Another well telegraphed 25bp rise in the Federal Funds Rate by the Federal Reserve has the optics of removing excess accommodation. With such strong economic fundamentals and excessive accommodation in the system, it is becoming critical for the Fed to remove some of their emergency accommodation post the 2008 financial crisis. However, this was just another Fed rate hike that has an impotent impact on excess accommodation. In fact, their latest move can be arguably viewed as adding additional stimulus and inflationary pressures to the economy.
The US and global economy are experiencing strong growth. Troubling, this strong growth comes at a time of little excess capacity. This includes a tight labor market that recently has seen a number of high profile potential strike announcements. This will have an upward influence on labor costs. Increased future inflationary pressures are hard to reverse when such a great degree of excess accommodation is still in the system.
How much excess accommodation remains unclear. Typically, the Fed is accommodative until Fed Funds climbs above the rate of inflation by 1 percent or so. Since annual CPI inflation is now running around 2.7%, the Fed remains accommodative until Fed Funds rate hits 3.75%. The Fed Funds Rate is not expected to get to 3.75% for a couple of years, if at all. This excess accommodation should continue to exert upward pressure on inflation. This means the neutral Fed Funds Rate – one that neither increases or decrease future inflation – should continue to climb as well.
Additionally, the excess accommodation added by the Fed’s balance sheet will never be reduced. The market just has no capacity to step up and own this paper at these levels. Every trillion in quantitative easing is estimated to be the equivalent of a 75bp reduction in the Fed Funds Rate. If the Fed maintains their balance sheet, the Fed Funds Rate would have to be at least potentially 2.5% higher than the neutral rate to have a neutral impact on potential inflation rates.
And finally, long term rates, currently lower than during the financial crisis, continue to have an excessively simulative impact on the economy. Pre-2008, long term rates were between 5 and 6 percent. Historically, long term rates tend to be around 2 to 3 percent above the rate of inflation. That would put non-inflationary long term rates around 5 to 6 percent. Long term rates would have to sell off and rise around 3% before having a neutral impact on excess accommodation and a neutral influence on inflation. This would be devastating for such an overvalue bond market.
The rate of inflation since the Federal Reserve’s last meeting has increased by around 25bp. This means the Fed’s 25bp rise in the Federal Funds Rate is a push and removes no excess accommodation. This clearly shows the Fed is behind the curve. In fact, this Fed Funds increase is simulative. The income in the system from higher money market rates increases future spending power. And long term rates have remained stable leading to no consequences from higher debt costs.
The Fed’s monetary policy over the last decade has created a debt bubble with the amount of debt doubling. The consequences of popping that bubble would lead to a recession and lower inflationary pressures. The Fed is caught between corking the inflationary genie bottle and remove the excess accommodation at a more rapid pace, potentially triggering a financial crisis in the overvalued bond market or remaining behind the inflationary curve. Staying behind the inflationary curve will eventually lead to inflation fears and market forces popping the debt bubble. We get to the same results either way. Either the Fed gets ahead of the curve and a financial crisis in the bond market is triggered or market forces trigger a larger crisis with fears of uncontrolled inflation limiting Federal Reserve monetary responses down the road. This lose - lose situation is obviously a result of excess accommodation over the last decade.
The Fed has made it clear they prefer the economy to continue running hot. And as long as they pretend they are doing their job with 25bp moves every quarter or so, Fed monetary policy avoids being blamed for the resulting negative financial impacts... again.
by Michael Carino, Greenwich Endeavors, 6/13/18
Michael Carino is the CEO of Greenwich Endeavors and has been a fund manager and owner for more than 20 years. He generally has positions that benefit from a normalized bond market and higher yields.