The Fed's Monetary Policy Is Becoming Unsuitable, Even President Trump Realized It

Summary

• The Fed’s policy of rising interest rates is not shared by other main central banks worldwide.
• The Fed’s intent is not clear: the US core inflation is not worrisome and the unemployment rate is lower than it may look at first sight.
• The results achieved by the Feds in the last 3 years are not thrilling: A flattening yield curve and a general uncertainty about the current stage of the US cycle.
• Moreover, the Fed’s policy works against the Trump’s administration goal of reducing the US trade unbalance, as it intrinsically boosts the US dollar.
• Further developments are not easy to forecast, but a change in the monetary policy is likely to happen during the medium term.

Nearly 10 years have passed since Ben Bernanke, former chairman of the Federal Reserve, launched the first Quantitative Easing to help US banks get rid of hundreds of billions in bad loans that were inexorably sinking them.

This move was equivalent to a classical "All-In" (speaking in poker terms) and was met with both criticism and support at the same time.

In hindsight, we can now say that Mr. Bernanke was right. His monetary policy helped solve the worst financial crisis US had faced since the Great Depression and put the first world economy back on the path of stability and growth.

However, over time, more and more voices were raised to warn that an overly accommodative monetary policy could trigger excesses similar to those that had produced the 2008 crisis.

Moreover, the party of the so-called rentiers, irritated by the fact that their safe T-bonds produce increasingly lower returns, has always been very influential in the United States.

Then, Bernanke's successor, Janet Yellen, gradually reduced Fed security purchase programs during her term, to the point of introducing a first wave of increase in interest rates.

With the 2016 White House (and US congress) political change, those in favor of T-bonds with higher yields were pleased with an American Central Bank board much more oriented towards a monetary tightening.

The new Fed Chairman, Jerome Powell, raised the target range for the Federal funds rate up to 2% and set the path for other two hikes before the end of the year. When Mr. Powell assumed office as Chairman of the Federal Reserve Board last February, the Federal funds rate was 1.5%.

Why the Fed should stop its tightening policy

The Fed's mandate has two well-known goals: Price stability and maximum level of employment. Is US inflation accelerating above guard level? Not exactly.

Source: Trading Economics

As we can see, during the last 5 years, the US core inflation has ranged between 1.6% and 2.3%. The last survey was carried out around the time inflation was at its highest point, as it had been for 3 times between 2016 and 2017, before falling back to 1.7 points. Therefore, it is too early to talk about a dramatic price hike.

More importantly, the 10-year T-bond yield today is around 3%, a sign that they are not expecting inflation to rise in the long run.

Three years of increases (seven consecutive ones so far), which brought the benchmark rate from 0% to 2%, have produced an increase of about 50 basis points to the 10-year T-bond yield and of only 20 basis points to the 30-year T-bond yield.

Basically, so far, the Fed's policy has caused nothing but a flattening of the US interest rate curve.

Source: U.S. Department of the Treasury - Author's elaboration

Perhaps the Federal Reserve knows something that financial operators do not know at the moment, because, in the long run, nobody expects US inflation to go much higher than the current level.

In any case, a general market uncertainty and anxiety were evident during the course of last year.

The American index (NYSEARCA:SPY) has gained about 4% since the beginning of the year, but has undergone sudden and deep retracements at least 3 times, the most dramatic above 5%. Now it is below the highest levels reached at the end of January.

Source: Yahoo Finance

This is nothing exceptional in a long-term perspective, but certainly enough to give voice to those who have been thinking for years that the current bull market has lasted too long.

As far as the level of unemployment is concerned, just to be clear, there are several indicators that measure the degree of unemployment.

Source: US Bureau of Labor Statistics

As we can see, both the official unemployment rate U-3 and all the other benchmarks are at their minimum levels in the last 20 years at least. However, the labor force participation rate is still below 2008 levels.

Source: Trading Economics

Therefore, the picture is not completely clear. Surely, there is not enough evidence that we are experiencing a total absence of unemployment in the US.

However, the Fed's monetary policy, different from other central banks' policies, has led to the following situation when it comes to international government bonds yields:

Source: Author's elaboration

All this is happening in the midst of growing international tension and a somewhat outspoken trade war.

Fed policy and Trump administration are on a collision course

No administration is happy to see its central bank become less and less accommodating during its mandate. After all, there will be less room for deficit spending if the cost of public debt goes up.

However, the situation is certainly more complex. One of Donald Trump's strong points has been the narrowing of the US trade deficit since his presidential campaign.

The simple idea behind it is that if fewer foreign goods enter the United States, the same products will have to be manufactured in the US, which would boost the country's job creation.

There are clearly other ways to try to achieve this, but Trump is going down the most politically incorrect path, by calling into question international trade agreements and imposing duties and tariffs on certain imported goods. This road is bumpy, because international partners are now turning into competitors who have no intention of standing on the sidelines.

One example is the recent introduction of China's duties against soy imports.

The move is directly aimed at hitting the US administration. In fact, it will likely damage soybean producers from the Midwest, an area that strongly supports President Trump and that is crucial for his chances of re-election. They export one third of their entire crop to China: about 14 billion dollars.

There would be a classier (and probably more effective) way to reduce the US trade gap, by using monetary policy.

Unfortunately, we can rule out this possibility due to the Fed's policy, which is essentially implementing a monetary tightening.

In fact, the higher the US rates, the stronger the US currency, which is frustrating the commercial strategies of the current administration.

Indeed, with such a big yield gap between T-bonds and other major global government bonds, the Fed is effectively providing an opportunity that institutional investors will seize sooner or later.

In fact, in a scenario of international trade warfare and protectionism, is it unreasonable to think that central banks worldwide are going to stock up on American government bonds causing an increase in the price of the dollar?

President Trump is a low interest rate guy

Before becoming president, Mr. Trump had repeatedly accused the American Central Bank to act politically by speciously keeping the interest rate low.

Now his opinion seems to have changed.

The point is that now, more than ever, the American administration needs to weaken the dollar.

"I don't like all of this work that we're putting into the economy and then I see rates going up." D. J. Trump

He can't be happy with seeing the dollar go up either, after all the effort being put against US commercial competitors

And, actually, the dollar looks quite weak today, if we consider all the things that are currently going on.

Bottom Line

Personally, I am not keen to consider Trump's recent criticisms of the Fed's monetary policy as a temporary tantrum.

The US administration simply cannot afford an economic slowdown in the next year, nor a strengthening of the dollar, and will do everything to avoid both: Including moral suasion of the Fed's board.

After all, the president of the United States appoints the entire board of the Federal Reserve, even though his picks must be confirmed by the Senate.

In light of these premises, the much-vaunted independence of the central bank appears to be a pipe dream, especially with a centralizing and hyper-decision-making personality like D. Trump's.

Those who are betting on a gradual weakening of the US bond market (NYSEARCA: TLT) due to a more restrictive monetary policy, together with a weakening of the stock market, should carefully consider this scenario.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Lance Brofman]

Many securities analysts have the same logic as you, see below"

"..As to the key question of how much overinvestment is taking place now, some information can be gleaned by listening to equity analysts. Professional equity analysts seek to determine which of the public companies they follow are good investments and which are poor investments. Lately, I have noticed many more equity analysts are focusing on what they consider "shareholder-friendly" companies, which they recommend, as compared to companies they consider not to be shareholder-friendly that they suggest investors avoid.

The main criteria by which many equity analysts now consider when separating the shareholder-friendly companies from those that are not so, involves capital allocation. The equity analysts are recommending companies that they determine demonstrate what they term as prudent use of capital, usually referred to as practicing discipline in capital allocation.

Equity analysts are quite clear as to how a shareholder-friendly public company with a disciplined capital policy behaves. The equity analysts recommend the purchase of shares in companies that choose to spend money more on dividends and share buybacks as opposed to allocating capital to investments that increase capacity, such as business fixed investment. Some analysts say: they are sick and tired of seeing too many public companies taking the money and putting it into capital investments with no return.
There is no way to quantify just from the comments by equity analysts, how many companies are shareholder-friendly in terms of exercising discipline in capital allocation, or are not shareholder-friendly in their view. Clearly, there are some public companies whose capital allocation is not to the equity analysts' liking.

What the equity analysts consider an imprudent use of capital, is essentially what I refer to as overinvestment when I said that overinvestment caused by a tax policy that shifts the tax burden away from the wealthy, who have a higher marginal propensity to save and invest and onto the non-rich who have a much higher marginal propensity to consume is the primary driver of the modern business cycle.

What the equity analysts call imprudent use of capital and I call overinvestment, tends to increase as the business cycle progresses from the recovery phase to the expansionary phase. Thus, corporate management was unlikely to engage in overinvestment at the trough of the current cycle in 2009.

However, as the expansion lengthens, overinvestment and lack of discipline in capital allocation would tend to be more prevalent. It's likely that the question of the prospects of a recession in the next five years is more a question of when, rather than if. Unfortunately, for economic forecasters, it appears that the range of probable economic outcomes is now diverging rather than converging.

There are various risks that could impact the securities markets and interest rates in particular. These are policy risks that have arisen as a result of the 2016 election. In a March 2017 article: Investing In The Era Of Trump - Do Bad Economic Outcomes Necessarily Mean Bad Investment Outcomes?, seekingalpha.com/... I discussed various potential risks that unfortunate policy choices by the Trump Administration could pose to the financial markets..."
seekingalpha.com/...

[Lance Brofman]

"..In free-market capitalism, capital generates income for the owners of the capital which in turn is used to create additional capital. This is very good. Sometimes, it can be actually too good. As capital continues to accumulate, its owners find it more and more difficult to deploy it efficiently. The business sector generally must interact with the household sector by selling goods and services or lending to them. When capital accumulates too rapidly, the productive capacity of the business sector can outpace the ability of the household sector to absorb the increasing production.

The capitalists, or if you prefer, job creators use their increasing wealth and income to reinvest, thus increasing the productive capacity of the business they own. They also lend their accumulated wealth to other business as well as other entities after they have exhausted opportunities within business they own. As they seek to deploy ever more capital, excess factories, housing and shopping centers are built and more and more dubious loans are made. This is overinvestment.

As one banker described the events leading up to 2008 – First the banks lent all they could to those who could pay them back and then they started to lend to those could not pay them back. As cash poured into banks in ever increasing amounts, caution was thrown to the wind. For a while consumers can use credit to buy more goods and services than their incomes can sustain. Ultimately, the overinvestment results in a financial crisis that causes unemployment, reductions in factory utilization and bankruptcies, all of which reduce the value of investments.

If the economy was suffering from accumulated chronic underinvestment, shifting income from the non-rich to the rich would make sense. Underinvestment would mean there was a shortage of shopping centers, hotels, housing and factories were operating at 100% of capacity but still not able to produce as many cars and other goods as people needed. It might not seem fair, but the quickest way to build up capital is to take income away from the middle class who have a high propensity to consume and give to the rich who have a propensity to save (and invest). Except for periods in the 1950s and 1960s and possibly the 1990s when tax rates on the rich just happened to be high enough to prevent overinvestment, the economy has generally suffered from periodic overinvestment cycles.

It's not just a coincidence that tax cuts for the rich have preceded both the 1929 and 2007 depressions. The Revenue acts of 1926 and 1928 worked exactly as the Republican Congresses that pushed them through promised. The dramatic reductions in taxes on the upper income brackets and estates of the wealthy did indeed result in increases in savings and investment. However, over-investment (by 1929 there were over 600 automobile manufacturing companies in the US) caused the depression that made the rich, and most everyone else, ultimately much poorer.

Since 1969 there has been a tremendous shift in the tax burdens away from the rich on onto the middle class. Corporate income tax receipts, whose incidence falls entirely on the owners of corporations, were 4% of GDP then and are now less than 1%. During that same period, payroll tax rates as percent of GDP have increased dramatically. The overinvestment problem caused by the reduction in taxes on the wealthy is exacerbated by the increased tax burden on the middle class. While overinvestment creates more factories, housing and shopping centers - higher payroll taxes reduces the purchasing power of middle-class consumers. ..." seekingalpha.com/...

If anything, the case for an overinvestment-induced recession has increased in the five years since that article was written. The timing of such a recession is a key question for those with shorter-term investment horizons. For those with a five-year or longer holding period, maybe not as much. In any case it's always good to remember, as Keynes famously said: "The market can stay irrational longer than you can stay solvent."

An additional source of uncertainty is the labor market. An acceleration in wage growth would certainly increase the prospects of tightening by the Federal Reserve. There are reasons to believe that the 4% unemployment rate may not be an accurate indicator of tightness in the labor markets. As was pointed out in the article, Disability's Disabling Impact On The Labor Market, seekingalpha.com/... labor force participation has behaved cyclically in the midst of a slightly declining trend. Dubious and fraudulent disability claims have vastly increased the number of those collecting disability, with commensurate decreases in labor force participation and the unemployment rate. A segment on CBS, "60 Minutes" quoted employees of the Social Security Administration and administrative law judges who asserted that lawyers are recruiting millions of people to make fraudulent disability claims. One such judge said, "if the American public knew what was going on in our system, half would be outraged and the other half would apply for benefits."..."
seekingalpha.com/...

[David de los Ángeles Buendía]

Mr. Brofman,

You wrote:”The capitalists, or if you prefer, job creators use their increasing wealth and income to reinvest, thus increasing the productive capacity of the business they own.”

This is only true if more profits can be obtained, otherwise the capitalist will not reinvest. Were I to own a petrol station which was open 24/7, would need 21 8 hour shifts a week. I would need about five, perhaps six, employees to cover everything, including sick time. If I sell 1,000,000 gallons per week at 4.00 USD/g, then my weekly gross income is 4 MUSD. However I am purchasing the petrol at 3.90 USD/g so I have only have only earned 100,000 USD that week. If I now subtract wages of my six employees who each work a 40 hour shift at 10 USD/hr that is 2,400 USD less or 97,600 USD. There are other expenses like electricity, workers compensation, and so forth so let us say the net business profit for the week is 90,000 USD, let us say 20,000 USD which would give me an annual income of just over 1 MUSD.

If I hire more employees, will I sell more petrol? No but my profits will fall my costs have increased. If I install more pumps will I sell more petrol? It depends, is there unrealized sales, does demand for petrol exceed supply? If so then it might make sense to invest more. However if automobiles are not queued up outside my station, then no. Reinvestment of profits is not automatic, it only occurs when there are unrealized sales and profits to be had.

[AlexTheCat3741]

"The move is directly aimed at hitting the US administration. In fact, it will likely damage soybean producers from the Midwest, an area that strongly supports President Trump and that is crucial for his chances of re-election. They export one third of their entire crop to China: about 14 billion dollars."

Without question, you are correct. With the one Party Communist Country of China that just made Xi Jinpin "President for Life", the Chicoms don't have to worry about external manipulations of their elections when making their decisions.

But we've got to stop the hemorrhanging of our wealth and our jobs, and as you say, perhaps using monetary policy may be preferable.

[Josh MacKenzie]

Negative rates and quantitative easing forever? Normalcy is the only way forward. The unconventional monetary policy of the last decade was always predicated on EVENTUALLY a return to normal.

Devaluing the currency to gain the upper hand regarding international trade and economic production leads to the same result as the trade war. It actually might be worse because if populations lose confidence in the consumption power of their fiat currencies... that is not where you want to end up.

[drftr]

But could it be that we may need everlasting mild QE to stay on the same level and not end up in a deflational spiral? The US may/will go the same way as Japan and Europe. Buy investment grade corporate bonds, then equities. Great scenario for investors. Until the bubble bursts. But that really could be 5-10 years out or even much longer. It's simply a new phase to keep capatalism going and everone is in the same boat.

drftr

[David de los Ángeles Buendía]

Mr. MacKenzie,

It may be that this is “normal”.

[Gio Danisi]

Actually the analysis is intended to speak about relative terms and not absolute.
No matter if we think that raising cost of money is right or not in this moment, the point is that Fed is doing it and other central banks are not.
This is leading to a ridicolous comparing valuation of T-bond that pays more than Italian or Portuguese Gov. bonds.
This will eventually hurt American trade balance severly, so the question is: will Mr. Trump sit and watch all this happening passively?

[David de los Ángeles Buendía]

Mr. Danisi,

The Federal Reserve Bank (FRB) is not increasing short term interest rates in a vacuum. The FRB used to set Effective Federal Funds Rate (EFFR) through Open Market Operations (OMO), the buying and selling of government backed securities. That however has changed. The FRB began paying banks interest on their reserves (IOR) held at the FRB. FRB members lend each other reserves. The EFFR is the interest rate that member banks of the FRB pay each other for borrowing or lending reserves. No bank will anyone money at a rate lower than the interest that it can earn by depositing that same money in the FRB. The floor on ceiling on the EFFR is set by the Discount Rate (DR), the interest rate that the FRB charges banks for emergency liquidity. No bank will lend other banks reserves at rates higher than the Discount Rate because banks can go to the FRB at get those reserve from the Discount Window at the Discount Rate. So that seems all sealed up, the FRB sets the IOR and the DR and the EFFR sits primly between them. OMO is largely irrelevant.

However, it is important to note that many banks are not members of the FRB. These banks also lend each other reserves as well. This called the Overnight Bank Funding Rate (OBFR). In principle the EFFR should be the same as the OBFR with the EFFR guiding the OBFR. However if the demand for reserves exceed the supply outside of the FRB system, the OBFR will exceed the EFFR and the DR. This upsets the FRB’s applecart. Reserves would flow out of the FRB system if that were to occur. This would defeat the purpose offering IOR.

Banks also have the option of keeping the liquidity in other short term interest bearing venues. A bank could keep some of its reserves in One Month United States Treasury (UST) Bills which pay interest rate (DGS1MO). If the One Month UST Bill pays more than the EFFR, DR, or OBFR, banks will move more of their reserves there. Not surprisingly, these three interest rates track each other closely. In fact, if one examines the data carefully, the DGS1MO Generally rises and falls before the EFFR or the OBFR, it tends to be the leading metric.

The DGS1MO and OBFR have been rising [1]. Market forces, demand for reserves, is increasing so short term interest rates are also rising. The FRB has no choice but to increase the IOR, DR, and the EFFR. However long term interest rates are little affected[2].

I believe that you have confused interest rates with the tightness of credit markets. Dr. Milton Friedman once noted: "I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."[3].

To illustrate this point I would draw your attention to the conditions in late 2008 when interest rates were very low but liquidity was very low and the market was very tight, it was difficult to borrow.

In any event, the market does not appear to be tightening (edited). In the "April 2018 Senior Loan Officer Opinion Survey on Bank Lending Practices"[4] indicate that the market, despite “tightening” by the FRB, has actually loosened. The FRB reports “Regarding loans to businesses, respondents to the April survey indicated that, on balance, they eased their standards and terms on commercial and industrial (C&I) loans to large and middle-market firms and left their standards unchanged for small firms.” So despite higher interest rates on overnight loans of bank reserves, loans are easier to obtain. Indeed the total volume of bank loans continues to rise [5].

The bottom line is that short term interest rates are rising irrespective of the desires or actions of the FRB or Mr. Trump. The only question is will the FRB accommodate them or let reserves flow out of the FRB system.

[1] fred.stlouisfed.org/...

[2] fred.stlouisfed.org/...

[3] http://hvr.co/1IiPBCw

[4] www.federalreserve.gov/...

[5] fred.stlouisfed.org/...