Hilsenrath Just Reset Market Expectations: "Fed Is Worried Rates Will End Up Right Back At Zero"

Two weeks ago, we predicted that if the same September storm clouds return, and if December, which is increasingly looking as shaky as August as a result of a return of China deval fears, soaring dollar concerns and - the cherry on top - the collapse in junk bonds, forcing the Fed to have some literally last minute concerns about a rate hike, then the Fed's official mouthpiece, Jon Hilsenrath will be very busy...

... as he scarmbles to realign market expectations of a rate hike "because the economy is oh so strong", with the reality that a rate hike may just unleash the next Lehman event of the past 8 years.

It looks like Hilsenrath indeed had a very busy weekend with his Fed "sources", as he attempts to readjust the market consensus for a December rate hike lower, warning that the Fed's "big worry is they'll end up right back at zero."

For some inexplicable reason, he also adds that "Federal Reserve officials are likely to raise their benchmark short-term interest rate from near zero Wednesday, expecting to slowly ratchet it higher to above 3% in three years. But that's if all goes as planned." Well, just how many things can take place in the next 72 hours that derail the Fed's "planning?" And just what kind of lift-off is this, if the Fed's decision is quite literally dependent on daily market, pardon economic, fluctuations?

It was not immediately clear what the answer to these questions is. What Hilsenrath did answer, however, is why and how the Fed will proceed to cut rates right back to zero.  Here is Hilsy:

Any number of factors could force the Fed to reverse course and cut rates all over again: a shock to the U.S. economy from abroad, persistently low inflation, some new financial bubble bursting and slamming the economy, or lost momentum in a business cycle which, at 78 months, is already longer than 29 of the 33 expansions the U.S. economy has experienced since 1854.

Sounds an awful lot like setting the stage for an imminent, and confidence destroying, rate cut unleashed by, drumroll, the Fed's own rate hike. In fact, so likely is that the Fed's rate hike will be the catalyst for the Fed's next easing cycle, that practically nobody has any doubt:

Among 65 economists surveyed by The Wall Street Journal this month, not all of whom responded, more than half said it was somewhat or very likely the Fed's benchmark federal-funds rate would be back near zero within the next five years. Ten said the Fed might even push rates into negative territory, as the European Central Bank and others in Europe have done--meaning financial institutions have to pay to park their money with the central banks.

 

Traders in futures markets see lower interest rates in coming years than the Fed projects in part because they attach some probability to a return to zero. In December 2016, for example, the Fed projects a 1.375% fed-funds rate. Futures markets put it at 0.76%.

 

Among the worries of private economists is that no other central bank in the advanced world that has raised rates since the 2007-09 crisis has been able to sustain them at a higher level. That includes central banks in the eurozone, Sweden, Israel, Canada, South Korea and Australia.

 

"They effectively have had to undo what they have done," said Susan Sterne, president of Economic Analysis Associates, an advisory firm specializing in tracking consumer behavior.

Here is the bigger problem: what the Fed has done - which is very little for the actual economy -  is to push the S&P from 666 to 2100. It is the undoing of that most market participants are terrified about, and what will be to most, very unpleasant.

The pre-emptive excuses continue:

The Fed has never started raising rates so late in a business cycle. It has held the fed-funds rate near zero for seven years and hasn't raised it in nearly a decade. Its decision to keep rates so low for so long was likely a factor that helped the economy grow enough to bring the jobless rate down to 5% last month from a recent peak of 10% in 2009. At the same time, waiting so long might mean the Fed is starting to lift rates at a point when the expansion itself is nearer to an end.

 

Ms. Sterne said the U.S. expansion is now at an advanced stage and consumers have satisfied pent-up demand for cars and other durable goods. She's worried it doesn't have engines for sustained growth. "I call it late-cycle," she said.

Actually, there is one time when the Fed waited this long to tighten conditions, in fact waited too long: the economy was already in recession. That was back in 1936. What happened next was the second part of the Great Depression and a 50% collapse in the Dow Jones.

Hilsenrath's odd litany of preemptive excuses continues:

Several factors have conspired to keep rates low. Inflation has run below the Fed's 2% target for more than three years. In normal times the Fed would push rates up as an expansion strengthens to slow growth and tame upward pressures on consumer prices. With no signs of inflation, officials haven't felt a need to follow that old game plan. Moreover, officials believe the economy, in the wake of a debilitating financial crisis and restrained by an aging population and slowing worker-productivity growth, can't bear rates as high as before. Its equilibrium rate--a hypothetical rate at which unemployment and inflation can be kept low and stable--has sunk below old norms, the thinking goes.

 

That means rates will remain relatively low even if all goes as planned. If a shock hits the economy and sends it back into recession, the Fed won't have much room to cut rates to cushion the blow.

This goes to the question of what r* is, or the Equilibrium Real Interest rate, one which as we showed last week, is almost entirely a function of nominal US economic growth rate (very low) and consolidated debt/GDP (at 350%, it's very high). Under current conditions, it is either negative or just barely in the positive, suggesting any Fed rate hike will be followed by an immediate rate cut, something Hilsenrath just acknowledged.

The excuses continue:

Among the risks to the economy are financial booms that could turn to busts. One is in commercial real estate. Another in junk bonds is already fizzling. Each of the past three expansions was accompanied by an asset price bust--residential real estate in 2007, tech stocks in 2001 and commercial real estate in the early 1990s.

 

Normally in a recession the Fed cuts rates to stimulate spending and investment. Between September 2007 and December 2008 it cut rates 5.25 percentage points. Between January 2001 and June 2003 the cut was 5.5 percentage points, while from July 1990 to September 1992 it was 5 percentage points.

 

If the Fed wants to reduce rates in response to the next shock, it will be back at zero very quickly and will have to turn to other measures to boost growth.

Yup: such as QE4 and NIRP, which are inevitable, but which the Fed wants to "hike" rates first just so it has the alibi to unleash even more easing. And now even Hilsenrath is warning that this is the endgame:

Fed officials worry a great deal about the risk. The small gap between zero and where officials see rates going "might increase the frequency of episodes in which policy makers would not be able to reduce the federal-funds rate enough to promote a strong economic recovery...in the aftermath of negative shocks," they concluded at their October policy meeting, according to minutes of the meeting.

 

In short, the age of unconventional monetary policy begun by the 2007-09 financial crisis might not be ending.

Coming from Hilsenrath, it does not get any clearer than that.