal funds rate. So what made the Federal Reserve junk the Evans rule?
In February 2014, the rate of unemployment was at 6.7% and was closing in on the Evans rule target of 6.5%. In April 2014, the rate of unemployment had fallen to 6.2%.
If the Fed would have still been following the Evans rule, it would have to start raising the Federal Funds rate. This would have meant jeopardising the stock market rally which has been on in the United States. In the aftermath of the financial crisis, the Federal Reserve had cut the federal funds rate to 0-0.25%, in the hope of encouraging people to borrow and spend more, to get their moribund economies going again.
While people did borrow and spend to some extent, a lot of money was borrowed at low interest rates in the United States and other developed countries where central banks had cut rates, and it found its way into stock markets and other financial markets all over the world. This led to a massive rallies in prices of financial assets. In an era of close to zero interest rates the stock market in the United States has seen the longest bull market after the Second World War.
Any increase in the federal funds rate would jeopardise the stock market rally. And that is something that the American economy can ill-afford to. So, it is in the interest of the Federal Reserve to just let the stock market rally on.
Interestingly, the Federal Reserve has been changing the so-called “forward guidance” on raising the federal funds rate for a while now. In March 2009, it had said that short-term interest rates will stay low for an “extended period.” In August 2011, it said that short-term interest rates would stay low till “mid-2013.” In January 2012, the Fed said that short-term interest rates would remain low till “late 2014.” And by September 2012, this had gone up to “mid-2015.”
In March 2014, it junked the Evans rule. So, what this means is that the Federal Reserve will ensure that interest rates in the United States continue to stay low. Peter Schiff, the Chief Executive of Euro Pacific Capital, summarized the situation best when he said that the Federal Reserve would “keep manufacturing excuses as to why rates cannot be raised” and this was simply because it had “built an economy completely dependent on zero % interest rates.”
Given this, be prepared for Janet Yellen offering more excuses for not raising the federal funds rate in the days to come.

The column originally appeared on The Daily Reckoning on Mar 20, 2015

Janet Yellen is not going to takeaway the punchbowl any time soon

yellen_janet_040512_8x10
Central banks are primarily in the business of sending out messages to the financial markets. In a statement released on January 28, 2015, the Federal Reserve of the United States had said: “
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.”
In simple English what this means is that the Fed would be patient when it comes to increasing the federal funds rate, which in the aftermath of the financial crisis which started in September 2008, has been in the range of 0-0.25%.
The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans. This is the longest period for which the rate has remained at such low levels, in over fifty years.
In the aftermath of the financial crisis, the Federal Reserve and other central banks around the world had cut interest rates to very low levels in the hope of encouraging people to borrow and spend more, to get their moribund economies going again.
While people did borrow and spend to some extent, a lot of money was borrowed at low interest rates in the United States and other developed countries where central banks had cut rates, and it found its way into stock markets and other financial markets all over the world. This led to a massive rallies in prices of financial assets. In an era of close to zero interest rates the stock market in the United States has seen the longest bull market after the Second World War.
Given this, the stock markets in the United States and in other parts of the world have been doing well primarily because of this low interest rate scenario that prevails. With the return available from fixed income investments(like bonds and bank deposits) down to very low levels, money has found its way into the stock market.
The January 28 statement was released after a meeting of the Federal Open Market Committee(FOMC) which is mandated to decide on the federal funds rate. These meetings of the FOMC are followed very closely all over the world simply because if the Federal Reserve does decide to start raising the federal funds rate or even give a hint of it, stock markets all over the world will fall.
After the January meeting, the FOMC met again on March 17-18, 2015. In a statement that the Federal Reserve released yesterday (i.e. March 18) after the FOMC meeting, it had dropped the word “patient”. So does this mean that the Federal Reserve will start to be “impatient” when it comes to the federal funds rate?
The Federal Reserve chairperson Janet Yellen held a press conference yesterday after the two day meeting of the FOMC, in which she clarified that: “M
odification of our guidance should not be interpreted to mean that we have decided on the timing of that increase. In other words, just because we removed the word “patient” from the statement doesn’t mean we are going to be impatient.”
So what Yellen was essentially saying is that even though the Fed had removed the word “patient” from its statement released yesterday, it was not going to be “impatient,” when it comes to increasing the federal funds rate in particular and interest rates in general. Welcome to the world of central bank speak.
In fact, Yellen also clarified that the FOMC won’t increase the federal funds rate when it meets next towards the end of April, next month. At the same time she said there was a chance that the FOMC might raise the federal funds rate in the meetings after April.
This statement of Yellen has led to the conclusion in certain sections of the media that the Federal Reserve will start raising interest rates June onwards, when it meets next after the April meeting. Only if things were as simple as that. Chances of the FOMC raising interest rates this year are remote. There are multiple reasons for the same.
First and foremost is the fact that inflation in the United States is well below the Federal Reserve’s preferred target of 2%. In fact, for the month of January 2015, this number was at 1.3% much below the Fed’s target of 2%. The Fed’s forecast for inflation for 2015 is between 0.6% to 0.8%. At such low inflation levels, the interest rates cannot be raised.
Inflation is down primarily because of low oil prices as well as the fact that the dollar has rallied (i.e. appreciated) against other major currencies of the world, in the process making imports cheaper for the people of United States. Lower import prices have a significant impact on inflation. The dollar has gone up in value against the yen and the euro primarily because of the money being printed by the Bank of Japan and the European Central bank. This money printing is not going to stop any time soon. As more money is printed and pumped into the financial system, interest rates are likely to remain low. At low interest rates the hope is that people will borrow and spend more and this will benefit businesses and the overall economy.
Getting back to the dollar, an appreciating currency has the same impact on the economy as higher interest rates. Higher interest rates are supposed to slowdown demand and in the process economic growth. Along similar lines when a currency appreciates, the exports of the country become expensive and this leads to a fall in exports. This slows down economic growth. Hence, in a way an appreciating dollar has already done a part of what the Fed would have done by raising interest rates.
With a lot of money printing happening in other parts of the world, chances are the dollar will continue to appreciate. Also, oil prices are likely to remain low during the course of this year, meaning low inflation in the US.
Further in December 2014, the Fed had forecast that economic growth in the US in 2015 will range between 2.6% to 3%. This has been slashed to 2.3% to 2.7%. In this scenario , it doesn’t seem likely that the Federal Reserve will raise the federal funds rate any time soon (may be not during the course of 2015).
William McChesney Martin, the longest serving Federal Reserve Chairman, once said that the job of the Fed
is “to take away the punch bowl just as the party gets going.” Yellen as of now doesn’t want to spoil the party. What this means is that the stock market rallies in large parts of the world are likely to continue in the days to come.
The only thing one can say at this point of time is—Stay tuned!

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The article originally appeared on www.firstpost.com on Mar 19,2015

Will Federal Reserve spoil the stock market party by raising interest rates?

Federal-Reserve-Seal-logo
The prospect of future company earnings are supposed to drive stock markets. But this basic theory has broken down in the aftermath of the financial crisis that started in September 2008.
Western central banks led by the Federal Reserve of the United States have printed an astonishing amount of money over the last six and a half years and some like the Bank of Japan and the European Central Bank, continue to do so. The idea was that money printing would lead to lower interest rates, and at lower interest rates banks would lend more and consumers and businesses would borrow more. This would lead to businesses and in turn, the economy doing well.
But that hasn’t turned out to be the case. As the following table clearly shows, bank loans to small and medium enterprises(SMEs) in the United States have been falling as a proportion of total loans, over the years.

The shrinking importance of SME lending

Nonetheless, lower interest rates in much of the Western world, has allowed investors to borrow money at rock bottom interest rates and invest it in stock markets all over the world.
This is why stock markets including the Indian one have rallied big time over the last few years. For this rally to continue it is important that Western central bank continue to maintain low interest rates.
The economic situation in Europe continues to remain bad, and as of now there is very little chance that central banks of Europe will go around raising interest rates any time soon. In fact, in Switzerland the short term interest rate currently is at
 − 0.75%.
Japan also continues to remain in doldrums and the chances of the Bank of Japan, the Japanese central bank, raising interest rates any time soon remain minimal. This leaves the Federal Reserve of the United States, the American central bank. And this is where things get a little tricky.
The Federal Open Market Committee of the Federal Reserve which decides on the interest rate is supposed to meet today and tomorrow (i.e. March 17 and March 18). The rate of unemployment in the United States has come down significantly over the last one year. In fact,
the USA Today reports that in 2014, job growth hit a 15 year high.
Typically, a fall in unemployment leads to an increase in wage growth, as employers compete to recurit employees. But that doesn’t seem to have happened in the United States. The Fortune magazine reports that the average hourly pay of an American worker has risen by just $0.03 in the last one year. This basically means that wage growth in the United States has been more or less flat over the last one year.
The overall inflation also remains much lower than the Federal Reserve’s target of 2%. The Federal Reserve’s preferred measure of inflation is personal consumption expenditures(PCE) deflator, ex food and energy. For the month of January 2015, this number was at 1.3% much below the Fed’s target of 2%.
This number falls further once the imputed(i.e. made-up data) is excluded. Before we go any further I need to explain what imputed data is. Take the case of an individual who owns the house he lives in. As the Statistics Bureau of Japan points out: “B
uying a house or a piece of land is a form of property acquisition and not consumption expenditure. Such a purchase, therefore, is not counted in the CPI. Still, it is an undeniable fact that a household living in a house it owns receives some service from the house…Also, many households are paying a mortgage. Here, it leads to an issue that, one way or another, the housing expense of an owner-occupied house should be counted in the CPI calculation.”

Hence, such a situation needs to be taken into account. It is done by assuming that the “house-owning household is renting the same house from someone else.” “Then, the household has to pay some rent…An “imputed rent of an owner-occupied house” refers to the rent paid to owner-occupied houses assuming that owned house were rented. Such imputed rents are taken into the CPI calculation,” the Statistics Bureau of Japan points out.
If such data were to be excluded from inflation calculation in the United States, the results would be significantly different from the way they currently are. As Albert Edwards of Societe Generale points out in a recent research note titled
Forget the ECB: A key measure of global liquidity is now in freefall, published on March 6, 2015: “We use a variant of this core PCE where the US statisticians exclude imputed (i.e. made-up) data..Five out of the last six months have registered zero inflation with only one 0.1% rise! Headline core PCE is being inflated by made-up data.”
As the fall in price of oil seeps through the system Edwards expects the inflation rate to come down to 0.3%. The other major reason for low inflation in the US is the fact that dollar has rallied majorly against all major currencies. This ensures that imports to the United States become cheaper, and thus drive down inflation.
In this scenario of almost no wage inflation and low overall inflation, will the Federal Reserve start increasing interest rates?
If the Fed does not raise interest rates then foreign investors will continue raising money in dollars and investing that money in stock markets all over the world, including India.
But if the Fed does start to raise interest rates then this carry trade may run into some trouble and fresh money from foreign investors may not come into India at the same pace as it has in the past. The way things stand as of now, this remains too close to call. Nevertheless, I will stick my neck out and say, the Fed won’t raise interest rates in June this year, as it is widely expected to.
Having said that, I have my fingers crossed!

The column originally appeared on The Daily Reckoning on Mar 17, 2015