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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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