Mission Impossible 5: Rate Hike

Put this shot on the list of things more likely to hit its target than the Fed’s inflation expectations.

Janet Yellen has a better chance playing Ethan Hunt in the next mission impossible film than she does successfully raising rates without disaster. As the days go by and central bank after central bank eases monetary policy even further the prospects of a rate hike dims. The currency wars are full on now as countries try to export deflation and import inflation and yet the Fed is going to try and buck the trend. It’s confusing to me and it’s confusing to the market which believes a rate hike is more likely to occur at the end of the year.

I’ve been trying to make sense of a decision that on the surface following the Fed’s (and I’m using this word very lightly here) “logic” they shouldn’t raise rates. I specifically remember being reassured by a Fed president that if inflation gets too high he only needs 10 minutes to beat it back down. So why raise rates? The Fed hasn’t achieved 2% inflation yet. It stopped printing money before the goal was ever achieved and now it’s tightening monetary policy even further as inflation expectations continue to fall. The Fed was close to its 2% inflation target why not wait till they hit it and then worry if there is too much. Did Jason the Argonaut toss his sword away just before he got to the Minotaur? Did Achilles throw away the Hephaestus’ shield before his duel with Hector? Did David throw away his sling before he fought the Goliath? No. Of course not. So why the Hell is the Fed tightening into a deflationary environment!? It seems almost every central banker in the world is trying to get his or her hands on the secret elixir that is inflation. But here the Fed is tossing it away like it’s a love potion from Bill Cosby.

On the surface, it appears the Fed once again is overestimating the strength of the US economy. Bernanke a “student” of the depression knows very well how devastating an artificially strong currency can be during times of a currency war. And yet this is exactly what the Fed is risking with a June/July rate hike.

Already the USD has strengthened to a point where it is affecting American companies. Proctor and Gamble as well as Microsoft are some of the big name companies to suggest the strong dollar is providing a headwind for growth. Growth that the world economy is depending on to sustain itself through these lean times.  Remember the Fed hasn’t even hiked interest rates yet. Imagine what would happen if they did. And that’s the point…

Four months from now, will the Fed be armed with enough data to support a rate hike? It certainly doesn’t look likely, which is why the market believes a Fed rate hike won’t occur till late in the year, but perhaps the market falls victim to the belief that five extra months will make all the difference. The dominant force in the world isn’t inflation right now. It’s deflation. So given even more time, which is most likely to win out? Most likely, deflationary forces will force the Fed into an awkward position come June.

This brings up a potential answer to the question “why hike rates?”. Simply put, if the Fed waits too long they won’t have enough data support a rate hike. Then when the next crash comes the Fed won’t have enough ammunition. It’s important to remember these people are academics. They don’t run businesses or take risks. They take the easy way out. Which is what I think they are trying to do now. Is that a real fear? Not having ammunition? I don’t know if this is actually a real argument or not. But imagine if we do go into a recession with the fed funds rate at zero. What do they do? Do they go negative like Europe?

Perhaps there is a misunderstanding of where the world economy is at the moment compared to where it was nine years ago when they last hiked rates. Back in 2004, the demographics of the developed world were RISING towards their respective peaks. But now the demographic trends are stacking up against the developed world. As the population ages and the young remain depressed, unemployed, and underemployed we won’t see any growth to support a tightening of monetary policy.

What I think most people can agree on is that the Fed’s behavior is unusual. They didn’t have to tell the market they were going to hike rates. They didn’t have to give a specific date when they would like to do so. But they did. And that was a huge misstep on their part because it opened them up to doubt. Doubt in their omnipotence. Doubt in their omniscience. Doubt in the public’s belief in their ability to control the economy. Four months from now I still expect the Fed to hike rates but it seems silly to put their credibility at risk for a couple of basis points.

 

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