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RISING INTEREST RATES ARE REVEALING THE TRUE DAMAGE DONE BY THE FED

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Reprinted with permission Mises Institutue Tho Bishop

On May 4, Jerome Powell dismissed the possibility of the Federal Reserve hiking the federal funds rate by three-quarters of a percent.

On June 15, he announced that America’s central bank was doing just that, a reminder that the Fed continues to give itself more power over the economy, even as it repeatedly demonstrates an inability to predict inflation, economic growth, or even its own policy.

Markets were already reacting to the move days in advance after a deliberate leak of the Fed’s decision to the Wall Street Journal this past weekend. The result is tens of millions of Americans watching their net worth collapse with stocks, cryptocurrencies, and other financial asset prices as investors pull capital away from investments and into cash and other safe harbors.

Of course, the demand for these investments that are now being devastated by rate hikes was itself a deliberate policy goal of the Federal Reserve. Low interest rates maintained by aggressive quantitative easing and other new Fed tools were designed to discourage Americans from saving in traditional banks and low-risk financial assets. The Fed subsidized risk, and risk is what we have.

While panic over America’s economic environment is starting to make its way into the pages of the corporate press, savvy Fed watchers have been warning about this self-made trap for years. On the Mises Wire, Austrian analysts like Daniel LacalleThorsten Polleit, and Brendan Brown have warned about the damage a decade of monetary hedonism has done to the financial health of the global economy. The lingering question has been whether central banks’ concern over price inflation would trigger the policy corrections necessary to pop what Lacalle has called “the bubble of everything.” 

The Fed seems to be trying. We will see how other central bankers respond.

The fight against inflation should illuminate one of the most important, but often overlooked, parts of the Austrian understanding of business cycles. While a lot of the online conversation about Fed policy will often focus on the dollar’s declining purchasing power or concerns about hyperinflationary environments due to central bank mismanagement, the more pressing insight is the true costs of the malinvestment that occurs in a low interest rate environment.

Artificial credit expansion means capital is invested in firms and industries that would not appear profitable without the intervention of central banks. One way we can see this manifested is in the form of zombie companies, which are firms whose operations are not profitable and that depend upon cheap debt to survive.

As Joshua Konstantinos noted on the Mises Wire in 2019:

Following the Great Recession, zombie companies became a worldwide phenomenon. Even with today’s very low interest rates; more and more companies are unable to pay the interest on their debts out of profits. According to the BIS, the share of zombie companies in the US doubled between 2007 and 2015, rising to around 10 percent of all public companies. And counterintuitively, as interest rates have fallen lower and lower the number of zombie companies has increased.

These numbers, of course, do not consider the financial frenzy that was created as a result of covid-related policies after the article was written.

An additional consequence of the Fed’s subsidization of risk in the financial system is damage done to important institutional investors. Pension funds and insurance companies, for example, have been forced to manage investment portfolios at a time when government bonds and other historically low-risk investments are yielding little. In such an environment, these institutions can either reduce payouts in the future or adjust their investments to higher-yield assets. If an aggressive increase in interest rates ends up taking down a large portion of these zombie companies, this could secondarily impact millions of Americans who never benefitted from the stock market.

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It is precisely these deeper consequences to the busting of financial bubbles that inspired Ludwig von Mises to spend so much effort in trying to illustrate the consequences of central bank–fueled malinvestment. As he notes in Economic Policy:

Credit expansion is not a nostrum to make people happy. The boom it engenders must inevitably lead to a debacle and unhappiness.

The question going forward is how truly dedicated the Fed is to its campaign against price inflation. The purpose of its severe move, the largest single move in forty years, is to demonstrate a willingness to act boldly in the future—the Powell Fed has enjoyed a reputation for being willing to bring out “a bazooka,” nerd speak for engaging in aggressive monetary policy. This was also an act of political necessity: $5 gas and double-digit increases in food costs is the sort of kitchen table issue to get Americans very angry at politicians and their bankers.

Will those calculations change with Americans seeing their 401(k)s draining away? Data from the Atlanta Fed is now signaling an official recession in the coming months. Will Jerome Powell be willing to increase rates with those head winds?

Only time will tell.

What we can be confident about is that the damage the Federal Reserve has done to the economy is only now being exposed. Unfortunately, the institution responsible is as blind and powerful as it has ever been.

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2 comments

fredric longabard June 18, 2022 at 10:22 am

Maybe the FED has outlived its usefulness, if it ever had one. All interest rates trade in the markets, why not overnight money? The Fed also encourages government overspending by purchasing their bonds. If the overnight rate was a market rate I think it would have increased long ago and maybe some of this inflation would not have happened.

Reply
Don Smith June 19, 2022 at 3:41 pm

1) Reinstitute the gold standard
2) Repeal the 17th amendment
3) Abolish the FBI and DOJ. Send these powers to/through the states
4) Honor the 10th amendment
5) Abolish the Department of Education
6) Give all Federal lands back to the states in which they are located
7) Abolish the federal income tax
8) Limit the size of banks. Encourage local credit unions. Only people who serve on local credit union boards can be appointed to the fed.
9) Federal health agencies should be overseen by doctors who are retired and spent their careers in small communities
10) Make congress subject to all laws that everyone else is.

So that would be a good start.

Reply

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