Fed Funds, Inflation & Crime
Canadian economist Reuven Brenner lists the five sources of capital as inheritance, savings, capital markets access, government, and crime. Brenner’s mention of crime has rung particularly true of late.
Just last week USA Today reported that high “honey prices are being blamed for a surge in thefts of beehives.” This follows headlines from the same paper last October including, “Copper: Hot loot for some thieves”, and “States battle rise in copper thefts”.
Put simply, government can take from us in two ways: first by taxing our income, and second through the debasement of the money we earn. While marginal tax rates fell across the board for Americans in 2003, the federal government has more than erased those gains through its oversight of a collapsing dollar that began to decline in 2001. With money not buying nearly as much as it used to (a dollar bought 1/253rd of an ounce of gold in 2001 compared 1/870th of an ounce today) some citizens are apparently resorting to crime to retrieve some of what the federal government has taken.
Commodities are of course priced in dollars, and with the dollar’s fall, commodities have shined such that thievery has been on the rise. And even though commodities have been surging for nearly seven years, record highs reached since last fall have generated a not insignificant amount of editorials fingering the declining Fed funds rate as the cause. Going back to last September, the Fed has overseen reductions in its target rate of 325 basis points, and looked at in isolation, editorials suggesting a correlation between rate decreases and a falling greenback would seemingly make a lot of sense. Since the Fed began reducing rates last September the dollar price of gold has risen 29 percent, and oil has risen 59 percent.
But what frequently goes unmentioned is the direction of commodities from June of 2004 to September of 2007; a period in which the Fed funds rate was increased 425 basis points. During the time in question, the dollar price of gold rose 72 percent, and the price of oil rose 85 percent.
As Stanford economist Ronald McKinnon wrote in his 1996 book Rules of the Game, “the traditional ‘Keynesian’ precepts of monetary management, where ‘the’ absolute level of nominal rates of interest is accepted as a measure of ease or tightness, are highly suspect.” Notably, dollar history since 1971 shows a much greater correlation between a weak dollar and rising rates, as opposed to the consensus assumptions today suggesting the opposite. Faulty intuition or perhaps repetition of the statement that high nominal rates mean the Fed is “tight” has won out over empirical evidence revealing something quite different.
In August of 1971 (a worthwhile dateline considering August marked the end of the Bretton Woods system of fixed exchange rates) the Fed funds rate sat at 5.5%, but by year-end 1974 the rate had risen 300 basis points. Despite this alleged tightening gold rose 385 percent. From 1974 to 1977, the Fed’s cash rate fell roughly 300 basis points, and gold fell 20 percent.
From January of 1977 to January of 1980, the Fed funds rate was increased 925 basis points, but rather than a tightening whereby the dollar price of gold collapsed, the yellow metal instead rose 686 percent. As mentioned before, intuition perhaps suggests the Fed tightens or strengthens the dollar when it raises rates, but referencing McKinnon once again as to what happened in the 70s, “the higher American rate of interest reduced the demand for non-interest bearing dollar balances while, at the same time, the Federal Reserve failed to reduce the supply of base money commensurately (emphasis mine).”
More modernly, the Fed began raising rates in July of 1999, lifting the key interest rate from 5 percent to 6.5 percent in November 2000. Amidst this seeming austerity, gold actually rose from $258 to $265 an ounce. In December 2000 the Fed began lowering the bank rate once again, from 6.5 percent to 3.75 percent by July of 2001. But after 275 basis points of rate cuts, the gold price was largely unchanged.
All of the previous examples ignore the outsized impact Treasury policy has on the direction of the dollar, along with geopolitical and domestic factors such as terrorism and tax rates that surely impact trust in the currency, and general demand for same. So even if the negative impact on the dollar due to high rates of interest is wholly coincidental, there remains the question of whether the Fed funds rate itself is the driver of currency liquidity and valuations as so many assume.
In considering this, we can look to RealClearMarkets articles by Wayne Jett and Doug Johnson. Sure enough, Jett and Johnson have made the basic point that, “the funds rate is not the valve to liquidity flows that it has been represented to be.” Both have bolstered the latter view through presentation of a St. Louis Fed study explaining just that. Indeed, as Johnson noted in an article last week, even though the Fed funds rate see-sawed from 1% to 19% from the 50s to the 80s, “base money reserves grew at a steady 3.1% annual rate regardless of the Fed funds rate.”
Moving to rate comparisons, when not decrying allegedly low nominal cash rates, many editorials have mentioned low levels of U.S. rates relative to those in other countries as an explanation of the dollar’s woes. The logic underpinning the latter argument is that high nominal rates attract investment which allegedly bolsters the currency; an assumption that at first blush seems logical until we consider that U.S. rates in the 70s were higher and the dollar weak precisely because investment was lagging. If that’s not enough, since 1978 Japanese long-term rates have averaged 3 to 4 percentage points lower than those in the U.S., but rather than a yen negative, the latter has risen well over 100 percent against the dollar.
In defense of rate-hike advocates, the positions taken by those in that camp emanate from a pro-dollar perspective in the sense that a stronger dollar is desired. But it should at the very least be acknowledged that the overnight rate for money set by the Fed is artificial, and even at 2 percent it is roughly 30 basis points above 6 month T-Bill rates set by markets and over 60 basis points higher than 3 month T-Bills. With T-Bill rates in mind, can any rate hawk credibly suggest that the overnight rate for cash would be higher than 3 and 6-month rates in a free-floating rate environment?
In the end, it should be remembered that strong, stable currencies are low-rate currencies. Rather than engaging in rate machinations totally unsuited to achieving a strong and stable dollar, rate hawks might concede that as the issuer of the world’s reserve currency, we should have the lowest rates in the world. Rather than utilizing the highly questionable rate mechanism to fix the dollar, a better solution would be to jawbone the U.S. Treasury to simply define the dollar in terms of gold; an action that if credibly done would cause a positive collapse in rates across the curve. If so, tales of beehive thefts and recession would quickly disappear.