Fed blinks: US deflation risk is growing
The suspense is over.
I’m talking about what how many times the Fed will raise rates in 2019.
As Jim says below, we already knew it was going to raise rates for December.
What we didn’t know were the plans for next year.
And now we do.
The Fed has planned two rate increases for 2019. For most of this year, experts have swung between ‘There’ll be none’ to ‘There’ll be some’.
The point is, the biggest problem on Wall Street was not having an accurate template to ‘Fed think’.
Which, by the way, is something I continue to find bizarre.
Many years ago, the Federal Reserve Bank didn’t need to ‘talk’ to the market like it does today.
Sure, there were clues in the lead-up to monetary policy meetings.
But pre GFC, the Fed didn’t need to spell out where it thought interest rates would be one or two years from now.
Yet, that’s the investing landscape we find ourselves in now.
The biggest and most powerful central bank in the world must declare its intentions to the markets.
The Fed calls it ‘forward guidance’. That is, tell the markets what your plan is. Plot out that plan in detail. And if there are any long-term changes to the plan, let the market know.
That way, there are no surprises.
In reality, the use of forward guidance should set off alarm bells for investors.
The markets are so fragile that the Fed must have a multiyear-long plan for monetary policy.
Investors and business alike need a ‘clear’ picture of what central bankers will do, in order to go about their business.
Quite frankly, the market shouldn’t be that reliant on the actions of just a few.
But it is.
Markets have never before needed such a detailed picture of the Federal Reserve’s plans for interest rates. And it highlights just how precarious the US market is.
The Fed is clinging to forecasts that may not matter 12 months from now.
Global markets are so fragile that it’s essentially reading tea leaves to make decisions.
Now, it’s over to Jim. He’ll talk you through what last night’s Fed outcomes mean for next year.
Fed blinks: US deflation risk is growing
Jim Rickards, Strategist
The Fed is so confused that it’s starting to confuse the markets, too.
I have frequently described the Fed’s model for interest rate hikes. This model was put in place by Janet Yellen in December 2015 at the time of the rate hike ‘lift-off’.
It was carried on by Jay Powell after he became Fed chair in February 2018.
This model provides that the Fed will raise rates four times per year (March, June, September and December) by 0.25% each time, until the federal funds target rate hits 3.75%.
At that point, the Fed will step back and evaluate the policy rate situation in relation to the economy.
The reason? The Fed needs to increase the rate before a US recession hits.
It may be out of time…
Creating the recession the Fed is preparing to fix
The reason the Fed is targeting 3.75% (possibly higher) by early 2020 is that research shows it takes 3-4% in rate cuts to get the US out of a recession.
The Fed is not predicting a recession right now (it never does), but the Fed knows recessions happen.
After nine years of expansion, the next recession may come sooner rather than later.
If a recession happened tomorrow, how would the Fed cut rates 4% if the federal funds target was only 2.5%? It can’t.
This situation would force the Fed to go back to quantitative easing (QE) in the form of QE4 in order to fight the recession.
The Fed would much rather have higher rates so it can cut more and not have to revert to the notorious QE playbook.
These rate hikes have nothing to do with ‘data’ and everything to do with having dry powder for the next recession.
The only exception to this autopilot program is an occasional ‘pause’ if the Fed sees strong disinflation, disorderly market declines or job losses.
The Fed’s finesse is to raise rates without actually causing the recession the Fed is preparing to cure.
While Wall Street jabbers on about other factors (yield curve, non-existent inflation, bad days in the market), the Fed has stayed on track. So far, so good.
Central bankers using meaningless jargon
But the Fed can’t leave well enough alone.
Yellen threw a monkey wrench into her rate hike plans with quantitative tightening (QT), which started in October 2017.
QT is the equivalent of burning money; the opposite of QE. Today, the base money supply (M0) is actually shrinking, in contrast to the mistaken belief that the Fed is still ‘printing money’.
It’s not. QT is slowing the economy with or without rate hikes. The combination of QT and rate hikes is like slamming on the brakes when it comes to growth.
Powell threw another monkey wrench into the Fed’s plans with his early October comment that the Fed was a ‘long way’ from a ‘neutral’ policy rate.
This was a mistake because a ‘neutral’ rate doesn’t exist. It’s another meaningless academic theory. Neutral is not the Fed’s goal anyway (it’s the 3.75% target).
Powell’s hawkish comment about neutral rates sent stock markets into a tailspin in October.
Powell corrected the record in November by saying the Fed was actually ‘just below’ neutral (another irrelevant comment).
Still, markets cheered the new dovish Powell and reversed some of the October losses.
The Fed is now boxed in by Powell’s sloppiness and his flip-flop from hawk to dove.
But the entire neutral rate debate is like a false flag operation; it has nothing to do with the Fed’s real goal of getting dry powder.
Powell is not an economist; he’s a lawyer.
He should stick to a pragmatic approach and not get pulled into academic mumbo jumbo about the ‘neutral’ rate.
In the meantime, the markets were holding their breath, waiting to see what rabbit Powell pulls out of his hat overnight.
Working with what we know
The single-most important factor in the forecast for the Fed’s rate decision last night was Powell’s remarks at the press conference that followed.
We already knew the Fed will raise rates by 0.25% for December.
The only mystery was the forecasts of the FOMC (Federal Open Market Committee) members (the ‘dots’) and Powell’s performance at the press conference.
I have not changed my basic Fed model, but we do have to consider the fact that Powell is now chair.
He’s a lawyer, not an economist, and he’s a pragmatist, not a model-based ideologue.
The difference is that he seems to look forward more, whereas Bernanke and Yellen were always stuck in real-time data because that’s how they understood the models.
Powell is more open to the unexpected.
Powell just went through an education process of first misstating the distance to neutral as ‘a long way’ (which took the market down in October) and then having to correct to ‘just below’ (which boosted the market lately).
The markets took the correction as dovish, but in fact it was just part of the education of Jay Powell.
It was also a bow in the direction of the White House. Trump is unhappy with Fed rate hikes.
Powell will not change course just because of this, but he knows Trump is watching and will do his best to reassure the White House that the Fed is carefully watching the economy too.
It would be confusing and a bit reckless for Powell to change tack again and suggest the Fed was back on autopilot with regard to rate hikes.
The Fed will probably try to square the circle with slightly more dovish economic forecasts and slightly more hawkish comments on ‘gradual’ rate hikes.
Meanwhile, the QT juggernaut is slowing the economy with or without rate hikes. The markets are already discounting this.
Expectations for further fed funds target rate hikes after December have come way down.
The markets will have to digest all of this along with their Christmas turkeys.
Confusion reigns, but confusion can be an investor’s best friend if you can see through it to the Fed’s endgame.
All the best and happy holidays,