With its announcement today that it will keep interest rates near zero at least until late 2014, the Federal Reserve has put another large crack into the foundations underlying the US dollar. Not surprisingly, precious metals and foreign currencies rallied strongly on the news - with gold up more than 2.6% and the dollar index down nearly half a percent in the wake of the announcement. Tellingly, bond market investors reacted with less conviction. After rallying on the prospect of lower interest for years to come, longer-term Treasury bonds lost traction and gave back the lion's share of their intraday gains by the end of the session. Could it be that investors have finally realized that the Fed is the most dovish of all the world's central banks?
In coming to this momentous decision, which extends the Fed's prior low rate promises by another 18 months, Bernanke and his cohorts relied on a sanguine view of the economy that was at odds with the sunnier view presented last night by President Obama in his State of the Union address. To hold rates so low for so long, the Fed is choosing to ignore all signs that CPI inflation is currently running north of 3%. Instead, they have conveniently chosen to look at the chain-weighted core PCE, which comes in just a shade below the Fed's arbitrary 2% target.
Although the U.S. economy has been badly distorted by negative real interest rates over the past three years, it is now a matter of policy that these rates will persist for the foreseeable future. As a testament to its own faith in itself to forecast economic conditions, 6 of the 17 voting FOMC members indicated that they would have preferred to keep rates close to zero at least through 2015! This comes from the body that couldn't predict the 2008 financial crisis, even while it stared at them from point-blank range.
As long as interest rates remain far below the rate of inflation, the U.S. economy will fail to equitably restructure itself for a lasting recovery. As a secondary effect, U.S. savers will continue to suffer from a lack of yield and a weakening currency, while those wise enough to park savings in gold will likely see continued success.