The Federal Reserve is lying to us about what their goals are. Their motivations are not what we are told. The "dual mandate" of maximizing employment and maintaining stable prices are only secondary goals of the Fed.

The third objective established by Congress for the Fed is to moderate long-term interest rates. With over a $100 trillion of debt and deferred liabilities, the U.S. Government needs interest rates low long-term. But there is a secret mandate that is even more important.

Dissecting the Federal Reserve's Dual Mandate

"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

Most analysts, economists, pundits and investors focus on the "dual mandate" of the Fed. This obsession is rooted in the idea that what happened in the past, will happen in the future. This is a myopic worldview that believes the economic landscape has not materially changed from the post-World War II period. 

The dual mandate concept is derived from an era when economic growth was abundant. Nations were rebuilding after World War II and populations were young due to so many dying in battle. That has changed. 

Global growth is plodding along at about half the rate from the second half of the 20th century despite massive monetary stimulus. There must be something structural to create this economic environment where massive stimulus results in below average growth.

The answer is simple really. Aging populations in the four largest economies, the United States, China, Europe and Japan are resulting in governments soaking up more and more capital. Only the United States has a large young generation that is partially offsetting the aging of a large older generation.

The debts generated by governments all over the world, from both good times and bad, on top of obligations to take care of their aging populations are and will continue to prevent any sort of economic recovery to the growth of the 1950s to 1990s. 

I laid much of what is going on out in a report a year ago titled: The Bear Market Has Begun (a rolling sector by sector bear market in 2015 and early 2016, has been met by several months of irrational market rallying, we will see how that turns out soon).

I said this a few weeks ago: You Must Accept Economic "Slow Growth Forever." The economic growth of the past is never going to return again. If you fight that idea, then you are in for a world of hurt as an investor at some point.

I want to be very clear about this. No amount of monetary stimulus, fiscal policy, helicopter money, wishing it so or promises from politicians, will ever give us the growth of the past again except for very brief periods. This is so due to the severity of aging demographics and overwhelming global debt.

The dual mandate was established before there was an understanding of aging demographics or global debts that could never be repaid. However, it is the perfect cover to manipulate global economics and currencies. 

The Dollar is the Fed's Secret Mandate

It is important to view global finance in the construct of currency strength. The standard of living of a population is directly related to the strength of their currency. If a currency collapses, then there will be massive inflation and diminished standards of living. The opposite is also true. 

This is the point at which checkers players start screaming "fiat money" as if there were something else. A currency is as strong as the economic assets backing it. In that regard the dollar is strong so long as our monetary policies aren't significantly looser than the other major currencies, particularly the Euro, Yen, Pound and now the Yuan. 

A strong currency is the global equivalent to a free ride for improving standard of living. It's like having the fastest race car on the track. Yes, sometimes the driver will want to slow down for a turn, but in the end, presuming the driver doesn't hit a wall, the fastest car wins.

The United States is the world's reserve currency. That is slowly changing though. The inclusion of the Chinese Yuan in the IMF Special Drawing Rights next week will be another step towards the dollar having to share reserve currency status. 

Ultimately, as long as the dollar is one of a handful of reserve currencies, the United States, due to her massive economic advantages, will not suffer the sort of economic calamity awaiting much of the globe.

It is here where the Fed's secret mandate resides. Beyond all else, the Fed must preserve the dollar's role as a reserve currency. Consider what it might need to do in order to achieve that in a world that is challenging that position. 

It is not unlikely that the Fed will attempt to cause global economic and market instability. The U.S. economy is in a soft period again, but there is talk of an interest rate increase. We really need to ask why that is? 

Could the instability that an interest rate increase brings be good for the United States? That of course begs the question: who is the United States? Is it the people or is it the Federal Government and financial elites? Could it be both, but at different times? There are multiple levels to this line of thought. 

In a perfect situation, the United States could grow its economy fast enough to pay its debts. There is almost no chance that is possible. 

What would be the next scenario to consider? A situation where the dollar remains strong, but interest rates stay low. How could the two things co-exist long-term? 

I first talked about this scenario on MarketWatch way back in 2014. I don't think people understood the importance of: The Strange World of a Strong Dollar and Low Interest Rates

After the financial crisis of 2008, the dollar initially rose and then went into a four year decline as investors mistook the relative strength and position of the U.S. versus Europe and China. Since the summer of 2014 however, the dollar has risen against a basket of currencies. The PowerShares DB US Dollar Index Bullish (UUP) has risen significantly the past two years and is now in a range that has been consolidating into a narrower band:

UUP

Given the weakness of the Chinese, Japanese and European economies, it makes sense that the dollar is about to go onto another significant rise defying the dollar bears. Japan is on the verge of helicopter money, Europe's economy is flat and demands action if the European Union is to be saved and China needs to reclaim manufacturing business and is likely to devalue once they are included in the IMF SDR. That all adds up to UUP being a buy short-term. 

Americans should hope the dollar remains strong against the other major currencies. Not only does that help our standard of living, but it could stimulate global economies that in turn stimulate us. We will see.

The Fed and Inflation

The idea that the Fed takes seriously maintaining a stable price level is ludicrous at this point. They flat out talk about wanting to raise inflation on a constant basis. The inflation calculations have been getting fudged since the early 1980s and it has only gotten worse with the advent of hedonic adjustments.

In addition, we are now hearing about potential new changes to how inflation is measured. All the better to hide the stagflation that is coming.

The Fed certainly wants to show us inflation numbers that are low, however, they don't actually want inflation to be low. They need to inflate away as much government debt as possible. Notice that I did not say pay down government debt. Until the Baby Boomers have passed on, the United States has no hope of ever avoiding massive debt service. 

By the middle 2020s, all of the Baby Boomers will be on Medicare. Over the next few decades, the United States has over $100 trillion of obligations beyond the normal Federal budget. Where will that money come from?

"By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens." - John Maynard Keynes

If the government can lie about the true inflation rate, by 2 or 3 percentage points, that could offset the lack of growth when combined with low long-term interest rates. Take a look at the charts at alternate inflation charts at Shadowstats.com. You'll see that the government is indeed understating inflation by about 2 to 3 percentage points. 

So, when inflation data is low, the Federal Reserve has an excuse to keep interest rates low. So, we can expect that there will be another adjustment to how inflation is calculated as people start to notice their milk, meat and Big Macs getting more expensive. It doesn't matter that inflation is low at the moment on paper due to the transitory impact of cheap energy.

Rising inflation would necessitate higher interest rates. If interest rates were anywhere close to the historical long-term average of around 5%, then the United States would have no chance of servicing its debt. With over $100 trillion of obligations over the next few decades, the U.S. Government will be in dire straights within a decade. 

"Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output."- Milton Friedman

The Fed needs to keep interest rates low for the U.S. Government and the dollar strong so that Americans standard of living doesn't decrease any further. It will be a difficult task without another flight to safety by foriegn investors and savers. 

The Fed and Maximum Employment

Reaching maximum employment is a tricky concept. It revolves around what the Fed believes full employment can be. We know that the U-6 unemployment number, which is the closest we get to an honest unemployment number, is about 10%. Depending on what you believe labor participation should be, closer to 65% than the current 63% as one scenario, then unemployment could be as high as about 12%.

U-6 Unempoyment

Because U-6 is a couple points higher than it ought to be, that gives the Fed cover not to raise interest rates. In fact, it's a pretty good reason. It is a way for the Fed to keep interest rates low, but not defend the dollar.

There is a very real skills mismatch in the economy right now. According to the Labor Department, there are 5.8 million job openings. Employers are having a hard time filling those positions. Either people are unqualified for those jobs or unwilling to work for the wages offered. 

If that skills mismatch could be conquered, then unemployment would fall just enough that we would legitimately have full employment. 

If we get full employment, then we could face inflation from rising wages. Again, the Fed wants inflation, but not really. See the problem they face.  

What We Should Expect from the Fed Next

Because the Fed needs to maintain both a strong dollar and low interest rates it is in a tough spot.

In an ideal world the U.S. Government would level with the American people and tell them that we are over-extended financially. They would then explain that for the next 20-30 years we can slowly dig our way out with only minor sacrifices. Of course, once we are faced with sacrifices without an apparent crisis right now, nobody will want to sacrifice.

That brings us to what will likely happen. 

The U.S. Treasury has about $3 trillion of debt coming due in the next year or so. It needs to refinance that debt for longer time periods even though average maturity is relatively high already. Currently, treasury bills are taking up a large portion of new issuance, that needs to be reversed again to longer-term maturities. 

Foreign governments have been selling U.S. Treasuries the past couple years. Saudi Arabia to fund itself due to the oil slide, China to prop up the Yuan in its bid to enter the IMF SDR and other nations to plug budget holes. 

If there were to be a financial event in the next year, then the U.S. could issue longer-term treasuries at low rates, as the demand for U.S. debt would rise once again as the cleanest dirty shirt. 

By raising rates in December, the Fed could virtually guarantee a recession by late 2017. This would create enough havoc in markets to stimulate U.S. debt demand.

If Donald Trump becomes the American President, interestingly the Fed might not have to raise rates to get a recession. As Barron's pointed out, corporate CEOs have no love for Trump. By them holding onto their wallets a little tighter than they already are under a Trump Presidency, a near certainty, they might cause a recession.

There is also the possibility of an external event, i.e. Chinese bank crisis, Japanese capitulation or European fracturing, causing a global financial event. 

At this point, the Fed really is playing a wait and see game with the Presidential election and global economies as it awaits the financial event it needs. If need be, the Fed will cause the event, but it's a coin flip if they'll need to.

I hope I've made this clear enough, it's a hard enough set of ideas to think about much less explain on a Sunday night.

What Investors Should be Doing Now

As I've suggested for over a year now, investors ought to be reducing risk. 

I like UUP here. The dollar is going to get stronger before it gets weaker. Be careful not to buy the dollar collapse hype. The current range is likely to hold a long time.

The low volatility equity ETFs are at risk as many have been bid up. The iShares Edge MSCI Min Volatility USA ETF (USMV) and the PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV) are both sells in my opinion. SPLV has a weighted average P/E of 22 and USMV has a weighted average P/E over 23. Both also have Price to Book ratios over 3. Hardly the low volatility value numbers an investor would expect.

Our asset allocation is 25-50% cash again depending on personal risk tolerance. Our equity exposure is limited to industries and regions with strong top down characteristics. We are finding a small handful of companies with strong bottom up fundamentals and handful of ETFs with proper risk to reward characteristics. Most of the equity market globally however is overvalued and has increasing risk as economies fail to grow and debt continues to rise. To learn what we are investing in try a month subscription to Fundamental Trends