Saturday, April 2, 2016

Yellen To The Rescue

There was a speech by Janet Yellen earlier this week at the Economic Club of New York that got markets a little excited this week. While it wasn't one of the regular FOMC meetings; sometimes Yellen and other committee members drop pieces, or every once in awhile loads of verbiage the market deems important during routine speeches. This week was no different.

After a few weeks with conflicting comments from James Bullard(FOMC voting member) stating the next rate hike as closer than people expect, Yellen came out blasting all fears away.  She stated "developments abroad imply that meeting our objectives for employment and inflation will likely require a somewhat lower path for the federal funds rate than was anticipated in December."

Not sure what that means? No worries I'll explain.

Back in December 2015 the Federal Reserve raised interest rates for the first time in 9 YEARS!  This was a big deal considering interest rates stayed near zero for the entire anemic recover from the Great Recession. Also in that FOMC meeting the Fed announced they would raise rates up to 4 times in 2016. That was huge since many people did not expect rates to rise that quickly.

Based off that rhetoric it was a contributing factor to the market volatility from December to February as institutions and traders tried to re-position themselves in every market for an abrupt new reality. So Yellen decided after a couple more months that the original statements were mis-guided, and changed paths.  Of course in the back of my mind I have to wonder if their statement to raise rates that much was a test.  I would honestly think no one in the room would have really thought they could raise rates 5 times in 13 months after 9 years of nothing.

So the new signal from the Federal Reserve is a much slower and obvious path to higher interest rates. What crosses my mind is how Yellen cited "developments abroad". While the world economy is connected more than it ever has been - the Federal Reserve is supposedly America's central bank.  Undoubtedly Janet fielded phone calls from the IMF and other central banks worldwide regarding the implications of rate hikes in 2016.  When just about every other central bank in the world is lowering rates, some to negative territory, it would create a huge imbalance in global currency flows. By default the Fed had to succumb to pressure worldwide to pursue a slower path of rate hikes. Otherwise capital would rush into the United States potentially causing debt defaults in other parts of the world as money left.

How is that possible? Remember QE?

The majority of the money the Federal Reserve created by buying government debt was absorbed worldwide. Remember we have a connected economy.  Various other institutions and central banks all were receivers of US dollars throughout QE as the Fed increased the money supply.  To the dismay of many inflation never picked up in the USA which was the entire point.  Well if most of the money you create leaves your economy and goes elsewhere there is never a chance for it to create the intended consequences at home.  So all these other receivers of US money did what they thought was a good idea. They issued debt denominated in US dollars with all that extra currency laying around.  Now if the US raises rates it creates a stronger currency relative to theirs(especially if their currency has rates that are going lower).  This then makes the debt harder to repay as more dollars are needed to repay the existing loans.  Coupled with the fact that dollars become scarcer as money moves out of the country it creates a huge repayment problem.

In summary the Federal Reserve can't just act on domestic policy alone. Despite that being its original mission.  The US dollar is the worlds reserve currency since it's the only real option out there right now. That means the Fed is stuck policing not only the domestic economy(Congress' job anyway), but also the worlds due to the role our US dollar plays.

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