Surviving the First Fed Rate Increase

Economics, Premium POM

By JC Collins

It looks like things may be settling down after the first Federal Reserve rate increase in almost a decade.  The volatility was expected and there will be more to come.  Contrary to doom and gloom reports and the constant propaganda of everything is horrible and the end is near, global markets are rebounding and the price of crude is beginning to rise.

Whether the low this week constitutes the low from which further appreciation will be based on is challenging to determine.  The deflation which has been taking place internationally has not yet ran its full course.  More will come.  More will come after each rate increase.

But we can conclude that the international monetary system will survive this first rate increase by the Fed.

Even back in November Chinese monetary authorities were expressing the need to just get on with the normalization of monetary policy.  As stated above, the volatility and pressure on the emerging markets was expected and plans and mechanisms were put in place to counter the instability which ensued.

It was stated by all parties involved back in 2009 that the imbalances in the international monetary framework were the biggest threat which needed to be addressed.  This included the People’s Bank of China, the US Treasury, the IMF, the BIS, and the European Central Bank. Not to mention endless think tanks and universities.

The diversification of USD denominated foreign exchange reserves is the number one goal.  As I’ve written endless times, there are multiple methods of achieving this reduction, diversification, and substitution.  One is the use of sovereign wealth funds.

In the post Potential Path Forward on Fed Rate Increases, I wrote the following:

“It doesn’t take a big leap of imagination to see how a process of reserve diversification using sovereign wealth funds could lead directly into the substitution of invested reserves for SDR denominated assets in the event of another financial crisis down the road.  This in fact could very well be the play as the sovereign wealth funds become bloated with reserves and invest that wealth into the stock markets around the world, leading to new and larger bubbles.”

“This could very well lead to another commodities boom as the sovereign wealth funds invest in massive infrastructure projects.”

“In fact, the China Investment Corporation has already stated it is ready and able to work with the Asian Infrastructure Investment Bank (AIIB), which most countries of the world, including US allies, have signed up with as founding members.”

Other methods by which China, and other large holders of US Treasuries, including Saudi Arabia (maybe why them and China and been meeting again recently) can diversify reserve holdings, is by funding large infrastructure investment projects in other emerging economies.  This has also been covered here multiple times.

And even another method, not yet on the horizon, would be a reduction in USD denominated reserves through the substitution account of the International Monetary Fund.

There are many opportunities and possibilities to achieve the macro goal of reserve diversification.  It is also likely that more than one method will be used.  It is also likely that this diversification will also be used to spur economic growth around the world.

Talk of ending dollar pegs and restructuring exchange rate arrangements around the world is also starting to pick up pace. This is also something which has been widely and thoroughly covered here on POM.

These things will all come to pass.

Capital flows will change, and change again.

The strategy of incremental rate increases and the implementation of mechanisms to address the subsequent volatility will continue throughout the year, and into next.  Each step will see the international monetary system adjusted a little more.

Eventually the imbalances will begin to be corrected and additional alterations, such as exchange rates and infrastructure development funding, will take over the stage from the doom and gloom.  Growth will return and eventually other countries and central banks will be able to end stimulus and the fiscal mechanisms which were meant to keep the boat afloat will no longer be required.

Keep in mind, China projected a growth of 7%.  This is still large compared to the rest of the world.  The fact that they actually had a growth rate of 6.9% is extremely telling of the overall state of the economy.

Yes deflation is happening.  No it is not a depression.  Sure credit markets are tightening. So what. This is the draining of USD liquidity from QE which has driven markets to disproportionate highs.  It needs to unwind.

Yes, some banks and corporations will default on debt.  So what.  New things will emerge to take their place.  The world will survive and new opportunities will present themselves.

And no, this time is not different.

Everyone is missing the script of volatility and instability for what it is.  The monetary system is changing right under our noses.

If there’s anything different this time, it’s that the international monetary framework is better positioned to absorb the financial shocks then it was during the last crisis.   – JC