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The 1937 mistake – will Fed make it again?

The markets breathed a sigh of relief (up 164 followed by 99 Dow points) when, in the middle of September, the Fed decided not to raise the federal funds rate. The DJIA was as high as 18,538 on Sept. 6, but fell 504 points over the next six trading days, including three days in a row of significant gyrations (down 395, up 240, down 258). The past week continued the volatility (down 166, up 133, up 111, down 196 and up 165); this is an equity market with no clear direction.

The statement that accompanied the Fed’s non-announcement was hawkish, with every voting member of the FOMC (Federal Open Market Committee, the Fed’s rate setting body) penciling in at least one rate increase this year. Despite their apparent warning to the markets, it does appear that, given the weak data now emanating from the economy, any rate hike is going to be accompanied by equity market volatility – tilted strongly to the downside.

Don’t forget, this has been the slowest economic recovery in the post-WWII period and 2016 has been the year of the slowest growth of that slow recovery. Early in the century, at a meeting celebrating the career of Milton Friedman, the famous monetary economist, the then-Fed economist Ben Bernanke thanked Friedman for showing the Fed how the raising of rates in 1937, when the economy was still fighting the effects of the Depression, caused another recession, which lasted until the U.S. began its WWII war preparations. Bernanke thanked Friedman, indicating that the Fed would never make that mistake again! Really?

Because the Fed is cognizant of the potential financial turmoil that could result from a rate increase in a world where such an increase is unanticipated, it specifically told the markets that every FOMC member sees a December rate hike. The question is, even though the Fed has so signaled, will this approach prepare the markets? In my view, probably not! For several weeks prior to the September meeting, some of the more dovish FOMC members had signaled their willingness to raise rates at the September meeting. But, despite that jawboning, August’s weak data did not support a rate hike and markets were ill-prepared for one as is evidenced by market downside price volatility at that time. Thus, if the data remains weak in Q4, as appears likely, the markets may once again be unprepared for a rate hike.

On top of this, there was another very significant revelation in the Fed’s press release. All of the forward-looking interest rate and economic growth projections by the voting FOMC members were lowered once again. The lowering of the expected GDP growth rate to 1.8 percent for 2017 and 2018 means that the Fed itself is now waking up to the fact that we have entered a slow-growth world and past policies and practices may no longer be appropriate.

Still, despite the wake-up call, all of the Fed’s policy tools and approaches remain anchored to a world of much faster growth, a world in which the central bank is much more effective at controlling growth than at stimulating it. In fact, the Fed may have exhausted its toolkit and any future monetary policy moves to stimulate may end up being sterile. The situation calls for the effective use of fiscal policy. But if you think the politicians in Washington, D.C. are going to effectively use fiscal policy, you haven’t been observant for the past two decades.

Over the past few months, I have commented on the implications of a slow-growth world for the economy and for investors. Here is a distillation of my thinking: In a faster-growing world, equity indexing worked, as a rising economy lifted all indexed portfolios. But, in a slow- to no-growth world, portfolios that are indexed are going to go nowhere. After all, if there is no general economic growth and your portfolio is indexed to that, it won’t grow either. And, depending on the expenses charged by your advisory firm, it could actually have negative long-term performance. The only way to grow is to select growing companies, not an index which includes the low and negative performers. If you don’t have time to do that yourself, you need someone who does that, not someone who simply diversifies your assets into various indexed-asset classes.

On the fixed-income side, no matter what the Fed does, it only impacts the short end of the yield curve. Because the world is awash in the supply of everything from labor to productive capacity to oil, energy and commodities, it is deflation, not inflation, that dominates the economic landscape. In a slow- or no-growth world, no matter what the Fed does, long-term rates aren’t likely to rise. In the faster-growing world, you wanted to keep your fixed income allocation in short-term bonds. That protected you from principal losses as rates rose (i.e., interest rate risk) in a frothy economy. In a slow- or no-growth world, your fixed-income portfolio has much lower interest rate risk, and may not be endangered if its duration is somewhat longer than what you have become used to.


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