Janet Yellen

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

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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)

Too much debt, too little growth and too low interest rates

 

 
Vivek Kaul

The financial crisis that started in September 2008, after the Wall Street investment bank Lehman Brothers, went bust, led to the economic growth stagnating in large parts of the world.

The central banks around the world tackled this by cutting interest rates to very low levels. The hope was that at low interest rates people would borrow and spend. At the same time, corporates would use this opportunity to borrow and expand. And this would lead to economic growth coming back. QED.
But that is not how things panned out. Instead of prospective consumers borrowing and spending money, large institutional speculators borrowed money at low interest rates in large parts of the Western world and invested it in financial markets all over the world. This excessive inflow of “easy money” has led to bubbles in financial markets in large parts of the world.

This point is made in the latest annual report of the Bank of International Settlements (BIS) based out of Basel in Switzerland. The BIS is often referred to as the central banks of central banks. As the BIS annual report for the financial year ending March 31, 2015 points out: “very low interest rates that have prevailed for so long may not be “equilibrium” ones, which would be conducive to sustainable and balanced global expansion. Rather than just reflecting the current weakness, low rates may in part have contributed to it by fuelling costly financial booms and busts. The result is too much debt, too little growth and excessively low interest rates. In short, low rates beget lower rates.”

This is a very interesting point. What BIS is saying is that low interest rates have led to very little economic growth. At the same time the total amount of global debt has gone up (as can be seen from the accompanying chart). In order, to tackle this low economic growth rate, the central banks have either cut interest rates further or maintained them at their low levels. In fact, several central banks in Europe have also taken their interest rates into negative territory i.e. you have to pay money in order to deposit money with them. Hence, lower interest rates have led to further lower interest rates without creating much economic growth.

As can be seen from the accompanying table, the total global debt has touched around 260% of the global gross domestic product (GDP). In 2008, it was around 230% of the global GDP. It’s a weird economic world that we live in. While the low interest rates did not lead to economic growth as was expected, they did lead to financial market booms.

Interest rates sink as debt soars

As Gary Dorsch of Global Money Trends newsletter puts it in his latest column: “Cheap money encourages more debt and creates financial booms and busts that leave lasting scars on the economy. They underpin both the potentially harmful high risk-taking in financial markets, while subduing risk-taking in the real economy, where investment is badly needed. And while increases in interest rates could cause stock prices to fall, – the likelihood of turmoil is only increased by waiting.”

Long story short—the longer the era of easy money continues, the worse the crash will be, as and when it comes. This is a point that the BIS makes it in its report as well, where it says: “Risk-taking in financial markets has gone on for too long. And the illusion that markets will remain liquid under stress has been too pervasive. But the likelihood of turbulence will increase further if current extraordinary conditions are spun out. The more one stretches an elastic band, the more violently it snaps back.”

This basic elastic-band analogy should tell us very clearly how delicately poised the global economy is with all the excessive debt that has been built up over the last few years, in the hope getting economic growth going again.

The BIS feels that the era of easy money and very low interest rates needs to be reversed as soon as possible. “Restoring more normal conditions will also be essential for facing the next recession, which will no doubt materialise at some point. Of what use is a gun with no bullets left? Therefore, while having regard for country-specific conditions, monetary policy normalisation should be pursued with a firm and steady hand,” the BIS annual report points out.

The question is will the central banks take the risk of raising interest rates in the days to come. The economic recovery (whatever little of it has happened) continues to remain very fragile. And will any central bank governor (or Chairman) take the risk of killing even that by raising interest rates? As John Maynard Keynes once said: “’Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

It is also worth asking here if central banks will sacrifice the short-term for the long-term? As the BIS report points out: “Shifting the focus from the short to the longer term is more important than ever. Over the past decades, it is as if the emergence of slow-moving financial booms and busts has slowed down economic time relative to calendar time: the economic developments that really matter now take much longer to unfold. Meanwhile, the decision horizons of policymakers and market participants have shortened. Financial markets have compressed reaction times and policymakers have chased financial markets more and more closely in what has become an ever tighter, self-referential, relationship.”

The Federal Open Market Committee (FOMC) of the Federal Reserve of the United States is meeting over July 28-29, 2015. Many experts have said time and again that the Federal Reserve will raise interest rates this year. The Fed chairperson Janet Yellen has hinted at the same as well. Let’s see if FOMC comes around to doing that.

The column originally appeared on The Daily Reckoning on July 29, 2015

Yellen does a Greenspan, talks about “irrational exuberance” in the stock market

yellen_janet_040512_8x10Vivek Kaul

Janet Yellen, the chairperson of the Federal Reserve of the United States, said yesterday: “equity market valuations at this point generally are quite high…There are potential dangers there.” This is the strongest statement that Yellen has made against the rapidly rising stock markets in the United States and other parts of the world.
In February earlier this year Yellen had said that the stock prices where “somewhat higher than their historical average levels.” In March, she had followed this up by saying that the stock market valuations were “on the high side”.
Central bank governors don’t say things just like that on the stock market, like the stock market analysts tend to do. When a central bank governor makes his view public on the stock market, the idea is to temper down the expectations of stock market investors in some way.
Take the case of a speech that Alan Greenspan, who was the Chairperson of the Federal Reserve between 1988 and 2006, gave on December 5, 1996. In this speech Greenspan said: “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance[emphasis added] has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade.”
Greenspan was essentially saying that the stock market level might have run way ahead of the kind of earnings that were being generated by companies. And hence there was an “irrational exuberance”.
Greenspan recalls in his autobiography The Age of Turbulence that at the end of the speech, he wondered whether people would understand what he was trying to get at. They sure did.
The Japanese stock market, which had opened by the time Greenspan finished his speech, reacted instantly. The Nikkei index dropped 3.2 percent. The Hang Seng in Hong Kong dropped 2.9 percent. The DAX in Germany went down four percent and so did the FTSE 100 in London.
The next day, when the stock markets in the United States opened for trading, the Dow Jones Industrial Average, America’s premier stock market index, was down 2.3 percent. The NASDAQ Composite Index, where most of the technology companies listed, was down 1.8 percent at opening.
By the close of trading, NASDAQ Composite Index was down 0.9 percent and had recovered half of its losses. When the stock market opened for trading again on December 9, 1996, after the weekend, it was back trading at the levels it had been at before Greenspan made the “irrational exuberance” speech.
Various explanations have been offered over the years as to why the stock market investors chose to ignore what Greenspan had said and continued to stay invested in the dotcom bubble. One is that Greenspan did not immediately back his speech with the concrete action of raising interest rates. This argument is not totally correct because Greenspan did raise interest rates a couple of months later, although he did not do anything immediately. The second reason given is that by the time Greenspan raised the red flag, the market was already irrationally exuberant. It had already formed a mind of its own and was in no mood to listen. As the economist Ravi Batra writes in Greenspan’s Fraud: “The lure of free lunch is so powerful that it clouds our vision. For once Greenspan had offered words of wisdom, but in doing so he lost his audience. The master bartender wanted his customers to sober up. They wanted more: whiskey, champagne, rum, just bring it on.”
The stock market needed a little more than just one Greenspan speech to sober up. A series of interest rate hikes might just have done the trick. But this can only be said with the benefit of hindsight. Nobody likes to spoil a party that is on. Greenspan too was human, and he did not want to be a killjoy.
So what is it that we can learn when we compare Greenspan’s warning with those made by Yellen in the recent past. Yellen’s warnings on the stock market like that of Greenspan might also have come a little late in the day. But unlike Greenspan who just made one warning and then more or less kept quiet, till the dotcom bubble burst in 2000, Yellen has come up with a series of warnings. If she keeps saying the things she has been the investors will eventually take her seriously. The only question is when.
Further, just talking about stock market being overvalued won’t help. If Yellen has to rein in the stock market then the Federal Reserve also needs to start raising the interest rates. The trouble is that with the American gross domestic product(GDP) growing by just 0.2% between January and March 2015, Yellen and the Fed are not really in a position to start raising interest rates.
In fact, what makes the economic situation even more worse than it actually looks is the fact that even a 0.2% economic growth is overstated. This is primarily because it includes a huge inventory build up. Inventory essentially refers to goods which are being produced but not being sold.
Inventories during the period January and March 2015 went up by $110.3 billion. They had risen by $80 billion during the period October to December 2014. An increase in inventory adds to the GDP. Nevertheless what it also means is that there will be production cuts in the months to come, which in turn will pull the GDP down. Albert Edwards of Societe Generale estimates that without this unprecedented rise in inventories, “GDP would rather have declined by some 2½%!” He also said in a recent research note that: “The US economy is struggling and the Fed will ultimately re-engage the QE spigot.” QE or quantitative easing is the technical term that economists use for a central bank printing money and pumping that money into the financial system to keep interest rates low.
Until October 2014, the Federal Reserve had been printing money and pumping money into the financial system by buying government bonds and mortgaged backed securities. The idea was to flood the financial system with money by buying bonds and drive down interest rates. At lower interest rates, people were more likely to borrow and spend money. This would help businesses and in turn, the overall economy. While this happened to some extent, what also happened was that institutional investors borrowed money at low interest rates and invested them in financial markets all over the world. This led to stock market rallies all over the world.
Hence, while Yellen might keep making statements about the stock markets being overvalued, she needs to back it up with some concrete action(like raising interest rates) for investors to take her seriously.
The trouble is Yellen can’t raise interest rates. At least, not in near future. Given the American economic growth scenario, an era of low interest rates and easy money is likely to continue in the days to come. And what this means is that BSE Sensex just might go back to rallying despite the recent fall.

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

The column originally appeared on Firstpost on May 7, 2015

Janet Yellen will keep driving up the Sensex

yellen_janet_040512_8x10Vivek Kaul

The Bombay Stock Exchange (BSE) Sensex, India’s premier stock market index, rose by 517.22 points or 1.88% to close at 27,975.86 points yesterday (i.e. March 30, 2015). On March 27, 2015 (i.e. Friday), Janet Yellen, the Chairperson of the Federal Reserve of the United States, gave a speech (after the stock market in India had closed). In this speech she said: “If conditions do evolve in the manner that most of my FOMC colleagues and I anticipate, I would expect the level of the federal funds rate to be normalized only gradually, reflecting the gradual diminution of headwinds from the financial crisis.” 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. What Yellen was basically saying is that even if the Federal Reserve starts raising interest rates, it will do so at a very slow pace. In the aftermath of the financial crisis that started in mid September 2008, when the investment bank Lehman Brothers went bust, central banks in the developing countries have maintained very low rates of interest. The Federal Reserve of the United States, the American central bank , has been leading the way, by maintaining the federal funds rate in the range of 0-0.25%. The hope was that at low interest rates people would borrow and spend more than they were doing at that point of time. This would help businesses grow and in turn help the moribund economies of the developing countries. 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. For the rallies in financial markets all over the world to continue, the era of “easy money” initiated by the Federal Reserve needs to continue. And this is precisely what Yellen indicated in her speech yesterday. She said that even if the Fed starts to raise interest rates it would do so at a very slow pace, in order to ensure that it does not end up jeopardizing the expected economic recovery. Yellen went on to add in her speech on Friday that: “Nothing about the course of the Committee’s actions is predetermined except the Committee’s commitment to promote our dual mandate of maximum employment and price stability.” This is where things get interesting. The rate of unemployment in the United States in February 2015 was at 5.5%. This was a significant improvement over February 2014, when the rate of unemployment was at 6.7%. But even with this big fall, the Federal Reserve is unlikely to raise interest rates. Typically, as unemployment falls, wages go up, as employers compete for employees. But that hasn’t happened in the United States. The wage growth has been more or less flat over the last one year (it’s up by 0.1%). The major reason for the same is that more and more jobs are being created at the lower end. As economist John Mauldin writes in his newsletter: “66,000 of the 295,000 new jobs[that were created in February 2015) were in leisure and hospitality, with 58,000 of those being in bars and restaurants…Transportation and warehousing rose by 19,000, but 12,000 of those were messengers, again not exactly high-paying jobs.” Further, in the last few years the energy industry in the United States has seen a big boom on the back of the discovery of shale oil. But with oil prices crashing, the energy industry has started to shed jobs. In January 2015, the energy industry fired 20, 193 individuals. This was 42% higher than the total number of people who were sacked in 2014. As analyst Toni Sangami pointed out in a recent post: “These oil jobs are among some of the highest-paying blue-collar jobs in the country, so losing one oil job is like losing five or eight or ten hospitality-industry jobs.” The labour force participation ratio, which is a measure of the proportion of the working age population in the labour force, in February 2015 was at 62.8%. It has more or less stayed constant from December 2013, when it was at 62.8%. This is the lowest it has been since March 1978. The number was at 66% in December 2007. What this means is that the rate of unemployment has been falling also because of people opting out of the workforce because they haven’t been able to find jobs and, hence, were no longer being counted as unemployed. So, things are nowhere as fine as broader numbers make them appear to be. 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 February 2015, this number was at 1.4% 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. Yellen summarized the entire situation beautifully when she told the Senate Banking Committee earlier this month that: “Too many Americans remain unemployed or underemployed, wage growth is still sluggish, and inflation remains well below our longer-run objective.” What does not help is the weak durables data that has been coming in. Orders for durable goods or long-lasting manufactured goods from automobiles to aircrafts to machinery, fell by 1.4% in February 2015. The durables data have declined in three out of the last four months. Given this scenario, it is highly unlikely that the Yellen led Federal Reserve will start raising the federal funds rate any time soon. Further, as and when it does start raising rates, it will do so at a very slow pace. What this means is that the era of easy money will continue in the time to come. And given this, more acche din are about to come for the Sensex. Having said that, any escalation of conflict in the Middle East can briefly spoil this party. The article originally appeared on The Daily Reckoning on Mar 31, 2015

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

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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