Domestic and Foreign Events Are Tying the Fed's Hands

NEW YORK ( TheStreet) -- Despite apparent emerging strength in the U.S. economy, the Fed is faced with serious consequences, if it moves toward a reduction of policy ease. Those consequences include:
  • A potential violent market reaction;
  • the quashing of the nascent private sector animal spirits;
  • the short-term negative consequences of a stronger dollar on imports and exports; and
  • the long-term issues of the size and cost of the debt.

The Wealth Effect

The "wealth effect" has been studied for decades with the universal conclusion that its overall economic impact is marginal; i.e., the wealthy simply have a low marginal propensity to consume. Yet, this appears to be the only benefit of the massive QE programs, which -- as documented by two revered market pundits, David Rosenberg and Jeffrey Gundlach -- has a nearly 90% correlation with the equity markets.

In recent weeks, we saw the violent reactions in both equity and fixed-income markets to the mere concept of "tapering," which is not tightening, but simply less easing (a change in the 2nd derivative). Clearly, a move to lessen ease risks the small success that massive QE has had to date.

Deflation

Deflation is a worldwide issue, even among emerging industrial powers like the BRICS. China's economy, which has been the world's economic growth engine for the past half decade, appears to be slowing significantly, despite its official purported 7.5% growth rate. The underlying data tell the story, including depressed raw commodity prices, excess high seas shipping capacity, the value of the currencies of commodity-producing countries like Australia, and a falloff in exports from lower-cost producers like South Korea.

Except for Japan, in April, the IMF significantly lowered its growth forecasts for every industrial economy. Thus, any tightening move by the Fed would only exacerbate worldwide deflationary pressures.

Debt Costs

The high and rising cost of U.S. debt, much of which is financed by foreigners, makes abandonment of easy money highly risky for U.S. fiscal policy. The U.S. public is unaware that the true GAAP deficit has exceeded $5 trillion for the past five years. Instead, the $1 trillion cash-flow budget deficit is viewed as the issue. Nevertheless, as time passes, the already built-in additional $4 trillion per year of promises will become current obligations.

I have seen several estimates of the cost of that future debt in rising-interest-rate scenarios. None are pretty. The most recent from Jeffrey Gundlach of Doubleline estimated the cost of the debt and deficit at $2.5 trillion by 2017, if the 10-year rate were to rise gradually from its current 2.1% level to 6.0%. By then, Gundlach says, the debt itself will be $26 trillion. Such deficits and debt levels risk not only inflation, but the dollar's role as the world's reserve currency.

Conclusion

The consequences of rising U.S. interest rates are dire. They would exacerbate worldwide deflation, play havoc with the nascent U.S. economic recovery, reverse the limited positive impact of the wealth effect via U.S. equity markets and have dire consequences for the dollar and U.S. fiscal policy. Rising rates will inevitably occur, but don't count on them anytime soon.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.

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