I Dare The Fed To Raise Interest Rates

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Summary

All of the criteria for a rate increase have been met, but the Fed won't budge.

This is because stellar financial market performance is really a monetary mirage that doesn't reflect the reality on the ground.

So the Fed will articulate excuses for staying the course, as market prices and economic fundamentals continue to diverge.

All of the criteria have been met for an increase in interest rates. The government's statistics on employment reflect a vibrant economy. At the same time, the Fed's preferred measure of inflation, otherwise known as the core rate of personal consumption expenditures, is conveniently approaching its target of 2%. The Fed tells us that the US economic recovery is on a firm foundation and well positioned to strengthen in 2017. Furthermore, all of this good fortune has seemingly been confirmed by new all-time highs for the stock market, as measured by the S&P 500 index (NYSEARCA:SPY). All that is missing from this Goldilocks scenario is another rate hike by the Federal Reserve to coronate its masterpiece.

Of course, we all know that the Fed will not raise interest rates. It will figure out a way to modestly upgrade its view of what is really economic malaise, while at the same time warning about the potential threats from global economic uncertainty, which of course is a constant. Why? Because its only real accomplishment has been to boost significantly the value of financial asset prices, giving the impression that the economy is far more vibrant than is the reality on the ground. Raising interest rates runs the risk of unraveling the steady melt up in markets and destroying this monetary mirage.

What substantiates my assertion is the sentiment that reverberates in the days prior to every Fed meeting. Investors speculate on when the next interest rate increase may occur in the Fed funds futures market, which continually pushes out the likelihood of a near-term hike. Just prior to each meeting the market's primary concern is that "any indication that the Fed may hike sooner than anticipated could rattle investors." This has been the norm ever since the Fed ended its bond-buying programs in late 2014. This makes absolutely no sense.

It implies that investors would rather have monetary conditions consistent with an economy that is on life support rather than modestly tighter conditions that would reflect a strengthening economy and improving fundamentals. In between Fed meetings we see the same perverse psychology when markets react to disappointing economic data. This morning's dismal durable goods report is a perfect example. Market ignore the reality and grind higher.

This growing disparity between economic fundamentals and the financial market prices that are supposed to reflect these fundamentals is the typical pattern of the boom and bust cycles we have seen in the past. This difference today is that this disparity is being propagated by the Federal Reserve.

I don't believe the Fed can, or will, raise interest rates for the foreseeable future. Certainly not in 2016. One clue as to when the Fed may do so could be found in a change in the level of excess reserves in the banking system in the weeks leading up to the hike. In the weeks prior to the December rate hike we saw a significant decline in excess reserves, but the amount has remained fairly stable since then. This figure is updated twice a month, so the data is only available through July 13, as can be seen below.

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If there were an opportunity for the Fed to begin the process of normalizing interest rate policy and raising short-term interest rates, it has come and gone. In my view, that train left the station more than a year ago when the annualized rate of economic growth was running close to 3%, and the labor market indicators were continuing to strengthen rather than weaken, as they are now.

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So expect to hear more drivel from the Fed about how the economy is doing much better than reality dictates. Yet there remain concerns, which there will always be, that prevent the Fed from withdrawing the crisis-level stimulus that has been in place for close to a decade. I seriously doubt that the Fed is willing to call its own bluff and raise interest rates. I would welcome it. Go ahead Janet, I dare you to raise interest rates.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.