The Fed raised the Federal Funds Rate by 25 basis points (a quarter of a percentage point) to 1.0%. This is the anchor rate on the yield curve, and, most other rates respond to it, with shorter rates today responding more than longer rates. It appears from their communications that they intend to hike rates several more times over the next 12-18 months.
While I don’t see a recession over the next few quarters, the fact is that when the Fed embarks on a rate hiking cycle, like this, recessions occur most of the time. Since 1950, the Fed has embarked on thirteen rate hiking cycles. Ten of these have resulted in recessions. The three that ended up in a “soft landing” were early in the business cycle. There is no evidence that the U.S. economy, or any economy in the modern world, for that matter, is anywhere near “overheating,” so a “soft landing” doesn’t appear necessary. In addition, our current cycle is long in the tooth, and the Fed has never accomplished a “soft landing” in a late cycle scenario.
Should we be worried? Just why are they on this rate hiking mission? It appears they just want to have some ammo when the next recession comes along. Their traditional weapon of choice has always been to lower rates. Because it is extremely difficult and market distorting to try to lower rates from a near zero starting position, the Fed wants to raise rates back to more “normal” levels.
I have two areas of concern: 1) The Fed doesn’t seem to have recognized the paradigm shift over the last decade in the economy’s ability to grow or its inability to produce any sort of sustainable inflation; and 2) The positive sentiment in the business community (as evidenced by the stock market spurt) which the Fed is viewing as a strengthening of the economy and a justification of its rising rate regime, has not translated, so far, into any sort of real economic growth.
The Paradigm Shift
Changes in demographics, poor tax policies, and rapid technological innovation, have all come together to generate significant headwinds for economic growth. GDP growth is defined as the production of more goods and services this quarter than last. More goods and services are produced if either there are more jobs and/or productivity rises.
• In the 70s and 80s, and even into the 90s, the labor force was growing at a healthy clip, 2% to 3% per year. So economic growth could easily occur. Today’s U.S. labor force is growing 0.2% to 0.3% per year, and the Census Bureau predicts this trend is long lived;
• Due to tax policy, corporate cash continues to be held offshore, lest the corporation have to pay a 35% tax upon its repatriation. As a result, over the past few years, investment in plant and equipment has been scarce; thus productivity growth has stagnated and appears to be negative this quarter. In today’s environment, companies would rather grow by acquisition (or increase their share prices via stock buybacks) rather than organically;
• To make matters worse, it now appears that the rapid advance in technology has caused many to drop out of the labor force due to inadequate skills for today’s jobs. There are currently 5.5 million unfilled jobs with businesses indicating inadequate skills in the applicant pools.
The result of the above has been a slow growth economic recovery. And, given these realities, slow growth appears to be the best we can do for the foreseeable future. The Atlanta Fed’s GDP-Now model recently cut its Q1 GDP growth forecast to 0.9% (it was 2.5% just a month ago). If we were disappointed with Q4’s 1.9% GDP growth, what will we think of 0.9%? Europe’s growth seems to be better than “normal,” but that isn’t saying much. Even at “better than normal,” it is just about the same as that in the U.S. Japan hasn’t had any real economic growth for years, and China growth rate continues to fall. China is forecasting 6.5% growth in 2017 after a disappointing 6.7% growth rate in 2016. This will be the slowest growth rate in that economy this century. Even in the ’09 recession, China’s growth was 9.2%!
The world is awash in excess capacity. From China’s heavy industries to U.S. retail, to the supply of oil and basic materials, overcapacity is everywhere and price competition is fierce. The headwinds described above indicate that such overcapacity is likely to persist translating into a world where deflationary forces predominate. Those few inflationary forces that we have seen over the past couple of year (gasoline prices, rents, and medical costs) are currently about to deflate:
• In February of 2016, the price of oil fell to $26/bbl. By May, 2016, it had risen back to just under $50/bbl. In the second week of March, that price fell back below $49/bbl. because of the fear of a supply glut due to U.S. shale production and/or a response from the Saudis. Barring any major political event, over the next couple of months, the year over year change in the price of oil (and gasoline) will likely be zero or negative;
• Rent increases have been the mainstay of what little inflation we have had over the past few years. This was due to a lack of housing supply as a result of the credit collapse of ’09 which put most small home builders and developers out of business. But, now, there is evidence that even in the most supply constrained markets, like NY and CA, rents are rolling over;
• The other inflation mainstay, medical costs, have also begun to roll over. It wouldn’t have mattered who was elected, as both Trump and Clinton had the pharmaceutical industry on their attack radar.
In such a slow growth economy, it appears that any Fed rate hikes will only serve to flatten the yield curve. “Flattening” means that the difference between long-term and short-term yields contract. An “inverted” yield curve can and does occur when short-term rates are higher than long-term rates. And, every time the yield curve has “inverted,” it has been due to Fed rate hikes. Furthermore, nearly every time there has been an “inverted” yield curve, a recession has quickly followed.
The sentiment indexes have skyrocketed since the election. These include Consumer Confidence, the ISM Manufacturing and Non-manufacturing indexes, and stock market bullish gauges. Yet despite the ebullience, real economic activity has not increased. The recent job market reports appear to indicate strength, but much of the outsized job gains in February and March appear to be due to unseasonably warm winter weather over much of the country (February was the warmest in the U.S. since 1954). Because, much of this data is “estimated,” and because a “seasonal adjustment” process is applied, the warm winter may have caused a significant upward bias in the data.
The Fed has been itching to raise rates, and the jobs reports sealed that FOMC decision for March. At the end of 2015, the Federal Open Market Committee (FOMC), the rate setters, forecast three rate hikes for 2016, only one of which actually occurred (perhaps due to a slow economy). The FOMC continues to forecast three rate hikes for 2017 and they have set a 3% Federal Funds Rate as their long-term neutral rate (a long way from the current 1.0% level just set). They think about this as “getting back to normal!!”
Unfortunately, today’s “normal” is far different than what we remember as “normal” pre-’09 for all of the structural reasons I outlined earlier. Perhaps the Fed is just trying to reload its traditional recession fighting weapon – i.e., have the ability to lower rates when the next recession occurs.
My fear is that they have interpreted the ebullient sentiment indexes as economic strength. But, as I read the real data, there is no economic froth nor is there underlying inflation. If an increase in economic activity and/or inflation doesn’t occur, and, so far, it hasn’t, then the Fed may have just begun to give itself the ammo that it will need to fight the next recession, the recession that it may likely cause.
Don’t panic yet. It may take a couple of more rate hikes and continued tepid growth. But maybe some precautions would be wise.