Greenspan’s Big Blunder

The last time this happened, the Fed funds rate
subsequently surged from 5% to 20%
in less than two and a half years!

The last time the Fed pushed interest rates below the inflation rate — and then held them down for so long — was in the mid-1970s. This chart tells the story …

The Fed has kept their Fed funds rate BELOW inflation for 31 months in a row!

The black areas in the chart show the normal times — when borrowers have to pay an interest rate that is higher than the inflation rate.

The red areas show abnormal times like today — when borrowers are getting free money … or are even paying an interest rate that is below inflation.

What is most revealing, however, is the similarity between the mid-1970s and today:

Back then, like today, stock investors had lost a lot of money. And like in recent years, millions of Americans had lost their jobs. So, like now, the Fed figured they would turn things around by dishing out abundant amounts of free money … and they continued doing so nonstop for about three years.

Interest rate levels were higher back then. So the numbers look larger. But that’s deceiving. In reality, the situation is actually MORE extreme today:

• In the mid-1970s, at worst, inflation was double the Fed funds rate.

• In this cycle, inflation has been as much as TRIPLE the Fed funds rate.

The critical turning point of the 1970s cycle …

Fall 1977

It was September, and the Fed was in a predicament very similar to the one they’re in right now.

Like today, it had taken the Fed three long years to START the process of catching up with inflation. It wasn’t until then that the Fed finally began to recognize their past blunders and focus on the task of narrowing the gap between interest rates and inflation.

Then, the gap was 35 basis points. Today, it’s exactly the same — 35 basis points.

And like today, no one had any inkling of what was coming.

The abundant supplies of free money were a super-drug that drove nearly everyone in America into a frenzy. Banks and S&Ls dished out loans with wild abandon. Consumers spent money they didn’t have. Businesses, local governments, even the federal government did the same. Soon, the nation’s inflation monster, thought to have been tamed by the mid-1970s recession, was back with a vengeance.

At first, the Fed thought they could tame the monster with minor rate hikes, just as they’re doing now.

In October 1977, for example, they started hiking the target rate for Fed funds by quarter-point increments — again, much like they’re doing today. But it was too late. The fires of inflation were already out of control.

Soon, the Fed discovered that quarter-point hikes simply didn’t cut it. They tried raising the Fed funds rate by three quarters of a point … and then a full point.

But even that wasn’t enough. No matter how high the Fed jacked up rates, they were STILL behind the curve.

Inflation, like Godzilla, resisted all weapons.

Ultimately, the Fed had no choice but to drop the equivalent of a nuclear bomb — a single, one-time rate hike of a FULL FIVE PERCENTAGE POINTS.

Hard to believe? But it’s true:

In January 1980, the Fed funds rate was at 15%.

In February, the Fed jacked it up to 20%.

Overall, from the time the Fed first began to realize they needed to start doing something to fight inflation in 1977 … until the time they finally were able to start achieving that goal in 1980 … the Fed funds rate rose from 5% to 20%. That’s an overall rise of a full FIFTEEN PERCENTAGE POINTS.

Why The Situation Today Is, In Many Ways, Even More Dangerous

You saw the similarities between 1977 and today. You saw how the Fed was in a very similar predicament. And you even saw how the gap between inflation and interest rates was actually identical to the gap we have today.

Now, let me show the differences and why they are so dangerous.

First, the budget deficit …

In 1977, the last time interest rates began to soar, the red ink in Washington was nearly $54 billion.

Now, based on 2004 numbers, it’s almost ten times larger — $521 billion.

Even in proportion to the size of the economy, our deficit is worse today — 4.5% of GDP now vs. 3.1% back then.

This means more pressure on the Fed to “print” money to finance the deficit … more pressure on inflation … and more money that the government is going to have to borrow, pushing interest rates up even higher.

Second, the trade deficit …

In 1977, we imported $27 billion more than we exported. Not good, but not that bad, either.

In contrast, in 2004, the trade deficit came in at a record-smashing $618 billion. That’s nearly TWENTY-THREE times worse than the 1977 trade deficit.

This is truly the great scandal of our time.

In proportion to the size of our economy, the trade deficit back in 1977 was actually quite small. For every dollar of GDP, there was only about a penny and a half of red ink in the trade balance.

Today, for every dollar of GDP, the trade deficit is sopping up about FIVE and a half cents. It has the capacity to do more than triple the damage the trade deficit did in 1977, the last time interest rates began to soar.

Third, the debts to foreigners …

After so many years of such large trade deficits on the U.S. side … and trade surpluses overseas … foreigners have now piled up trillions of U.S. dollars — money we owe them.

So far, they’ve been willing to invest those dollars back in the United States — mostly in U.S. bonds. So we haven’t felt the pain … yet.

But as soon as they slow down their buying of U.S. bonds — or, God forbid, actually start selling — it’s going to drive U.S. bond prices into a tailspin. And lower bond prices automatically mean higher interest rates.

The prognosis: The danger of an interest rate super-spike is even greater today than it was in the late 1970s.

While everyone else is trying
to divine the tea leaves of
the Fed’s decision tomorrow,
you need to act based on
THE BIG PICTURE

This is no time to sit around trying to decipher every subtle nuance of the Fed’s decision. It’s time, instead, to start taking protective action based on the big picture.

Now that the Fed is jacking rates up to 3%, how much further will they have to raise them to finally catch up with inflation? No one can say for sure.

But …

If the Fed funds rate rose from 5% to 20% last time (a factor of four to one), it’s not unreasonable to assume that, this time around …

The Fed funds rate could ultimately rise from 3% to 12% (also a factor of four to one).

My recommendations:

1. If you have a fixed-income portfolio, make sure the average maturity is short.

2. If you have a stock portfolio, make sure you’re invested in the few sectors that benefit from an inflationary environment — such as energy and gold.

3. If you own real estate or any other asset that’s vulnerable to higher interest rates, start taking protective action. At the very minimum, do your best to HEDGE.

To hedge against rising interest rates, you can use a specialized mutual fund (such as Rydex Juno) that’s designed to go up in value in lock step with rising interest rates.

Or you can buy interest rate options that can surge in value even with relatively minor interest rate rises.

No matter what action you take, be sure you use strictly the funds you can afford to risk. And no matter where you are, be sure you’re on the right side of this interest rate rise. It could emerge as the most defining force of our time.