At its meetings next week, the Federal Reserve will let us know if it has decided to take the first step toward policy normalization by hiking the Fed Funds rate for the first time in nine years. This is a very tough call for the Fed. Some people believe that the Fed has backed itself into a corner and will lose credibility if it does not go through with a rate hike this month. Many of these same people argue that the Fed has done its job – the unemployment rate has dropped dramatically from its high of 10% to the most recent reading of 5.1% in August. And despite a modest shortfall in non-farm payrolls added in August (173k versus the consensus estimate of 217k), the economy has added an average of 225k jobs per month since the beginning of 2013 – well above the average monthly increase in the labor force.
However, the Fed has a second mandate, and that is price stability. Despite some more encouraging data on wages in last week’s employment report, we still appear to be a long way off from the Fed’s target of 2% inflation. Inflation is being held down by plummeting commodity prices and a strong dollar, which effectively results in the importation of deflationary pressures. If the Fed were to hike rates sooner rather than later, the dollar would likely resume its appreciation, commodity prices would continue to fall (since, for the most part, they are traded in dollars), and our trade deficit would spike higher, depressing both domestic GDP and inflation rates (at a time when the Fed is trying to increase both).
For my part, I think there are several reasons why the Fed will either defer the first rate hike or do one symbolic hike and then pause. Most importantly, the Fed does not like the recent instability in the capital markets. The capital-markets volatility we have seen in recent months represents the downside to an ill-conceived policy of targeting stock prices in an effort to spur economic growth. The Fed’s explicit goal was to boost household wealth through stock and housing gains, hopefully causing a trickle-down effect that would jumpstart economic growth and job creation. But if it moves too soon to increase interest rates, the Fed risks reversing some of these (perceived) hard-fought asset-price gains.
Secondly, a Fed rate hike next week could have a punishing effect on emerging market economics. Indeed, the Fed is being lobbied hard by emerging-market countries and the IMF to stand pat for now. As expectations rose that the Fed would soon hike rates, the dollar appreciated dramatically. This resulted in capital flight from emerging market countries, which has the potential to raise borrowing costs and inflation in these countries. Therefore, a too-hawkish Fed could put emerging economies at further risk, and this could depress global economic growth. To boot, the billions in dollar-denominated debt that has been issued by entities in emerging markets would become much more difficult to service or refinance in the event of further capital flight and dollar appreciation. Finally, the competitive currency devaluations we’ve seen in recent weeks in emerging countries could be exacerbated by a Fed rate hike.
And then there are the varying interpretations of the true state of the labor market in the US. Notwithstanding the big increases in payrolls and the drop in the unemployment rate over the past several years, there are lingering concerns among Fed officials about the underlying strength of the labor market. The newly-created jobs are generally lower-paying, service-related jobs rather than relatively high-paying manufacturing jobs. In many cases, job seekers have been forced to take part-time jobs out of inability to find full-time gigs. And then there is the issue of stagnant household incomes. The medium inflation-adjusted household income is at 1995 levels, and dramatic increases hardly seem imminent (despite some improved news last week). To the extent that Fed officials believe that loose monetary policy has been an effective tool for generating job and income growth (and they do), they will be less likely to meaningfully raise interest rates until internal labor market conditions improve to a greater extent.
This is not to say, however, that I agree that the Fed should defer its rate hikes. Rather, I think the first rate hike is long overdue. In exchange for very little economic benefit, the Fed has inflated asset prices to dangerous levels. This has created a situation whereby a very small percentage of well-off citizens have been enjoying the lion’s share of the income, wealth and spending gains since the Great Recession. We think this creates numerous long-term challenges, among which is social stability. Our view is really quite simple: the Fed should incorporate the cost of saving for retirement into its assessment of inflation. Since the vast majority of US citizens are underinvested for retirement, high relative stocks valuations (due largely to easy monetary policy) will result in lower expected returns in the future. Lower expected returns mean that prospective retirees will need to save more to reach their retirement goals. This need to save more represents inflation of a major consumer expense: saving for retirement.
Despite lots of positive rhetoric on the business-news channels, evidence abounds that the middle class continues to struggle. The most recent evidence of these struggles may be the presidential election polling data. On the Democratic side, an avowed socialist (Bernie Sanders) is very near the top in many recent polls. On the Republican side, Donald Trump is leading the pack on a platform largely based on radical ideas to restrict immigration, expel illegals, and maintain more protectionist trade policies. According to a recent article posted on www.Detroitnews.com, “Trump, who says he shares the trade views of Sen. Bernie Sanders, the socialist running for the Democratic nomination, promises not to make any trade deals unless they give America a clear advantage.” Are these the types of candidates that would be supported by a thriving middle class? Of course not. But it is quite obvious why these types of messages are drawing widespread support: the economy is still only working for a relatively few, and years of ultra-loose monetary policy has done little to fix the situation. So why does the Fed keep doubling down on the same failed policies ?