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The Bullion Report

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March 9, 2011 in 'The Bullion Report'

What Happens if Central Banks Raise Rates?What Happens if Central Banks Raise Rates?

This week marks another round of speculative news that the European Central Bank may move to raise interest rates. Coming off comments from the ECB Chief Trichet, most analysts seem to take it as a given that their rate will ratchet up .25 percent at their next meeting. Does this mean that the Federal Reserve will also raise rates? If central banks start to raise interest rates, what could be the impact on precious metals?


The following chart shows some of the points in the past at which interest rate changes came from the Federal Reserve:

 
Past performance is not indicative of future results.

***chart courtesy Gecko Software

The first thing to dispense with is the idea that a rate hike from the ECB is a guarantee. According to governing council member Ewald Nowotny, members do not “pre-commit” to rate increases. However, other banks, like the Bank of Ireland, are nearly unwavering in their forecast that an interest rate increase will come in the next few months. The reasoning behind this speculation is two-fold. Reason number one is the obvious comments from their ECB president, and two is the ongoing price inflation seen in several sectors.

 

I can’t speak for Mr. Trichet, but I can address the idea of current price inflation.

Even before hot spots for political tension began erupting in the Middle East, consumers and manufacturers were seeing prices for some basic commodities gain ground. Although it may not have been reflected in a significant PPI or CPI report, there was still a marked increase in goods and an effect on the consumer. The general view is that the Federal Reserve and other central banks will raise rates to try to head off future inflation.

Before analysts run off to poke a hole in what they see as a commodity price bubble, let’s consider the other factors that could influence the ECB and the Fed in the months to come. The caveat to raising interest rates to combat inflation is that it happens to battle future inflation, and many central bank members, including our own Ben Bernanke, suggest that this rise in oil and commodities is only temporary. A general peace accord in Middle East nations or a bumper crop harvest could quickly turn the markets in their eyes. However, for most of us, the idea of these temporary causes is only part of the greater picture.

Stimulus programs at home and abroad (think Quantitative Easing Round Two) increased money supplies and depressed currency values. Before that, a credit crisis and global meltdown wreaked havoc on financial markets. These things haven’t really gone away. In fact, to some more critical eyes, the alleged rebound of the economy has been a figment based on inflation. That means that the unprecedented level of debt in the US and the high levels of unemployment are probably going to loom larger than any action the Federal Reserve might take.

Summary

As shown in the chart at the beginning of this discussion, the bigger picture impact of rising interest rates is closer to nil. Sure, there might be a short term pullback in precious metals off any changes in official policy, but a few things are clear. One, there has been no real remedy to the current economic issues that impact a full recovery in any country. There are still lingering problems on several fronts. That means that for most banks, there is a terrible balance they have to achieve between appearing to be taking action and stopping any whispers of recovery in their tracks. The wrong move now could stomp out any embers of future financial stability.

Two, interest rates have a long, LONG way to go before they approach a level where investors might weigh the luxury of perceived safe havens against the potential for higher interest payments. What I mean to say is that they are so close to zero that the interest rate earned on cash or other investments is almost negligible compared to the uncertain foundation they are built on. Investors have typically turned away from gold and other commodities when interest rates are high enough to offer an attractive return – and that return has to be adjusted based on the expected inflation rate.  

And finally, gold and other precious metals continue to offer a port in a storm of political and economic unrest. There are obvious downside risks, but they continue to retain demand growth in a time when consumers and investors have been treading more carefully.

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Disclaimer: The prices of precious metals and physical commodities are unpredictable and volatile. There is a substantial degree of a risk of loss in all trading. Past performance is not indicative of future results.