Is The Fed Mistaken About Inflation?

Includes: DIA, QQQ, SPY
by: Lance Roberts

This week's blogs will be titled "TFTB - Thoughts From The Beach," as I am on vacation with my family. One of the advantages of getting out of the office is that it gives me the opportunity to get away from the day to day "noise" of headlines allows me the ability to think about things from a broader perspective.

As of late there has been much commentary, particularly by members of the FOMC, that the economic recovery is now upon us and that interest rates will soon need to rise. In particular, was Fred Bullard who discussed in a recent Fox Business interview:

"'You are basically going to be near normal on both dimensions [unemployment below 6% and inflation at 2%] basically later this year. That's shocking, and I don't think markets, and I'm not sure policymakers, have really digested that that's where we are.'

He reiterated his belief that raising rates by the end of the first quarter in 2015 will be appropriate, based on his forecast that U.S. growth will register 3 percent for the next four quarters."

Mr. Bullard's comments reflect a growing belief that the economy is now on full pace of recovery and warrants a higher interest rate environment. The belief is that both the economy and the financial markets are on firm enough footing to withstand rising interest rates without a deleterious effect.

However, is that really the case? The chart below shows interest rates, economic growth and inflation.

While the economic growth trend was rising from the 50's to the 70's, sharp increases in interest rates led to both falling inflation and more sluggish economic growth, or even… gasp… outright recession. Beginning in 1980, those trends have been clearly negative. Weaker annualized economic growth has continued to drag inflationary pressures and interest to ever lower levels. The problem for the Fed is that with interest rates near historic lows, there is little ability to offset any economic drag in the future.

Not All Inflation Is Created Equal

In a normal economic environment as organic growth takes hold it leads to rising inflationary pressures in the economy. Inflationary pressures occur because businesses increase production to meet rising levels of aggregate demand. As production is increased, wages rise and "slack" in the labor force is absorbed which allows for higher levels of consumption. As "demand" increases, commodity and component providers raise prices to the producers and manufacturers. Those price increases are then passed through the system to the consumer who is being paid higher wages.

Since businesses are producing and manufacturing at increased levels, their demand for credit rises, which allows lenders to raise borrowing costs. The same goes for consumers who, now feeling wealthier, access credit to purchase increased amounts of goods and services.

The concern, of course, is that this cycle gets out of hand and leads to "high" inflation. Rapidly rising Inflation eventually has a deleterious effect on the economy as price increases outstrip the ability of producers to pass them on to the consumer. In response to this concern, the Federal Reserve attempts to cool these inflationary pressures by raising interest rates to reduce the "velocity of money" in the system.

It is in this very basic description of the inflation cycle that we can build a model of the inflation process. If "real" inflation is entering into the economic system, we should see three basic things occurring;

1) commodity prices rising from increased demand for basic components, 2) rising monetary velocity as the demand for credit increases; and, 3) rising wages as a tight labor market leads to higher competition for available jobs. The chart below shows the individual components followed by the composite index as compared to GDP.

The problem is that current there drivers of real economic inflation are barely present. The increase in PCE has primarily been driven by surging oil prices due to geopolitical risks and rising costs of living driven by droughts and cold winter conditions. However, there is little pressure from rising monetary velocity or wage pressure.

I have also notated (vertical blue dashed lines) periods where sharply falling levels of the inflation index have been coincident with either slowdowns in the economy or outright recessions. The current slowdown in economic growth is likely more than just a "weather" related anomaly.

The Federal Reserve is likely considering acting far too quickly to try and "normalize" interest rates at this point as the massive amount of "excess slack" in the labor market remains. The large number of individuals sitting outside of the labor force, or working part-time, keeps wage growth suppressed. The drop in first-time jobless claims is not translating into full-time employment, as I have discussed previously, as it is more reflective of continued "labor hoarding" by employers who are still focused on cost cutting and maintaining profitability. Full-time jobs remain an elusive commodity for a large percentage of the working age population.

A History Of Fed Driven Recessions & Crisis

The problem is that while economic theory suggests that increasing interest rates should be accommodated by the ongoing economic recovery, and simultaneously rising asset prices, this is actually not the case. As the chart of the "Fed Funds Rate" below shows, when the Federal Reserve begins to raise interest rates to "keep the economy from overheating," they have, in fact, been an ingredient to the subsequent economic recession or financial crisis.

The Fed is currently is pushing to convince the financial markets that inflation is coming and that interest rates will rise. However, there is currently little evidence that the economy is running at levels that would generate substantially higher levels of real inflation. The problem is very similar to what faced Alan Greenspan in the late 90's. At that time, Greenspan was convinced that inflation was a threat and that it needed to be dealt with. He then instituted a series of interest rate hikes that eventually became the "pin" that popped the "tech bubble." It is likely that the Fed is once again moving too soon and the resultant outcome will likely not be what is expected by the vast majority of economists and analysts. However, that has always been the case in the past.

In tomorrow's "Thoughts From The Beach," I will discuss the reasons that the Federal Reserve is desperate for you to believe that inflation is coming and why interest rates are about to rise.