Fed Chairman Powell Suggests Gradual Rate Hikes Are Needed

Summary

• Fed Chairman Powell recently informed Congress gradual rate hikes could be needed to keep the economy from overheating.
• The Fed would also like PCE to reach 2 percent for a sustained period before hiking rates.
• Investors should avoid financial markets until the impact of the Fed's balance sheet unwind and potential rate hikes become more clear.

Federal Reserve Chairman Jerome Powell

Last week Federal Reserve Chairman Jerome Powell submitted his semiannual monetary policy report to Congress. Mr. Powell convinced Congress the economy was not overheating, yet voiced there was still a need for gradual rate hikes. Financial markets were volatile on the strength of his comments. For the week the Dow Jones (DIA), S&P 500 (SPY) and the Nasdaq (QQQ) finished down 3%, 3%, and 2%, respectively. Below are highlights from Chairman Powell's comments and my interpretation.

Strong Jobs Growth

Chairman Powell

The U.S. economy grew at a solid pace over the second half of 2017 and into this year. Monthly job gains averaged 179,000 from July through December, and payrolls rose an additional 200,000 in January. This pace of job growth was sufficient to push the unemployment rate down to 4.1 percent, about 3/4 percentage point lower than a year earlier and the lowest level since December 2000. In addition, the labor force participation rate remained roughly unchanged, on net, as it has for the past several years--that is a sign of job market strength, given that retiring baby boomers are putting downward pressure on the participation rate. Strong job gains in recent years have led to widespread reductions in unemployment across the income spectrum and for all major demographic groups.

My Interpretation

The 200,000 jobs added in January confirmed the economy is at a fever pitch. It also appears to confirm that the Federal Reserve has done its job over the past decade by helping to create a wealth effect in stocks and keeping interest rates at record low levels. Construction, leisure & hospitality were particularly strong. Construction could stall in a rising interest rate environment. Leisure and hospitality could connote that jobs serving the wealthy - big beneficiaries of the Fed's wealth effect - are areas of growth.

A 4.1 percent unemployment rate suggests the economy is at or above full-employment and at risk of overheating. Powell's reference to the labor force participation rate was also telling. January's labor force participation rate of 62.7 percent has been flat over the past four years. Prior to that it had not been this consistently low since the late 1970s when President Carter was in office. If retiring baby boomers have hurt the metric then the low labor participation rate could potentially improve over time.

Moderate Wage Growth

Chairman Powell

Wages have continued to grow moderately, with a modest acceleration in some measures, although the extent of the pickup likely has been damped in part by the weak pace of productivity growth in recent years.

My Interpretation

Hourly wages in January 2017 were up 2.9% Y/Y. It was the fastest pace of wage growth since 2009 and topped forecasts of 2.7%. Fearing the Fed would use wage growth as a reason to hike rates, financial markets sold off after the February jobs report was released. The Dow Jones fell by 8% in early February. Fears that the Fed could get behind the curve if it waited too long to raise rates drove chatter of three or four rate hikes in 2018. The fact that Powell described wage growth as "moderate" could imply the Fed is more focused on personal consumption expenditures ("PCE") as the major catalyst to either hike rates or stay the course.

Gradual Rate Hikes

Chairman Powell

In gauging the appropriate path for monetary policy over the next few years, the FOMC will continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2 percent on a sustained basis ... In the FOMC's view, further gradual increases in the federal funds rate will best promote attainment of both of our objectives. As always, the path of monetary policy will depend on the economic outlook as informed by incoming data.

My Interpretation

Chairman Powell wants to avoid an overheating economy. If record low interest rates for nearly a decade are working then they should able to stimulate the economy. The low unemployment rate and pick up in wage growth suggest the economy is picking up. President Trump's tax cut could potentially be a tailwind if corporations share their boon in cash flows with workers. From that perspective gradual rate hikes would be warranted, lest the Fed risks falling behind the inflation curve.

However, Powell also wants to bring PCE to 2 percent on a sustained basis. PCE was 1.7% in 2017 and has not reached 2 percent since Ben Bernanke was Fed Chairman. The caveat appears to be that Powell is prepared to hike rates, but only if PCE reaches or exceeds 2 percent for a few quarters. I will believe it when I see it.

Conclusion

Fed Chairman Powell defined his goal of using Fed policy to achieve 2 percent inflation. Even if PCE does not reach 2 percent financial markets should be concerned that the Fed may no longer accommodate the markets at all cost. The punch bowl could get taken away by rate hikes or the gradual unwind of the Fed's $4 trillion balance sheet. Neither bodes well for financial markets. Investors should avoid the markets until the impact of global central banks' balance sheet reductions become more clear.

Analyst’s 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. I have no business relationship with any company whose stock is mentioned in this article.

Comments

[wald22]

Increased debt on all government levels is crowding out the private market. For most people living off of credit cards has become a lot more costly. So have loans for used houses under $100,000. The reason for this is because bundling those loans has become a lot more riskier. Higher yield is needed to compensate for that risk.

The real problem here is that banks don't lend money, they lend credit made out of thin air used as money. Borrowers need to be smart enough to take that credit they borrowed and force the bank they borrowed it from to turn it into cash before spending it. That forces them to go to the Fed and get the cash.

Borrowers need to better educate themselves and learn to create your own credit out of thin air, lend it to yourself and make the payments to yourself. That way the first payment will make the second payment and so on. To be smart enough not to make a slave out of yourself takes a little effort and knowhow. Financialization is destroying this country because most of us don't understand it. Learn to use it to help yourself to benefit yourself instead of making a slave out of yourself. There is no dignity in being a debt slave. There is a reason why most public placements come into being on the short side. Understand it.

[drdcwright2576]

The banks borrow money. Loans to consumer at 19% or more for credit card. Charge min payment customer never pays off debt. Fed raising rates makes customer enable to pay. Then customer goes bankrupt.

[drdcwright2576]

The Fed raising rates. Trump tariffs. The government pulls this bull every time we start to get ahead as working class.

[Colorado Steve]

We need to focus on getting the PCE to 2% first! . The Fed has been trying for 9 years. Investors are foolish to believe all this overheating economy- runaway inflation nonsense. As always, watch the long bond. If bond traders were worried about inflation they wouldn’t be buying 10-20-30 year treasuries. The long bond trader is betting on lower 10 year yields in a year or two.

[Joe China Puppet]

Fed has itself in a bind. QE (balance sheet) is so big they'll have to turn the balance sheet reduction into an on/off mechanism depending on where the economy is going, same as interest rates. Easy in, tough getting out of QE.

[wald22]

Chairman Powell fears that inflation is set to rise and knows interest rates will follow inflation no matter what he does. Thus he wants to raise rates 750 basis points before 2018 ends. So far I agree with him. But the problem is that the stock market does not make the economy. There is a disconnect between Wall Street and Main Street. On the last financial crisis, the FED bailed out the banks instead of the homeowners, and that was a mistake. The FED should have bailed out the homeowners by giving every homeowner and want to be home owner $10,000 worth of credit that we use as money that either has to be used for buying a home or make a $10,000 payment on the home, which would have went a long way to bail out the banks who caused the problem in the first place. This would have given Main Street a shot in the arm it needed to support the Main Street economy instead of the Wall Street economy. QE was used to bail out the Wall Street economy at the expense of placing debt on present and yet to be born population, most who are or will be stuck in the Main Street economy. We keep bailing out the Wall Street crooks at the expense of Main Street to a point where Main Street has lost its ability to maintain itself. Now we are borrowing just to do that.

[Spicy Cajun]

I understand what he is saying, but it still doesn't make any sense because investors still aren't sure what he plans to do. Does that make sense to everyone?

[Iron Hamster]

Janet Yellen told us we would have four rate increases, and she gave us one. I think the Fed will talk tough and do little.

[Shock Exchange]

Spicy Cajun,

The Shock Exchange will believe in rate hikes only when he sees them. Powell is just saber rattling.

SE