Markets facing crisis of faith with Fed rate hike

For those carrying an uneasy sense that the slump in global stocks signals something much darker than a run-of-the-mill correction, allow James Grant to confirm the sentiment.

“The world is at a monetary moment,” Grant said, adding it is one that will cause many to question exactly “what is money, and who says so.”

Grant, editor of the Grant’s Interest Rate Observer, spoke to the CFA Society of Colorado at its 12th annual forecast dinner on Tuesday evening.

A slowdown in China and an oil glut are being blamed for the current wave of market weakness, which has seen the Standard & Poor’s 500 drop 9 percent this year, hitting its lowest level in almost two years Wednesday.

Grant asked his audience, packed with money managers and investment analysts, to consider whether central bank manipulations might offer a better root cause.

Interest rates represent a price, and by suppressing rates for so long, central bankers have engaged in a form of price control. Grant argued that millennia of economic history show that price controls do not work and create unintended distortions.

Easy money is damaging in two regards:

It draws future consumption into the present and pushes out present failures into the future, he said.

And the weakness in equity and debt markets may be a sign that both issues are coming to a head.

For example, U.S. auto sales hit a record 17.5 million last year, a statistic often cited as proof of the country’s economic vigor. But record low auto loan rates and super-easy credit terms — the average loan term is now 67 months — might better explain why that happened, Grant said.

Easy capital creates excess debt and excess supply, issues China is grappling with. The world is awash in oil in part because plentiful capital combined with tech- nological breakthroughs allowed the U.S. to double its production in a few short years.

Grant argues that the Federal Reserve made a mistake when it raised interest rates in December, despite turmoil in the credit markets and the economic weakness evident overseas.

Not only did the hike give many a false confidence that the U.S. economy was ready for lift-off, but it has left the Fed vulnerable to a huge loss of face.

“The Fed has made a human error,” he said. But the admission of that error comes with huge implications in what is essentially a faith-based monetary system.

Grant is in the camp of those who think the Fed will be forced to backtrack on the rate hikes the market is expecting this year, before eventually reversing its December hike.

That loss of confidence will create waves, starting with questions like why is the U.S. dollar so strong and moving to more fundamental ones like what has monetary policy really achieved.

“Can this digital emission truly create value,” Grant asked his audience of the $4 trillion in money the Fed added to its balance sheet since the 2008 crisis.

Moving through that unsettling period will be painful and daunting. But it will allow the economy to find solid ground, one where a sustainable prosperity can take root.

“Risk comes out as prices fall,” Grant said.

The trick for investors, he said, will be surviving the fall and standing up again.