When Will the Fed Raise Interest Rates?

It is no secret that the Federal Reserve relies primarily on two data points when deciding monetary policy: output gap and unemployment. The output gap is the difference been potential GDP and actual GDP. Despite the fact no one really knows what potential GDP is, central banks rely upon the metric to predict inflation/deflation, unemployment, and slack in aggregate demand. Right now the US output gap is estimated at around $890 billion, down from 1.1 trillion back in 2009. To the members of the Fed this amount of slack in the economy indicates that deflation is the greatest threat to the economy. It also gives the Fed the impression that printing money and low interest rates are needed to stimulate the economy.

Please note that  I do NOT agree with any of this, but this is accepted to wisdom of Zimbabwe Ben and his co-conspirators at the Federal Reserve.

The purpose of this exercise is to try to understand what the members of the FOMC are thinking and how it relates to their interest rate decisions. We are trying to guess when the Fed might raise rates from zero percent to a more normal rate. It is obvious that zero interest rate policy (ZIRP) has been used as tool to illegally transfer wealth from honest savers to globalist banks. In fact, it is the hidden bailout for the banks as they rake in the cash by collecting deposits at 0.25% and reinvesting the proceeds in 10-year government treasuries yielding 3%. Leverage it a few times, and you get a really nice return, courtesy of starving seniors who cannot afford to live off their savings. Rinse.Wash. Repeat. This may be one of the largest transfers of wealth in US history all done surreptitiously by unelected officials at the Fed.

When asked to defend their criminally insane policies, Fed officials naturally turn to the output gap and unemployment as justifications for ZIRP. They say that it is necessary until the output gap closes, and when the unemployment rate returns to more normal levels (assumed to be 5-6%). So lets see some estimates of when this might occur. Below is a chart from Scotia which shows the output gap under different growth rates for the economy. To people who rely on savings for retirement, this is a very depressing chart. It shows that the US will not be closing the output gap anytime soon. Actually, under the most optimistic of scenarios (4.5% growth), it would still take until 2013 to close the output gap. If you use the more realistic case (2.5% growth), the output gap will not be closed before 2020. 

click chart for larger image

Now that we have seen the bleak outlook for the output gap, let's take a look at unemployment. The unemployment rate in the US is 9.8% and has been above 9.0% for the last 19 months, despite the recession officially ending in June 2009. As we have discussed before, the US economy needs to create 100,000 jobs per month just to keep the unemployment rate steady (assuming 1% population growth). The US is currently adding between 30-60K per month which means the unemployment rate is likely to tick higher in 2011. The chart below from the Minneapolis Fed shows the lackluster pace of job creation during economic recoveries. The first thing that you will see is the uncanny resemblance to the 2003-2004 recovery which featured very slow job growth coming out of a recession, often referred to as a jobless recovery (a misnomer if there ever was one)

If we assume a recovery similar to the 2003-2004 period, it will take a very long time to reduce unemployment to acceptable levels. The question is: How long? The answer, of course, depends on your assumptions, but I think it is safe to say the pace of the so-called recovery has been very weak from a historical perspective. The optimistic scenario is 4-5 years according to Bernanke in his 60 Minutes interview. The Fed has indicated that it will most likely increase rates before it ever starts to sell its bond portfolio. Under this best case scenario, the Fed will keep rates very low (under 1%), at least through 2013. Of course, for the best case scenario to occur, the economy would really have to pick up, and job creation would have to total between 150,000-200,000 per month. To me, this seems too optimistic so let's assume a more realistic case where it takes 7-10 years for unemployment to return to normal levels. Under this scenario, the economy does not have a double dip but remains at about the same pace it is on currently (with a slight pick up in the second half of 2011 and into 2012. If this scenario occurs we could see rates near zero through 2015 if not longer, which would pretty much ruin the retirements for millions of Americans. Indeed, bond guru extraordinaire Bill Gross of PIMCO has stated interest rates are likely to remain low for "several years." Regardless of where interest rates go, the bottom line is that the Fed is going to keep real interest rates negative for an extended period of time. 

The realization that interest rates will likely stay low for years to come makes saving and planning for the future much more difficult. Normally, when economic conditions are uncertain, the best thing to do is hold your assets in cash and wait for more clarity. However, money currently has a negative real value as real inflation exceeds what you can get in a money market fund or bank deposit. This makes cash a bad investment, especially if you hold on to it for the next few years as the Fed debases the dollar. You won't lose in nominal terms but will suffer in real inflation adjusted terms. So cash is out.

The obvious alternative is equities as every investment advisor will say stocks are a hedge against inflation. Unfortunately, history shows that equities have a poor record when it comes to high inflation and hyperinflation. For example, between 1968-1982 period known as stagflation, stocks lost about 80% of their value in real inflation adjusted terms. Hardly a hedge against inflation! It is true that that stocks do well in a low inflation environment (2-3%),but with the Fed literally printing money, inflation is working its way through the system, and it is only a matter of time before it appears in consumer prices (within 2-5 years). Early indications of this process are evident through the surge in commodity prices across the board. This is not to say that all stocks are bad, but as an asset class they will likely continue to lose value adjusted for inflation (as they have since 2000). 

Normally, owning hard assets like gold and silver do well when real interest rates are negative. We have written before why this is a good option for people who do not need income. But for people who live of their savings, this is not a viable option. The only real alternative is oil and natural gas royalty trusts and Master Limited Partnerships. These investments are primarily energy related (transmission, pipelines, storage, etc) and pay 5-8% per year and the amount should gradually increase as the company grows. The problem with these type of investments is the volatility, not just for income, but for capital as well. During the 2007-2010 period, we have seen dramatic swings in commodities with oil rising from $70 to $147 and then back to $40, only to rise again back to $90. This erratic behavior destroyed many royalty trusts with many cutting their dividends by up to 90%. You also saw large capital losses. 

Master Limited Partnerships did not fare much better because they rely heavily on debt to finance operations. When the credit crunch occurred in late 2008, many of these companies faced serious liquidity and solvency issues as they could not refinance debt or tap bank credit. The more prudently managed companies quickly rebounded after the 2008 crash and have largely recovered their losses from 2008. This is why I generally favor MLPs as a method of income in this zero interest rate world. MLPs have the luxury right now of being able to borrow very cheaply, which reduces their interest payments, leaving more money available for dividends and capital expenditures (for future growth). MLPs also have favorable tax advantages thing to keep in mind when considering MLPs is their business model. For safety of income, you want a MLP which has modest debt, strong cash flow, and a stable business. The most important thing is whether the company any commodity price risk. Many pipeline companies make their money by simply charging a toll on volume passed through their pipelines. This is the business model you want because it ensures stable cash flow. However, some companies role the dice and tie part of their revenue to commodity prices. While this works great during rising commodity prices, it can be quite disastrous when prices fall dramatically, like they did in 2008. This downward pressure caused reduced cash flow, leading to violations of debt covenants and increasing the risk of bankruptcy. So you really want to avoid these type companies as you are effectively gambling on commodity prices.

Well, there you have it-- some ways to generate stable and growing income in a ZIRP world. I deliberately chose not to include bonds because with likely inflation in the future, you do not want to own fixed income investments. Another reason for  not discussing bonds is because they are egregiously overvalued (especially government bonds) as everyone races to generate more income compared to zero percent in cash. This is most evident in the junk bond market as high yields attract unsuspecting investors who are taking extraordinary risk to generate 6-9% per year. The ZIRP of the Fed is a criminal act which is going to harm millions of people all in an attempt to bailout insolvent banks.



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