Get Set for Fed Rate Hikessssss

Item: In a major new report, a blue-ribbon panel of economists estimates that if all the brain power expended over the past 20 years forecasting the next move by the Federal Reserve had, instead, been used for productive endeavors, U.S. GDP would be 12% higher today.

So let’s discuss the next move by the Fed. It is a no-brainer it should raise rates later this year, even if it upsets equity and bond markets, not to mention central bankers in emerging markets. It’s not just that the ever-brilliant Larry Summers (if you don’t believe me, ask him) believes Fed tightening would be a huge mistake. It’s the anecdotal evidence that is most persuasive; the official data will catch up later. Consider:

  • Wal-Mart is raising wages for most of its 550,000 employees. Many other giant retailers, such as TJX and Ross Stores, appear to be following suit.
  •  Aetna has announced a major wage increase.
  • The California dock workers went out on strike.
  • Members of the United Steel Workers employed by oil refineries have gone out on strike.
  • Disney raised the cost of a theme park 4-6%.

These are not alarming headlines. They are typical headlines for an economy that is chugging along in the middle of an expansion, with the labor market getting tighter and workers having a bit more bargaining power. The economic expansion is maturing but shows no signs of tipping into a recession.

The problem is that current monetary policy is wildly inappropriate for an economy that is “chugging along in the middle of the cycle.” The Fed is still in panic-mode, with zero short rates. It’s way past time to start “normalizing” rates. In twelve months we will start to see telltale signs of wage pressure and corporate pricing power pushing up inflation. At that time investors will conclude the Fed is way, way “behind the curve” and must raise rates aggressively. Then we’ll see really severe “volatility” as investors wonder whether the Fed’s tardy response to inflation pressures will tip the economy into recession.

Of course, bumping up Fed Funds to 0.75% or 1% will have little impact on the economy. Once the rate hikes start, speculation in financial markets will quickly shift from “When does the Fed hike rates?” to “How far and how fast?” Rising rates may spook global bond markets, which have become overly dependent on easy money.

Inflationary risks have been exacerbated by the supply-side damage inflicted by Obamanomics. Fortunately Obama’s attack on fossil fuels failed. But Obamacare and other transfer payments create disincentives for employers to hire workers full-time, and for employees to work too much, lest they lose benefits. Tax hikes on high earners curb incentives to work and invest. America’s crazy corporate tax code continues to strand $1.5 trillion in corporate cash offshore, where it cannot be invested to expand U.S. economic capacity.

Not unlike 1997-98, when commodity prices collapsed during the “Asian Financial Crisis,” plunging oil prices have given the U.S. a reprieve from inflationary pressure. But that is transitory. A year from now the underlying inflationary pressures in the U.S. will be all too evident. With the dollar strong and other regions such as China having over-capacity, those pressures initially will not be severe, but they will be enough to force the Fed to keep raising rates.

Rising rates will weigh on the equity market. Stocks are no longer cheap, earnings growth is tepid, and rising wages will pressure profit margins somewhat. In a smart bullish report on U.S. equities, BAC strategist Savita Subranamian lists “10 reasons to stay long the S&P 500.” Reason number 7 is that “Valuations aren’t stretched.” Maybe not, but of the 16 valuation metrics she lists, the only ones where equities look inexpensive versus history are metrics that compare returns from stocks with current bond yields. So if long rates rise 150 bps, one of the chief props for the S&P 500’s valuation will disappear.

How to Spot a Mania

Identify bizarrely inappropriate and unsustainable economic conditions that go on so long they start to seem “normal” and irreversible—the sky-high PE ratios of NASDAQ 5000, cab drivers buying $400,000 houses with no money down in 2005, and—yes—zero Fed Funds in the sixth year of an economic expansion. During a mania, anyone who says “This has to end” is condescendingly reminded “You could have said that any time in the last four years and you would have been wrong.” They forget that “Past performance is no guarantee of future results.”

Pointing Eastward with Pride

In an article titled “China cuts interest rates as fears rise over deflation and slowdown” the Financial Times writes that China “faces the prospect of a much sharper slowdown than previously anticipated.” Not by us. Nearly two years ago (July 12, 2013) I wrote, “if you apply a little logic it is reasonable to conclude China growth will be much worse than current consensus.” It was obvious then that China was swimming in over-capacity and could not keep growing via investment and exports; the transition to growth driven by domestic consumption looked difficult, to say the least.

The new news since 2013 is that the crack-down on corruption is turning into a political purge that is A) scaring the Party elite, who are key economic decision makers, and B) freezing up the Internet, the central nervous system of a modern economy. Evidently Xi Jinping wants China’s economy to look more like Putin’s Russia.

Copyright Thomas Doerflinger 2015. All Rights Reserved.

 

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About tomdoerflinger

Thomas Doerflinger, PhD is a prominent observer of American capitalism – past, present and future. http://www.wallstreetandkstreet.com/?page_id=8
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