Interest Rates, Recession or Depression?

 
Before we can even begin to discuss interest rates intelligently, we must first define what it is that we are actually talking about, since it appears that all the talking Media Heads and Wall Street analysts don't seem to understand what interest rates are or how they work: The constant barrage of economists parading across our TV screens don't seem to know what interest rate's primary functions are, so how can they know whether to raise them or not?

WHAT ARE INTEREST RATES?

#1 Interest rate is just another word for price. It is the price to borrow money and its price is supposed to be determined exactly the same way as the price of any other commodity, product or service is - through the interaction of supply and demand.

#2 However, unlike every other product, commodity or service, interest rates and money do not operate in a Free Market. Interest rates and the supply of money are manipulated (controlled) by the Fed. They do this by controlling the amount (supply) of money that is available in the banking system through their Open Market Operations (buying & selling treasury bonds in the open market) and by changing their deposits that they hold with their individual member banks, directly affecting their reserves and thus their ability to lend. They also increase the money supply the good old fashioned way, by printing it.

WHAT ARE THE FUNCTIONS OF INTEREST RATES?

# 1 Interest rates determine the propensity of people to either save or consume: When interest rates are manipulated (by the Fed), it influences the degree that people are willing to defer present consumption, i.e. save. If interest rates are manipulated too low, like they are now, people are no longer willing to save. When the interest rate becomes negative (the interest rate is lower than the inflation rate) people, since they are now being paid to go into debt, take on excessive debt as well as excessive risk because that is exactly what they are being paid to do. Conversely, when interest rates are high, such as in the early 80's, people were willing to forego current consumption in order to avail themselves of the ultra high interest rates and we ended up having high saving rates.

# 2 When interest rates are high, the demand for cash is extremely low. People can't wait to deposit every cent that they can spare so as to earn that high rate of interest. However when rates are low, the propensity to hold cash is very high because at a 1% or 2% interest there is not much to be forgone by keeping extra cash in your pockets.

# 3 The Velocity of money (how many times the money supply turns over during the year) and therefore the calculation of the money supply itself is greatly affected by the level of interest rates. When rates are outside the normal range, the FED cannot calculate the velocity until long after the fact and thus they lose track of what the money supply really is and its effect on the economy, leading to the interest rate conundrum.

# 4 Interest rates also determine which investments should or should not be made, according to the investment's expected rates of return. When interest rates are manipulated too low, a great many investments and risks are undertaken that should not have been, because these poor investments will fail at the first signs of weakness in the economy or be forced into bankruptcy with the eventual return to rising interest rates. This is the main underlying cause behind the business cycle. The imbalances (wasted resources) in the economy must be liquidated before the economy can stabilize enough so that the misused scarce resources become available for the next growth phase.

# 5 A neutral rate of interest is the rate that neither stimulates nor restricts the economy. Greenspan was and Bernanke is in a conundrum as to what that rate is or should be. Previously, that rate was thought to be 1.5% to 3% over the inflation rate. (According to the latest CPI report (5%) the Discount Rate should be at least 6.5%.) In the past, when the Fed did not manipulate the rates except at the extremes, the market was able to determine what that rate should be through the interactions of the Free Market. But today with US savings nearly zero and the CPI and interest rates being highly manipulated, the Fed is unable to measure the Velocity of Money and with negative interest rates, the Fed does not have a clue as what the neutral rate should be.

# 6 The Discount Rate is the rate that the Fed charges Banks who need to borrow money from the Fed to meet their reserve requirements. The FED was originally created to be "the Lender of Last Resort", avoiding bank runs and liquidity squeezes. The Discount Rate charged used to be a Punitive Rate; a rate that was somewhat above the Fed Funds Rates (the rate at which Banks lend to each other in order to meet their overnight reserve requirements). But today, the discount rate is above the Fed Funds rate, drastically lowering the banks' cost of money and reducing the amount of interest they are willing to pay for deposits: so that now massive amounts of money are being borrowed from the FED without having to worry about the excess demand increasing interest rates, greatly increasing the banks' ability to create money out of thin air: Completely negating the supply/demand function in setting interest rates. This break down in the function of a free market has led to the creation of "The Carry Trade." In so doing, the Fed has completely lost control over the banks and near banks' (FNM, FRE, GE, GMAC etc.) ability to create money and have therefore lost control over the money supply. This has led directly to the creation of the Stock and Bond Market Bubbles as well as to the Real Estate Bubble that has, after 15 years, most probably topped out and is in the process of rolling over into a crash.

For a long time now, regardless of the ever increasing demand for loans and the seventeen ¼% Discount Rate increases, Long Term rates, because of the ongoing Carry trades, refuse to go up and reflect the true conditions of the market.

THE FED'S CONUNDRUM

Fed Chairman Bernanke like Greenspan before him once again raised the conundrum of the divergence between short term and long term rates. At the end of Jan 07, the yield on the 10-year Treasury-Note stood at 4.4% still below the 4.6% rate in June of 2004, the year when the Fed funds rate was only 1%. Bernanke like Greenspan before him blames some mysterious 'pressures' for the divergence between the Federal funds rate and long-term rates. However careful examination shows that there is no mystery. The so called mysterious pressure is in fact the natural outcome of the BOJ and the Fed's own easy money policies.

When it comes to the economy, what matters most is the availability of money and not the purported interest rate stance of the Fed. For example, in order to maintain a given interest rate target in the midst of a strong economy, the Fed is forced to push more and more money into the system to prevent the Fed funds rate from rising above its targeted rate. This in turn causes long term rates to fall. The opposite will happen should the economy go through a period of weakness. Since they are always behind the curve, they end up exacerbating the problem rather than dampening the fluctuations. Since June 2004, despite raising the Fed-funds rate from 1% to 5 ¼%, the Fed has actually hiked the pace of pumping money into the system, creating a negative yield curve. In short, the Fed has been talking tough while acting like a very loose $5 street walker.

TIME LAGS: Nobody seems to realize that there are always time lags whenever there are any changes in FED or Government policy, whether they be Taxes, Money Supply or even High Oil prices or ??? . It takes time for the Free Market to send its signals through to every participant and it then takes time for every participant to react. The estimated average time lag between changes in the Fed Funds policies and the growth momentum of industrial production is on average 12 to 36 months. Hence, at the same time as the FED'S attempted tighter stance (beginning June 2004), the effect of the previous and continuing loose money stance was still in force and continuing its influence for the following 30 months. So in spite of their regular ¼ % increases, the yearly rate of growth of industrial production stayed strong into 2007. However the strong economic activity made possible by its loose money policy, had made the FED Funds rate targets unsustainable-so the Fed had to continue to increase the money supply to prevent the Fed Funds rate from overshooting their stated targets. This monetary pumping has thus far prevented the growth momentum of the economy from slowing, also preventing any meaningful rise in long-term interest rates.

INFLATION: According to Milton Friedman, inflation is at all times a monetary phenomenon. If you keep printing money (beginning in 1994) at a rate that is 10% a year above the economy's real rate of growth, inflation must eventually ensue and it has. It first showed up in the stock market, then found its way into the Bond market and eventually into Real Estate. Now that the world economy is awash in Fiat cash, it's finally finding its way into commodities, takeovers and corporate buyouts. Now with nothing much left to inflate, the money is finally finding its way into the CPI. Witness the price explosion of Gold and Silver: Even though the government has thus far managed to convince everyone (through their ingenious manipulation of the CPI) that there was and is no inflation, Nevertheless, inflation has already begun to rear its ugly face and it won't be much longer before we see just how high inflation really is. Bernanke, to his credit, is now looking to the future while the rest of our esteemed talking heads are still focusing on their rear view mirror.

CONCLUSION

THE RIGHT MAN IN THE RIGHT PLACE AT THE RIGHT TIME

In my opinion, Bernanke is possibly the only man at the Fed who realizes that he has no other choice but to push interest rates even higher than most would now even dream of in order to try and head off an explosion in inflation: Even if it's in the face of the economy's growth momentum starting to trend down. Like it or not and despite what Wall Street and the politicians want, he knows that the economy cannot continue growing above trend for any more sizeable length of time without going into rampant inflation. He realizes that both the USA's and the world's economies are now more out of balance and are in the biggest bubble mode than in 1929 or any other time in world history. He realizes (at least I hope he does) that our only HOPE is to engineer a recession, hopefully it will only be a mild one, so as to avoid a combined Stock, Bond, Real Estate and Take-over CRASH, which would lead to a world wide depression.

He and only a few other people in the world realize that cutting interest rates now, especially in the face of tightening lending standards, would not only do nothing to save the real estate market, but would actually bring on the depression by causing the US Dollar to tank. A crashing dollar would set the world's financial system on it ear; the results of which would be devastating. He knows full well the lag effect of the last 18 months of interest rate policies will eventually end up setting in motion a depressing effect on economic activity which will begin to take effect, more than likely, within the next 1 to 3 months if it has not already done so. Let us hope that the FED, because of the lag effect will NOT, as they always have in the past, doesn't overshoot their targets and exacerbate the problem that they themselves have created.

In the meantime, the lag effect of the higher interest rate policies since June 2004 will eventually finding its way into rising long term rates, undermining the stock, bond and real estate markets that sprang up on the back of Greenspan's FED ultra loose monetary policy, setting in motion a much needed controlled economic slowdown instead of a Bust, giving the economy a chance to self correct its huge imbalances.

Greenspan realized full well that the bigger the boom the bigger the inevitable bust: His main objective was to push the time of the inevitable crash into the next Chairman's term and thus preserve his legacy. To give him his due, he was also trying to raise interest rates high enough before Bernanke finally took over so that the FED would then have some ammunition to hopefully slow down the crash and keep it in only a Recession mode.: However "IT" will be, when "IT" comes, at first similar to 2001, too little and too late. In 2001, we were sitting on projected massive budget surpluses and unified government so Bush was able to get massive tax cuts passed and succeeded in stopping the recession in its tracts; but this time around the US is not only in a "Guns and Butter Economy" but with both massive trade and budget deficits instead. With the Democrats now in control of Congress, there will be NO new tax cuts coming to save the day and stop the Crash. A looming and even bigger danger is that we may actually face tax increases and a return to job destroying NEW DEAL policies which are even now being bandied about in Congress.

Let us pray that I'm right and Bernanke is not only smart but lucky as well, he is our only chance to prevent a major financial catastrophe.

GOLD and SILVER

The Gold and Silver Bugs, after serving a 25 year prison sentence mired in a Bear Market, have been finally let loose: But they are still talking about fundamentals: They have been always right about the shortages of new supply vs. demand, but that didn't stop the Bear Market. For the past few years, the supply demand imbalances have become so acute that we are now in a world wide Bull Market for all commodities not just for Gold and Silver. But that is not from where an exploding Bull Market in Gold and Silver comes from. In order to get a 1978-1980 type explosion in Gold and Silver (and their stocks) prices, you require the combined emotions of both GREED & FEAR. So far we have been only experiencing the beginnings of the Greed phase. I know this because even the biggest and best of the Gold Bugs keep calling for periodic corrections. When Greed really takes over, there is no longer talk of correction as prices begin to jump 5% to 10% in one day and people line up to buy bullion as signs pop up everywhere "WE buy and sell gold". That final stage only begins as the FEAR of a collapsing currency embroils men's guts. Once both fear and greed take over the market and the short squeezes begin in earnest, there is no way of predicting how high the high. $2200 Gold and $200 Silver seems to me to be the barest minimum targets, maybe $5000 or even $10,000 could be in the cards. Your guess is as good as mine. I realize that the great majority of you may think I'm crazy, but when you yourself start thinking that these numbers might actually be too low, then and only then, will we be firmly in the clutches of the blind Greed and Fear phase that will mark the final top.

Who are these people that will end up buying at the top? Why they are the same ones that got in near the lows but sold out for what turned out to be relatively small profits and were waiting for that one more pull back that never came (it came, it was 36% but it only lasted two weeks) to get back in. Be careful and make sure that I am not describing YOU. Remember a Bull Market will always do whatever it has to do to make the majority of the people wrong.

WOULDA SHOULDA COULDA

We are now in or close to the end of that correction in Gold and Silver that everyone was dreaming of. In my opinion not only is that correction over, but we are about to complete Wave 2 of explosive the Wave 3. So now that it's here, how many of you are actually buying and or fully invested? Not very many since most of you have now lost your nerve.You are about to learn what a real Bull Market in Gold looks like when this market, which is about to enter Wave 3 of 3, finally explodes and starts to go up so fast you won't have a chance to get back in.

Just in case you haven't noticed, the resumption of the Bear Market in the overall stock market that I have been warning you about since October '06 is right on schedule to completing its top. Perhaps it will take one more breakout to a new high to set that final and biggest BULL TRAP in history.

What To DO Now?

Liquidate all your short term Debt. Build up your cash position by selling most of your stock and long term bonds into any further rally. Buy Gold and Silver NOW. Use your buying power if you have no cash to increase your gold and silver stock positions. But whatever you do, get back in now or you will be sucked back in right near the eventual top.

GOOD LUCK AND GOD BLESS

Aubie Baltin CFA, CTA, CFP, Phd. (retired)

Palm Beach Gardens, FL

aubiebat@yahoo.com

561-840-9767

5 April 2007

The above information has been gleaned from information that I believe to be reliable but is not guaranteed by me. The information provided is strictly for educational purposes and is not meant to be used as investment recommendations.

10 karat gold is 41.7% pure gold.