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Generational Dynamics Web Log for 15-Dec-04
Fed raises interest rates and makes a 2005 recession almost certain

Web Log - December, 2004

Fed raises interest rates and makes a 2005 recession almost certain

Signalling aggressive plans to fight the weakening dollar, the Fed on Wednesday raised the overnight funds rate a quarter percent, to 2.25%.

The Fed undoubtedly felt it had no choice, in view of the ever-widening trade deficit with other countries, which has caused a substantial fall in the value of the dollar overseas. If they had any doubt on Monday evening, I'm sure they lost that doubt on Tuesday morning when released figures showed an unexpectedly sharp increase of 9% in the October trade deficit, showing that the loss of value in the dollar may be accelerating.

According to Hans Redeker of BNP Paribas, speaking on CNN International this morning, this means an almost certain recession in 2005.

Redeker's remarks are not surprising, in view of the fact that analysts have been predicting for several months that there would be recessions in Europe and America in 2005 if oil prices stayed above $40 per barrel. Oil prices have been falling recently, after shooting up to $55 per barrel last month, but they're still above $40.

Still, the situation highlights the Fed's dilemma. If the Fed leaves interest rates unchanged, then the dollar's value will continue to fall.

If the Fed raises interest rates, which it is signaling that it will continue to do, then investors will pull money out of stocks.

Wall Street Historical Price/earnings ratio for S&P 500

Wall Street Historical Price/earnings ratio for S&P 500

The reason for this is related to the historically high price/earnings ratios of stocks today, running between 20 and 25.

When the price/earnings ratio is 25, it means that a company is earning $1.00 per year for each $25.00 in the price of its stock. This roughly means that an investor buying that stock can hope to earn only $1.00/$25.00 or 4% per year. At a P/E ratio of 20, the rate is $1.00/$20.00, or 5% per year.

Yesterday's increase in the overnight funds rate to 2.25% has had the immediate effect of causing banks to raise their prime interest rates from 5% to 5.25%. These are the rates that banks charge in loans to its most reliable borrowers.

So an investor with money has a choice of investing in stocks, and hoping to earn roughly 4% to 5% on the investment, or by lending at the prime rate, and earning 5.25%. As the Fed continues to increase interest rates to prevent further weakening of the dollar, stock investments become less worthwhile.

Total credit market debt <font size=-2>(Source: PIMCO)</font>

Total credit market debt (Source: PIMCO)

Increasing interest rates has another effect: The Fed lowered interest rates to near-zero in order to prevent massive bankruptcies and homelessness following the 2000 Nasdaq crash. Many people and businesses that would have gone bankrupt have, instead, borrowed large sums of money at near-zero interest rates, and are living off this credit. The result is the highest rate of public debt since the 1930s. As the Fed raises interest rates, the ability of individuals to continue borrowing to cover existing debt is reduced, and we can expect to see the level of bankruptcies increase.

From the point of view of Generational Dynamics, a 1930s-style depression is already in the cards, no matter what the Fed does. (15-Dec-04) Permanent Link
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Generational Dynamics Web Log for 15-Dec-04 Fed raises interest rates and makes a 2005 recession almost certain

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Generational Dynamics Web Log for 15-Dec-04
Fed raises interest rates and makes a 2005 recession almost certain