Everyone wants a forecast on the Fed interest rates because you can earn a lot of money with the right decision. In this article I will discuss the past actions of the Federal Reserve Bank (FED) on interest and money supply and explain why they did not have any effects on inflation and Gross Domestic Income (GDP). In the second part I give you my personal forecast on the Fed interest rates and how you can be prepared and gain in the new environment.
Let´s start with a look at the development of the interest rates. As you may have read in my previous article: “Federal reserve historical interest rates,” the interest rates have dropped in the long run since the early eighties from nearly 20% to 1% in the United States.
Where will it go? Again upward, remaining low or even dropping below zero?
Since the beginning of the financial crisis in 2008 the major central banks in the world, including the Federal Reserve Bank (FED), the European Central Bank (ECB) and the Bank of Japan (BoJ) all printed money like crazy. (see picture).
Mario Draghi, the president of the ECB said in 2012, that he will do “whatever it takes” to rescue the Euro. He started a big buying program. Today the ECB buys a lot of security papers from the banks in Europe. They hope, that the banks can lower their risk investment and gain the possibility to lend money to companies which will produce goods and reestablish growth in Europa.
The prime minister of Japan, Mr. Shinzo Abe announced, that the Bank of Japan, which has less autonomy then the FED or ECB, will grow the money supply (print money) and on the other hand he started an economic stimulus program. Because he has to finance this program, despite the highest debt in the developed countries, he lowers the debt limit for the government.
Quantity theory of money
In modern economics the Quantity theory of money claims that money supply has an impact on the price level. This is shown on a simple equation:
M * V = P * Y
Money * Velocity = Price * Yield [Gross domestic product (GDP)]
Let´s make a quick example:
Assume all variables equal 1, because it is easier to understand and to calculate.
Now we double the money (printing money, QE). In order to have the equation valid, we have 4 possibilities:
- reduce V to 0.5
- raise P to 2
- raise Y to 2 or
- a mixture of all
This can be one explanation, why QE does not work and inflation doesn´t raise. The central banks increase the money, but the velocity of money decreases.
How does that work?
You buy a bread at the grocery.
=> The owner goes to the hairdresser for a haircut.
=> The hairdresser buys new scissors
=> and so on.
What brings the velocity down?
- The grocery owner decides to go to the hairdresser later, or
- even worse, to cut the hair himself or by his wife.
Then the dollar will remain in his pocket and the other people don´t get the dollar and can´t spend it either.
The FED makes a calculation of the velocity of the money and as you can see on the image, the speed decreased in the financial crisis massive and it´s still diminishing.
Now we bring this observation back to our theory.
M * V = P * Y
The Fed increased the moneysupply (M) but the American people reduced their velocity of money (V) at nearly the same size. Therefore the inflation (P) and GDP (Y) remained without any change.
Imagine the velocity of money starts to increase
If the velocity of money decline slows to even start to grow, and
we assume that the money supply (M) remains the same, then there are the 3 impacts possible, which I already described above:
- raise P (Inflation)
- raise Y (GDP) or
- a mixture of both
Best case: The gross domestic income (Y) goes up. This is what we all hope.
Worst case: The inflation (P) starts without any outcome on the gross domestic income. This is what we are afraid of.
The problem is that nobody can control the speed of money circulation because this speed is it up to each person. Until the velocity of money does not change, the QE will remain without any effect on the outcome (GDP) and inflation.
In the next step I discuss the interest rate and then I will put it together. This will give you valuable insights about the future development and how to gain from it.
Change of interest rates
Besides the money supply, the FED can affect the economy through the interest rates and the changes of interest rates. Since the eighties the interest rates decline with a short exception.
At the same time the government increased the national debt from approximately 1 Trillion in the eighties to over 18 Trillion in 2016.
Let´s do some simple math:
1980: 1 Trillion * 19% interest rate = $180 billion to pay for interest.
2016: 19 Trillion * 2% interest rate = $ 380 billion to pay for interest
Now assume, that the FED raises the interest rate to 4%, which does not seems to be very high compared to the chart of the last 45 years. The payment for the interest would double to $760 billion. The overall budget of the government spending is about $6.5 Trillion. This means, that the fraction of interest payments goes from nearly 6% up to nearly 12%. Maybe, that it can work.
Total Public Debt as Percent of Gross Domestic Product
But you have to keep in mind another relation. This is the total public debt as percent of Gross Domestic Product (GDP). This increased from 30% in 1980 to over 100% today. Research shows, that most countries struggle, if the debt per GDP relation goes above 80% – 90%. In World War II the United States had a higher relation, but was able to reduce it. One reason could be that whole Europa was destroyed. American machines and supply were needed to rebuild the countries. This enabled the Americans to lower their dept.
Today there is no destruction and no need to build things up. On the contrary, you can read all over the world that there are overcapacities.
This leads to another point.
If countries on average start to struggle with debt per GDP relations over 80% – 90%, what does it mean? Often the countries fail to pay their dept. Like every debtor, they try to hide the problems. But some people start the process and leave. They leave the money and change it into other things, for example other currencies or gold. The main thing is, that they don´t trust the money. They try to spend or to change the money very fast. The velocity of money speeds up. According to the equation above, there is only one possibility that can happen. Inflation goes up. The GDP can´t go up, because no one invests. All people try to avoid the paper money. And this is the last point. The people don´t trust the money (paper) they get. In the end they don´t accept it and the government has to change the money.
The losers are people who have the paper money and people who have treasuries. Both are worthless. Sometimes people get a small compensation after a long time, but this all is very uncertain and uncomfortable.
What can you do to protect your wealth?
You can diversify your wealth over different countries and different assets.
By countries I don´t think of different states like Florida and California, I mean different countries like Australia, India, Canada and so on. Many people have a strong bias in their country. They have some stocks of companies which are in their country. Their house is in the same country and additional properties are also located in the surroundings. Further on they have some bonds from their own country. In the end it’s all concentrated in one single country. If this country struggles, you will struggle too.
Buy foreign stocks and properties outside of America. I recommend developing countries with increasing populations, because there the people need more buildings and houses.
b) Let your money work
- Furthermore I recommend trading in the forex market. You will see the changes first hand and you have the time to react properly.
- Additionally you can trade stocks from different countries and buy Exchange traded funds. But keep in mind, that these funds can be risky if the issuer is not credit worthy. Remember Lehmann Brothers? All this paper is worthless today.
- On top of that you could trade in the future market, for example the Russell 2000.
Negative interest rates?
Some people expect that the interest rate will sink below zero. This would confirm the long term trend. Further on there would be some great advantages:
Negative interest rates imply:
- You borrow money and get additional money (interest; money is free)
- Lenders have to pay interest. ( Can they pay the interest? Are they “lend worthy”?)
First question: Is it possible?
Yes. In Denmark you could borrow a credit for a house with a negative interest rate. It was restricted to qualified persons, but in general it is possible.
Second question: What are the impacts?
Let´s assume you have some money in your bank account. Until now you got some money from the bank. Now you have to pay for it. You can see it as a service fee, but on the other hand, you have the possibility to take your money from your bank account and store it at home.
If everyone does the same the banks wouldn´t have any money to borrow. But at first the banks would be not liquid, because they don´t have enough money for all people. So the government has to be sure, that people don´t store all their money at home. The easiest way is to forbid cash. All over the developed countries the government starts the discussion. In some countries like Sweden they are already relatively successful. In Germany it is quite difficult, because the Germans love cash.
If the government succeeds in removing cash negative interest rates could possibly happen. Furthermore the government hasn´t a problem anymore to pay the debt, because now they will get paid for the debt!
Third question: Does it work?
Silvio Gesell, a German businessmen, who immigrated in the twenties of the last century to Argentina, made an interesting observation: “All good you can buy will suffer from time.” Some faster, for example strawberries, some slower like leather or steel (rost). But there is one good, that does not suffer from time. This is cash!
Imagine you have some cash in your pocket and go to the local market. Every supplier wants your money in exchange for his goods, because he knows, that tomorrow his goods are less worthy or worthless (strawberries). But you can decide, that you can buy nothing today and return tomorrow, because your cash doesn´t get old. You have an advantage respectively the cash. In order to balance all good, the cash has also to mature. He claims, that the cash should diminish with a rate of approximately 5% – 10%. This is like a negative interest rate. Because of the declining worth of cash, it would speed up the velocity of money.
In the thirties we had the great depression in the United States and also in Europe. Silvio Gesell returned to Germany and tried to help his country. He wasn´t successful there, but a small community in Austria gave his idea a shot. The unemployment rate was incredibly high and the government had no tax income and was unable to spend any money for an economic stimulus plan.
They introduced a local currency just for their small local community. The miracle happened. The unemployment rate dropped, economic activity sped up, tax earnings increased and this local community was able to construct a ski jump of 70 meters! After one year their success reached the capital of Austria and the central bank forbade the local currency. The economic power of this small local community expired, but it proved the concept.
Forth question: Negative interest rates: Will they come?
I think yes. It is more likely than increasing interest rates because this will lead to bankruptcy. The politicians are working on the rules to establish it. I mean, which politician can resist the opportunity to borrow money for paying his followers and to get paid for the debt? This is his win – win situation!
What does it mean for us?
If the negative interest rates come with a proper framework, it could be a big deal for us all. Unfortunately I don´t believe that the authorities will establish this good framework and therefore we have to take care for our wealth. Because it is still far at the horizon, it´s difficult to give an exact advice, but you should count on this scenario. Follow my advice from above:
- Diversification in countries and assets
- Let your money work, for example trading
This would give you a good start into a new environment.
I hope that you got some ideas and that I could help you to protect and increase your wealth. I would like to share your comments and thoughts.