What the Fed Does not Say, Is More Important Than What It Does Say

May 10 2016

0.25 percent. That is where the official rate stood before the April-meeting and that is exactly where it stands now, two weeks after the meeting. When you carefully read the Fed’s press release of the April-meeting, you can almost see the Fed struggle. What do I mean?

The Fed would very much like to keep interest rates unchanged. Almost every member of the Federal Open Market Committee (FOMC) would be in favor of keeping rates where they are. But … they know very well that they’re not allowed to say so in public.

If they would do so, they would risk that either financial markets will think “gosh, if the Fed doesn’t want to raise rates now the economy grows, then there must be something wrong with the economy”, which might result in declining stock prices and all the negative consequences this entails, or that those same financial markets will think “wait a second, if the Fed keeps rates at current levels with a recovering economy, then that might lead to higher inflation down the road. In that case, long term interest rates might move substantially higher…of course with all the negative consequences this entails, too.”

What should the Fed do then? Well, exactly what the Fed did last week. A balancing act, in which on the one hand you try to make sure your words can be interpreted in such a way that it might imply an upcoming rate hike, while on the other hand you leave enough room to postpone raising rates.

This, of course, is nothing new. Last year, we witnessed a very similar dynamic. The official rate would almost certainly be raised for the first time before July. It didn’t happen. But then at least in September! Didn’t happen either. In both cases, the Fed helped create those expectations. Rates were hiked only in December, when the Fed also stated that it expected to hike rates four times more in the course of this year.

I already said that this was nothing short of a fairy tale, and that the Fed would raise rates, at most, twice and probably only once this year.

What happened after December? The Fed suddenly started to point to all kinds of “uncertainties,” such as economic developments elsewhere. Markets interpreted this, appropriately, as “forget about those rate hikes.”

The Fed was perfectly okay with that, but now the market expects only one or, at best, two rate hikes this year and that is something the Fed considers dangerous. That is why the central bank stopped mentioning negative economic developments in other parts of the world in its statements. The Fed, in essence, now says: a rate hike in June is also perfectly possible.

The Fed is struggling only to make it more complicated: it is struggling on both sides of the fence simultaneously! The central bank would prefer to raise rates rather, and only if it must raise them, after the summer than before. But … after the summer, Americans will vote, and somebody else will occupy the White House by November. Usually the Fed wants to avoid attracting any unnecessary attention in the midst of fierce election campaigns.

And then there is something else of great importance, which is barely mentioned. Everyone is talking about the prospects of economic growth and inflation in the United States as the most important factors that will determine when and how fast the Fed will hike rates.

Yet another, in my eyes even more important factor, is left unmentioned. What am I referring to?

US public debt amounted at the beginning of 2008 to about $9.2 trillion dollar. The US government paid an average of 4.7 percent in interest over that debt. US government debt now stands at $19.5 trillion dollar, which means it has more than doubled since 2008. Yet interest payments have remained unchanged, and amount to approximately $440 billion dollar a year. Why is this the case? It is because the average rate on US public debt, for a large part due to the Fed, has declined to 2.3 percent.

If the Fed would normalize rates, the interest on Treasuries with maturities of anywhere between 1 and 5 years would normalize as well. Interest expenses would increase to almost $1 trillion dollar (!) a year.

Every rate hike by the Federal Reserve would mean an increase of tens of billions of dollars in interest expenses for the White House. Nobody can possibly convince me that the FOMC doesn’t take this into account.

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