As I mentioned in my previous article, the Fed didn’t unwind the balance sheet because it can’t. Interest rates would rise to such high levels the federal government would have a tough time paying off the interest on the debt. The idea that the Fed isn’t using the balance sheet to affect the economy is laughable. The artificially low treasury yields allow the government to be in the position to cut taxes and do an infrastructure stimulus. The balance sheet is the Federal Reserve’s top tool to help the economy keep chugging along at a weak pace with the hope fiscal stimulus will save the day. If interest rates rose 100 basis points, it would cost the government $200 billion in extra spending. I contest that the treasury yields would rise even more than 100 basis points if the Fed unwound the balance sheet.
In this article, I will review the FOMC statement, analyzing the changes made to the wording. Near the end of this article, I have a screenshot which shows the changes made to the statement. The first change is about the unemployment rate as the Fed changed from saying it stayed near the recent lows to saying it was little changed. This may reflect the fact that the unemployment level has likely met the bottom of the cycle. While the unemployment rate says the labor market is at full employment, I think there’s still slack in the labor market from those who have given up looking for work, but want to get a job.
The chart below helps to illustrate my point about the slack in the labor market. Yellen believes the long-run monthly jobs growth should be between 75,000 and 125,000 jobs. Jobs growth has exceeded that amount in 60 of the past 72 months, yet hourly wage growth has only recently started to show a moderate pick-up. The Fed is tacitly acknowledging the unemployment rate isn’t an accurate depiction of the labor market by keeping rates low.
Another point I have about the labor market is that the Fed’s long-term projections don’t make any sense. The Fed expects the unemployment rate to be 4.5% in 2017, 2018, and 2019; it expects the long-run rate to be 4.7%. The unemployment rate probably won’t stay below its long-term average forever. The Fed predicts there will not be a recession in the next two years. This makes the Fed’s prediction like a broken clock; it always predicts a good future and never any economic woes.
The next change the Fed made was changing the wording from saying business fixed investment is weak to saying it has firmed. The chart below shows real private non-residential fixed investment. It started to rise moderately in late 2016. The dip in early 2016 made me think a recession was coming. It rarely dips outside of one. It certainly is not as strong as other parts in this cycle, but stemming the decline is encouraging. The Fed also got rid of the part which mentioned the strong sentiment data possibly because optimism has plateaued in the recent reports.
The next changes are about inflation. The Fed states inflation has increased, but the core rate hasn’t risen to the 2% target. Inflation is apparently dependent on the eye of the beholder as it can be various rates depending on what metrics you look at. The government stated consumer prices increased 2.7% in February year over year as you can see in the chart below. The PPI grew 2.2% in February. Inflation isn’t running out of control per se, but it’s not below 2% per many measures. The Fed expects the core PCE and non-core PCE inflation to be 2% for the next two years and the long-run (1.9% in 2017). The Fed sees nothing, but blue skies ahead even though inflation is much more volatile than that as you can see in the chart below. Even core inflation moves cyclically and will likely not be at exactly 2% consistently.
The final change the Fed made is it removed the word “only” to describe the gradual rate hikes. This change reflects the new increased speed at which rate hikes are coming. Jeffrey Gundlach has said the Fed will hike rates sequentially until something breaks. The Fed no longer has the stock market’s back, but the stock market doesn’t seem to care. It has rallied in the face of a hawkish Fed.
The final point I have about the Fed’s statement is criticism of its real GDP growth estimates. The real GDP growth predictions are like its inflation and unemployment predictions except its more pessimistic. The real GDP growth is expected to be 2.1% in 2017 and 2018; it’s expected to be 1.9% in 2019 and 1.8% in the long-run. Once again, the Fed expects there to never be a recession. While that’s overly positive, I think real GDP growth can be better than the long-run estimates. The Fed has lowered its long-run forecast because of near-term weakness. I think the near-term weakness is cyclical rather than secular. I find it strange that the Fed doesn’t recognize the business cycle which has always existed.
The Fed raised rates for the third time this cycle. Usually that’s bad news for stocks. The chart below shows the eleven previous times the Fed has raised rates three times without a cut in-between. Six of the eleven times this occurred there was a major cyclical top for stocks within one year.
Conclusion
The Fed may be trying to subdue stock market optimism with rate hikes, but it hasn’t been working. It’s dangerous for the bulls to have an emboldened hawkish Fed. If the Fed raised rates until something breaks, something will eventually break, namely a recession will occur. 0.9% GDP growth in Q1 would be far below the Fed’s forecast for full year growth.
The Fed has wanted to keep interest rates low because wage growth has been stagnant compared to the huge wealth gains by the top 1% in this cycle. This is an attempt to reverse its balance sheet policy since QE caused asset prices to appreciate and the wealthy to earn more money. If the Fed never bought bonds, it would be able to raise rates without worrying about the inequality gap.
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