Category: Contributors- Economic and Financial

It may be almost impossible to underestimate the gullibility of professional Fed watchers. At least Lucy van Pelt needed to place an actual football on the ground to fool poor Charlie Brown. But in today’s high stakes game of Federal Reserve mind reading, the Fed doesn’t even have to make a halfway convincing bluff to make the markets look foolish.

Just two weeks ago, the release of the Fed’s March policy statement and the subsequent press conference by Chairwoman Janet Yellen should have made it abundantly clear that the Central Bank policy had retreated substantially from the territory it had previously staked out for itself. In December it had anticipated four rate hikes in 2016,  but suddenly those had been pared down to two. Based on the conclusion that the era of easy money had been extended for at least a few more innings, the dollar sold off and stocks and commodities rallied.

 

But in the two weeks that followed the dovish March guidance, some lesser Fed officials, including those who aren’t even voting members of the Fed’s policy-setting Open Market Committee, made some seemingly hawkish comments that convinced the markets that the Fed had backed off from its decision to back off.

 

The campaign began on March 19 when St. Louis Fed President James Bullard said that the Fed had largely met its inflation and employment goals and that it would be “prudent to edge interest rates higher.” (H. Schneider, Reuters) Two days later Bloomberg reported that Atlanta Fed President Dennis Lockhart had said, “There is sufficient momentum…to justify a further step…possibly as early as April,” (J. Randow, S. Matthews, 3/21/16)

 

And it didn’t stop there. On March 22, Philadelphia Fed President Patrick Harker said,“there is a strong case that we need to continue to raise rates…I think we need to get on with it.” (J. Spicer, Reuters) On March 24, Bullard chimed in again, saying that rate hikes “may not be far off,” appearing to back Lockhart’s suggestion for a surprise April hike. Suddenly, chatter erupted on Wall Street that the April FOMC meeting should be considered a “live” one, where a rate hike was possible. With such caution spreading, the markets reacted predictably: the dollar rallied, gold and stocks declined. 

 

At the time I said, as I have been saying all year, that the Fed never had an intention to tighten further, and that it would continue to talk up the economy just to create the impression of health. But many believed that Janet Yellen would use her speech this week at the New York Economic Club (her first public comments since her March press conference) to underscore the comments made by her colleagues in the past two weeks. Instead she delivered a double-barreled repudiation of any potential hawkish sentiment. In fact, her talk could be viewed as the most dovish she has ever delivered since taking the Chair.

The market reaction was swift. In fact, as the text of her address was released a few minutes before she hit the podium, gold jumped and the dollar dropped even before she started speaking. The only surprise was that there was any surprise at all. 

 

If market watchers actually looked at economic data instead of trying to parse the sentence structure of Fed apparatchiks, they would know that the economy is rapidly decelerating, and most likely heading into recession (if it’s not already in one). These conditions would prohibit an overtly dovish Fed from any kind of tightening. Just this week February consumer spending increased at a tepid .1%, in line with very modest expectations (Bureau of Economic Analysis). But to get to that flaccid figure, the much more robust .5% growth rate originally reported for January had to be revised down to .1%. If that major markdown had not occurred, February would have come in as a contraction. The sleight of hand may have fooled the markets, but the Fed’s own bean counters had to take it seriously. The figures were the primary justification for the Atlanta Fed’s decision to slash its first quarter GDP estimate to just .6%. That estimate had been as high as 1.4% last Thursday and 2.7% back in February. Clearly something isn’t working. But whatever it is, Janet Yellen won’t speak its name.  

 

In her speech in New York, Yellen was careful to mention that the Fed has not reduced its full year growth forecast of 2.5% to 3.0% that it had laid out in December. This despite the fact that their first quarter predictions, which must be a big part of their full year predictions, have already been hopelessly shattered by the Atlanta Fed’s updates. 

 

If the Fed really believes that we are still on a solid growth track, then two major questions should immediately come to mind: 1) Given that she acknowledges greater than expected financial stresses and expected deceleration abroad, what could possibly be the catalyst that will suddenly reverse our economic trajectory, and 2) If it really does believe that this miracle will occur, why has the Fed abandoned the monetary policy trajectory that it announced in December?

 

The answer to the first question is a mystery. For much of the past year, Yellen stressed the improvements in the labor market, as evidenced by the low unemployment rate. But that figure has been thoroughly debunked by those who correctly point out that job creation in the U.S. has been dominated by low-paying part-time jobs that detract from economic health rather than add to it. But while Yellen clung to her rosy domestic outlook, she acknowledged the significant slowdown abroad. But if these global concerns are sowing caution at the Fed, why does she expect the U.S. to buck the trend?

 

She is correct that that many countries around the world have badly missed First Quarter forecasts. But she totally ignores the fact that the U.S. has been one of the bigger disappointments. For instance, since the end of last year, expectations for Q1 growth have declined 12.5% for Germany, 30% for Canada, 45% for Norway, and 57% for Japan (Bloomberg, 3/30/16). But based on the current estimates from the Atlanta Fed, the U.S. economy is growing at a rate that is 75% slower than the 2.4% projection Yellen and the Fed had forecast back in December. So why does the Fed acknowledge unexpected weakness abroad, yet ignore even greater unexpected weakness in the U.S.? Could it be that Yellen does not want to be seen as one of those “fiction peddlers” that President Obama criticized in his State of the Union address who have the audacity to suggest that the U.S. economy is not strong?

 

But the bigger question is not why the Fed is mindlessly cheer-leading, that is after all part of its job description, but how it can justify altering its monetary policy while holding fast to its economic forecasts. To square that circle,Yellen said that the Fed had erred in its assumptions as to what constitutes a “neutral” policy level whereby rates are neither stimulating nor restrictive. She said that based on her global concerns, neutral policy should now be considered close to 0% rather than the 2% that the Fed had hinted at earlier. She also said that the range of factors that the Fed considers in reaching its rate decisions had evolved beyond simply looking at the traditional inputs of GDP growth, inflation and unemployment to include global risk factors that could impact the U.S. In other words, the Fed is not simply “data dependent” but is now “globally data dependent,” a stance that could allow it to point to any potential crisis anywhere in the world as a rationale not to raise rates. Already many observers are suggesting that the June “Brexit” vote in the UK will be a justification to take a rate hike off the table for the June FOMC meeting.

 

Of course, this ever-expanding list of criteria should be viewed as what it really is: a continual shifting of goal posts that will prevent the Fed from EVER having to raise rates again (at least until a rapidly rising CPI forces its hand). It may have incorrectly believed it could get away with a series of increases when it first started raising in December, but those expectations may have wilted when the markets and the economy dropped so decisively in the immediate wake of December’s 25 basis point increase. Yet even though markets have recovered, I believe they have only done so because the Fed has backed off. In fact, if that initial rate hike was a trial balloon for future hikes, its flight was about as successful as the Hindenburg’s. As such, the Fed hardly wants to risk another sell-off that it may be unable to reverse.

 

So the handwriting is on the wall for anyone literate enough to read it. The Fed is stuck in a monetary Roach Motel from which it may never escape. Keynesian economists like to discuss a “liquidity trap” but their policies have created an undeniable “stimulus trap” that I believe will remain in place until the whole merry-go-round spins out of control.

 

The quarter that just ended yesterday saw the biggest quarterly declines in the U.S. dollar in five years (T. Hall, Bloomberg, 3/30/16), and the strongest quarter for gold in 30 years (R. Pakiam, Bloomberg, 3/30/16). These moves completely took the Wall Street establishment by surprise. But given the historic rally enjoyed by the dollar over the past five years, three months’ worth of declines may just be a small down payment on the declines the dollar may experience in the years ahead.

 

Despite having fallen for all of the Fed’s prior head fakes,  some economists are taking today’s March payroll report, which showed the creation of 215,000 jobs and a tick up in the labor participation rate to 63.0% (Bureau of Labor Statistics), as a sign that the Fed will now have to shift back into a hawkish stance. Putting aside the fact that the majority of the new jobs were part-time and went to people who already had at least one, and that the official unemployment rate actually ticked up, one wonders how much more of this will we have to witness before economists  finally realize that there will likely never be a real ball to kick.

 

The Federal Reserve’s years-long campaign to sheepishly back away from its own policy forecasts continued in earnest last week when it officially reduced the four expected 2016 quarter point hikes, suggested back in December, to just two. Given the deteriorating economic outlook, I believe there can be little doubt that the Fed will soon complete the capitulation process and remove all expectations for additional hikes this year. Even before that happens, savvy observers should have already concluded that the Federal Reserve is stuck in the monetary mud just as firmly now as it has been since the dawn of the financial crisis back in 2008.

 

Rather than actively voicing its retreat in either its March policy statement or in Chairwoman Janet Yellen’s press conference, the market-moving policy shift was buried in the minutia of the Fed’s “dot plot” information array, in which each voting committee member signals their assumptions of where interest rates will be in various points in the future. Those tea leaves needed to be read to reach the conclusion that policy just got significantly  more dovish. But despite the Fed’s soft peddling, the policy shift made an immediate impact on markets, with the dollar getting hit by a variety of rival currencies and gold (and more significantly gold miners) climbing to multi-month highs.

 

But perhaps the greatest casualty of the announcement was the Fed’s own credibility, which is now being stretched to the limit. At Yellen’s press conference last Wednesday, CNBC reporter Steve Liesman, who has perhaps been one of the most reliable supporters of the Fed’s policies, seemed to indicate that even he had grown weary of the Fed’s prevarications, saying to Chairman Yellen: “Does the Fed have a credibility problem in the sense that it says it will do one thing under certain conditions, but doesn’t end up doing it? And…if the current conditions are not sufficient for the Fed to raise rates,…what would those conditions ever look like?”

 

Yellen’s response was measured and lengthy, but what it really boiled down to was, “Steve, why have you taken our prior forecasts at face value? We never actually offered firm commitments on anything.  Nor did we specifically endorse the things that we seemed to have said. And just so you know, you should expect that the things we are saying now will ‘fully evolve’ over time as well.” Or in plain English: “Steve, don’t you know by now that we have no idea what we are talking about, that our forecasts are just guesses, and since we normally guess wrong, why should you expect greater accuracy now? If anything, it should be obvious that our guesses are biased in favor of stronger growth, as the intention is for those rosy forecasts to positively influence sentiment, thereby helping to obscure the problems that, for political reasons, we are hesitant to acknowledge”.

 

Talk is cheap, and the Fed buys it by the bushel. But when it comes time to actually do something, it is nowhere in sight. In voicing his frustration, Liesman pointed out that core inflation has gone up the past two months (in fact, it has already breached the Fed’s 2% target), that the jobs report was strong (in fact, the economy is creating 200,000 plus jobs per month), and that the GDP tracking forecast has returned to two percent. And while I have explained on many occasions why those data points are all misleading to the upside, Yellen has made no such qualifications. The growing chasm between what the Fed says it is going to do and what it is actually doing is getting increasingly hard for the mainstream to swallow. When it stops going down at all, a market shift of considerable proportions could begin in earnest.

 

One of the data points that Yellen likes to cling to most fiercely are the reports that show consumers are confident that the economy has improved and that it will continue to do so. But those reports, which I have always believed are poorly constructed, are completely at odds with what voters (who are also consumers) are actually saying at the polls. Presidential primary exit polls in state after state indicate that the economy has been the top issue on the minds of voters. Generally speaking, this should indicate that people are not overly optimistic about the economy. If they were, other issues, such as immigration, national security, the environment, and health care, would be cited as their top concern.

 

The big surprise this primary season has been the rise of Donald Trump among Republicans and Bernie Sanders among Democrats. Voters aren’t choosing Trump because they like his hair or Sanders because they like his glasses. Both are considered insurgents in their respective parties. They represent change and their popularity should be seen as a sign of deeply-seated economic uncertainty in voters rather than confidence. If confidence were high, candidates more closely aligned with the status quo should be on top.

 

According to both the Fed and its economic lapdogs on Wall Street, one of the few other bright spots in the economy is the fact that inflation is finally starting to ramp up noticeably. Last week it was revealed that the core Consumer Price Index (CPI) had risen 2.3% from the year earlier (Bureau of Labor Statistics), thereby eclipsing the Fed’s long-sought 2% target. The economists argue that rising prices will soon lead to rising wages. Yes, consumers are paying more for rent, insurance, food and healthcare, but the long-sought wage increases have yet to materialize. For obvious reasons, consumers tend to avoid celebration if their bills go up and their pay does not.

Higher prices may be the leading reason why consumers are not spending at the expected pace. Last month, economists cheered when January retail sales came in at up .2% for the month (up if you excluded autos and gasoline), according to Commerce Department data. In fact, the Atlanta Fed cited these numbers when boosting its annualized 1^st quarter GDP forecast to 2.7% (since revised back down to 1.9%) (FRB Atlanta). But, last week we were told that the January retail sales number was revised way down to negative .4% from the positive .2%. Excluding autos and gasoline, the numbers went down from up .4% to down .1% in February. I don’t recall ever seeing larger retail sales revisions to the downside. But because the revisions were so large, the February numbers could be viewed as positive even though they were way below the pre-revision January numbers. 

 

The slowing sales, in turn, are leading to a dangerous increase in business inventories as unsold goods accumulate on shelves. The inventory-to-sales ratio now stands at 1.4, the highest it has been since May 2009, when the nation was in the midst of the Great Recession. In fact, it has never been this high at times when the economy was not in recession. Similarly, data revisions released last week also indicate that we may ultimately post a full year 2015 current account deficit of $481 billion, the biggest number since the recession year of 2008. If interest rates go up, that deficit could grow significantly worse. The industrial production numbers are also on a downward spiral. Recent data show declines for four straight months, the first time since 1952 that this has occurred without the U.S. being in recession. But if we are already in recession, which I expect we are, then at least that statement will no longer be true.  

 

All this adds up to a nearly inescapable trap for the Fed. The economy is weakening while inflation is strengthening. In the meantime, asset prices, which have become the bedrock of any remaining economic confidence, are extremely vulnerable to an interest rate increase.

 

As a result, we should expect continued jawboning and inaction from the Fed. All it can do is pray that the economy heats up so it can finally do what it has long promised. But if we keep scraping along the bottom like we have, or go further into the danger zone, look for the Fed to take away those remaining two promised hikes just as easily as it did the first two. The last thing the Fed can bear is for a recession that may be bubbling just under the surface to boil over into full view in the months heading into the election. If that occurs, we all may be seeing a great many press conferences from Mar-a-Lago. That is a development that I’m sure Janet Yellen wants to avoid at all costs.