"I think I can, I think I can." - from The Little Engine That Could
Now that the dust has settled - somewhat - from last week's Fed statement, I want to discuss what might be some useful takeaways. The first involves what happened, the second considers whatever the Fed thinks it is up to (versus what we think it is up to), and finally, what it all means for us.
We all know that beyond slightly editing its previous statement, the Fed did nothing in its latest meeting. As the world tries to deconstruct this momentous action, the majority of the commentary is filtered through one sort of ideological filter or another - filters that are coincidentally held quite fervently by the commentator. While it's fine to be consistent with one's criticism, and not all of it is simple polemics, much of it is simple polemics, and I leave that fire-breathing to others.
Probably the key sentence to the Fed's latest posture was in Chair Janet Yellen's opening press conference statement that "recent global economic and financial developments are likely to put further downward pressure on inflation in the near term," followed in the next paragraph by the reiteration that the monetary policy committee (FOMC) will increase the Federal funds rate after "further improvement in the labor market" and "is reasonably confident that inflation will move back to its 2 percent objective over the medium term."
Those of us in the market tend to see the Fed in certain ways - doing the only thing possible, afraid of the markets, captives of the Taylor rule. None of the governors is going to drop the kimono to the floor for us, so we are left to speculate. Surely there are good clues to their thinking, though the loudest analysis tends to come from people who know what they want the picture on the puzzle box to be and dismiss what might actually be there as a minor inconsistency.
Of course, I too have my own opinion of what the picture of the economy is and what policy ought to be, but while I cannot be precise about what the Fed thinks the picture is, I can be sure it is not the same picture as mine, or the Fed would have started down the path of normalization long ago.
In recent years, the Federal Reserve has taken to framing its unconventional course in terms of its two-fold mandate to promote employment and monetary stability in a way that is consistent with growth. I have often wondered how much of the time the Fed is essentially punting to the mandate - "We're not really sure what to do, so we're going to keep doing the same thing and say we're just following the mandate" - and how often it uses the mandate as a kind of protective veneer over its (in)actions. In August 2011, for example, it looked as if an alarmed Ben Bernanke, lacking any credible inflation remit, used the Fed's other mandate of promoting employment as a cover for instituting quantitative easing (QE). At the time, it looked as if the still-nascent recovery might stumble into a double-dip, and the markets had stumbled badly after the S&P credit downgrade to the US. Since that time, the bank has consistently alluded to its employment mandate as justification both for additional QE programs and for maintaining its near-zero interest rate policy (ZIRP).
The unemployment rate is now 5.1% - a level slightly below what was stated a few years ago as the threshold for initiating normalization. Though the governors have duly shifted their definition of full employment from just north of 5% to somewhere a bit lower (4.9% seems to be in vogue), with Ms. Yellen and the Fed making frequent references to the true slack in the labor market, clearly the employment mandate has lost any urgency it once had. Ergo, it is time to punt to the inflation mandate.
In its last meeting, the Federal Reserve referred to deflationary pressures from abroad, with Ms. Yellen repeating the emphasis in her press statement. She then followed it up in further detail last night with a speech at the campus of the University of Massachusetts at Amherst - a speech which I attended (and which had a somewhat dramatic finish - Yellen struggled to finish the speech, interspersing rambling repetitions after awkwardly long pauses, and giving the impression that she was on the verge of collapse. I was relieved to see her walk off the stage on her own).
In her speech, Yellen gave some time to the dangers of deflation, but laid it squarely at the feet of a rising dollar and falling energy prices (why inflation did not behave similarly when oil was at $10-15 in the 1990s was left unexplained). From the Fed's point of view, the latest indecision may therefore have seemed straightforward - yuan devaluation; the mandate says price stability, we therefore have to wait for the world to digest these currency moves. Then, we will move. Indeed, towards the end, Yellen strongly reinforced the idea that the committee anticipated a rate raise before year-end - a posture consistent with the FOMC's recent pattern of leaning one way in the statement and then leaning back the other way immediately afterwards in the speeches from assorted governors. Perhaps that is what it thinks of as implementing neutral policy.
But Yellen also referred to the "solid" outlook for the US economy in her speech. Really? Here is a look at the latest industrial production:
It's difficult to lay all of the downward slope at the feet of the rising dollar and falling energy. Those factors are surely playing roles and are surely transitory in nature, but everything in the economy is transitory, including recoveries and recessions. The last cycle ended eight years ago this quarter, and while it's not a mathematical rule, eight years is about the limit for a cycle. Industrial production can oscillate for special factors, as it did in 2013, but it's reckless to dismiss a picture like the above in the eighth year of the cycle. Business cap-ex spending has had negative comps every month this year, and my article last week showed how the growth in retail spending has also been steadily descending.
The Fed's public forecasts and projections haven't anticipated the end of any cycle for as long as it's been in the business of making forecasts. It's understandable that the Fed might not ever want to publicly predict recession - it probably shouldn't, as an institutional rule - but only Paul Volcker in the 1980-1982 recession seems to have not been genuinely caught by surprise by the end of the business cycle (it was also the last time the Fed truly caused a recession).
So, although it looks to me - in a rather infuriating way - as if the Fed's mincing back and forth is the equivalent of trying to thread a needle with an ocean liner, it may well appear to the Fed's governors as if they are behaving perfectly consistently with their mandate. Bad winter? No rate raise. Good second quarter? Think about a raise. Whiff of deflation? Let's hold off again. We really could if we wanted to, though, so don't get any ideas. Unless, of course, the data tells us otherwise, as Yellen re-emphasized in her speech, and has so often repeated in recent months (which sounds a lot like, "So don't blame us").
So, what does it all mean for the outlook for the market? At this point, I believe it to be a strong possibility that the Fed never raises rates at all in this cycle. The central bank is badly positioned for recession, as the Fed staff has been saying in recent statements, and as Yellen herself reiterated in her speech, and I don't doubt it would like to get off the zero bound for that reason. It may also hope that somehow a rate increase might revive a whiff of inflation. While some maintain, as they do at the end of every cycle, that recession is (always) "at least a couple of years away," the data strongly suggest otherwise. Last week, I wrote that the fat lady of employment hadn't sung yet, and she still hasn't, but my analysis strongly suggests that this is the last quarter before it, too, begins to roll over. If the Fed follows last year's script of waiting until December, it may find itself confronted anew with data that says, "no raise."
Yellen addressed that possibility in her speech, saying that the bank could institute negative rates that would essentially be the negative inverse of the inflation rate, presumably about minus one percent, as well as bring back QE, for which parts of the stock market are already beginning to pine. And why not, as stocks essentially stopped rising after the program ended last October. However, a stock market with QE plus profit growth is very different from a stock market with QE and profit contraction.
It may be, despite the Fed's dismal track record, that the governors have varying degrees of awareness that the business cycle is near an end (though one would not guess as much from Yellen's remark that the bank intends to raise rates gradually over the next few years, implying the longest expansion in modern history). If so, it may also be that part of the Fed's caution is due to not wanting to get the blame for the end of the cycle, especially entering an election year.
It's an interesting thought, and there will probably be political repercussions down the road, but for now I would say this - the battle over the receding possibility of a nudge to the funds rate is more of a trader's sideshow than any decisive turning point for the economy. The business cycle is going to end, as it always does, with or without the Fed. The central bank may indeed be better off not raising rates ever, and so, not being tagged as the scapegoat, but the cycle is a natural part of our economic system and needs no party to be found guilty and held accountable. Of course, we'll do that anyway, but you should not distract yourself with the constant micro-noise of the daily din over a possible move from almost-zero to near-zero in the Federal funds rate. Focus on the cycle, the zero-to-negative S&P 500 profit growth, and prepare for that instead.
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.