"PERFECT GOLDEN STORM" » Interest-rate bind

Interest-rate bind

Keeping US interest rates at their present historic lows weakens the dollar, raising the price of gold. But raising the rate, as must eventually happen, will kill the housing market, which has been the main driving force of the US economy. A return to recession and a stock market crash will send the price of gold through the roof.

From August 24, 1999 to May 19, 2000, the Federal Reserve Board raised its discount rate (the rate at which banks can borrow money from the Fed for 24 hours) five times in a row, starting at 4.75% and ending at 6.0%. These successive rate increases helped suppress the “irrational exuberance,” to use Fed Chairman Alan Greenspan’s notorious phrase, that inflated the Internet bubble. Many equities investors are still licking their puncture wounds. On January 3, 2001, the Fed reacted to the downturn in the economy by reducing the discount rate from 6.0% to 5.75%. Reducing the rate is supposed to stimulate business expansion. Eleven additional decreases in the next 11 months slashed the rate to 1.25% by Dec. 2001— a 53-year low. Subsequently, the rate was dropped to 1.0%, where it hovers in March 2004.

“Jobless recovery” requires continued low interest rates
Other interest rates fall along with the discount rate. For example, the prime rate, which banks extend to their most credit-worthy customers, is (as of Feb. 2004) 4%. One of the major effects of interest-rate reduction has been to reduce mortgage rates, making it easier for people to buy houses. People who already own houses have lowered their mortgage rate through refinancing. Home buying and cash generated by refinancing has fueled the US economic recovery.

Recoveries traditionally create millions of new jobs. During this recovery, there has been a net loss of about a million jobs. Even though a sharp rise in global commodity prices raises the specter of inflation, the Fed is loathe to raise interest rates because without new jobs the recovery appears unsustainable, and because of the fear that raising interest rates will kill the housing market and the economy it supports. The Coming Crash in the Housing Market, by John R. Talbott, does a good job of explaining the economics of the residential real estate market and what you can do to protect what may be your biggest investment. (Buying gold is a good start.)

But interest rates must rise
As we explained earlier, low interest rates in the US contribute to the weakness of the dollar. This is particularly true when interest rates are higher elsewhere. The European Central Bank benchmark interest rate is 2% — exactly double the Federal funds rate, to which it is comparable. The Fed will try to hold off raising interest rates until after the November elections, but may be unable to do so. To keep the government solvent, the Treasury must be able to sell its daily $1.5 billion in bonds. These bonds are auctioned off to international and domestic financial institutions. When demand drops, the interest rate must go up, in a process outside the control of the Fed. Rising commodity prices, which will cause inflation to spread through the economy, will also push investors to demand higher interest rates. A December 2003 Merrill Lynch survey of US fund managers found that 71% — up from 36% in August — think that inflation will increase in 2004. Another sign that investors recognize the danger of inflation is the widening of the spread between the yield on 10-year Treasury inflation-protected securities and 10-year, non-indexed Treasuries — from 1.7 percentage points in June to 2.3 in January 2004.

Bottom line: Holding US interest rates down weakens the dollar, putting upward pressure on the price of gold. Raising interest rates might strengthen the dollar and lower the price of gold short-term, but will contribute to inflation and undermine investments in the real estate and equities markets, driving investors toward gold and therefore further raising the price of gold.

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