Jul 31/15 – A 1937 style mistake
2015-07-31 1pm EDT | #bonds #Fed #inflation #Ray Dalio #wage inflation #Yellen
I continue to be perplexed at why the Federal Reserve committee members have such a hard on for raising the Fed Funds rate. I know, I know, “zero was an emergency rate, and the time for the emergency is long past.” Yeah, I get it – the Fed wants off the zero rate because it is not an “appropriate rate for this stage in the recovery.” And as I argued previously, I would be fine if the Fed was willing to take the inevitable pain of the economic rebalancing that will occur as a result of their tighter monetary policy. But what do you think Yellen & Co. will do when the economy stalls and the deflationary vicious circle returns? There is almost a 100% certainty the Federal Reserve will panic when the economy rolls over. They will pull out the blue tickets for QE4 faster than Britney Spears gets divorced (google it – her marriage lasted an unbelievable 55 hours).
The Federal Reserve must be under the illusion the economy can withstand their tighter monetary policy. They are making the same mistake almost every Central Bank facing a balance sheet recession has made over the previous decade. Japan tried numerous times to withdraw monetary stimulus, and each time, the economy was quickly engulfed in a deflationary vicious circle that forced the BoJ right back to the table with more monetary stimulus. In 2012, the ECB thought they could reduce the size of their balance sheet, but in doing so, they tightened monetary conditions and caused an economic slump that eventually required the need of both a massive new QE program, and more importantly – negative interest rates! During a CNBC interview Jim Bianco highlighted that no country has successfully left a ZIRP (zero interest rate policy) environment (Jun 10⁄15 – The party is over Luke).
Yet the current Federal Reserve is confident they will be the first. And it’s not like they are alone. Smart guys like Leon Cooperman argue the economy (and the stock market) does well during the initial stages of rate hikes. Coop is not scared of the coming rate hikes, and thinks the Fed should just get on with it. This sort of thinking must be going through many members of the FOMC committee’s minds. After all, most of their econometric models have been screaming for them to raise rates for some time. Let’s just take the basic Taylor rule as an example.
According to these models, the time for zero rates has indeed long past.
Maybe wise old wizards like Cooperman and all of the FOMC committee members know better. Maybe the economy is ready for higher rates, and the sooner we bite the bullet, the better off we will be. Whom am I to say they are wrong? I don’t have a clue what will happen when (if) they raise rates. But I don’t think they know either. They are all assuming this cycle will look like previous cycles. Yet I think there are plenty of clues this cycle looks nothing like the past, and that they are hoping more than observing.
One of the assumptions in the Taylor rule is the concept as the employment rate approaches NAIRU (non-accelerating inflation rate of unemployment), wage inflation should appear. The employment picture has improved significantly over the past couple of years, so according to the model we should be experiencing large wage inflation. Yet this morning the wage inflation statistic was released and it was the lowest in 33 years!
What’s the point of following an econometric model if it has completely failed to predict even the direction of wage inflation? Does Yellen, who has long championed that the best way to help the struggling middle and lower class workers is through a strong economy, really think we should be raising rates during a period of the lowest wage inflation in three decades?
And it’s not like the rest of the inflation picture is screaming higher either. Earlier in the week I posted a picture of the Fed’s favourite inflation indicator:
Maybe the Fed sees some inflation somewhere else the rest of us are missing. Maybe there is some commodity inflation set to come down the pike.
Unless the FOMC members are staring at a different chart, I see nothing but more deflationary pressures from the commodity collapse.
The consumer knows better
The Federal Reserve sets policy for the US economy. They have no obligation to concern themselves with the health of the global economy except as it relates to their own economy. Yet, their unique position as the reserve currency means their policies have an exaggerated effect on the rest of the world.
I believe the current softening in the global economy can largely be attributed to the Federal Reserve’s decision to stop expanding their balance sheet. So far the economic pain has been concentrated outside the United States, but the rot is slowly starting to creep back home.
The economic optimists believe the tightening monetary conditions will not quickly slow the pace of the recovery. Yet, the recent drop in Consumer Confidence shows the true fragility of the current feeble recovery. The always great Bespoke Investment published a chart where they highlighted the largest misses of Consumer Confidence versus expectations:
This recent miss was the eighth largest decline versus expectations. Clearly the consumer is not quite as confident as the FOMC.
The bond market is also worried
I cut my teeth in the equity market, so it pains me to say this, but let’s face it – the bond guys are smarter. If credit is going one way, but equity is going the other, the safe bet is always to go with the bond market.
Credit spreads have been issuing the warning signal for some time now, and the past month has been particularly brutal. Again, the credit markets are signalling things are not as rosy as the FOMC believes.
The clueless Fed
The US economy is slowing rolling over, yet the Federal Reserve keeps setting the course for higher rates. In doing so, they are actually applying the pressure that is causing the slowdown. By talking up short rates, they are driving the US dollar higher, applying more pressure on the rest of the world, and in essence, tightening monetary conditions without even raising rates.
The global economy, along with the American economy, cannot handle these tighter monetary conditions. We have entered a new world where rates cannot be raised without an immediate collapse in asset prices, and then the economy.
The closer we get to an actual hike, the larger the pain will be in markets, and then the economy. If the Fed decides to raise rates just to “get it over with,” I think it might usher in one of the biggest surprises markets have ever seen. I will take the other side of Cooperman’s call that the market (and economy) can handle higher rates. We have never had a rate hike with inflation running considerably below target, when wage inflation was hitting 33 year lows and commodities were collapsing.
Ray Dalio said he feared the Federal Reserve might make a 1937 style mistake. I think the recent market action combined with the economic releases make it clear that even the threat of a rate hike is enough to snuff out the nascent recovery. Every day the Fed continues down this road is another step closer to one of the largest policy errors in a long, long time.
Thanks for reading – have a great wk-end,