Tail Wagging the Dog

For this week’s Market Commentary, we are taking an excerpt from our 1Q edition of The Farr View. With the Federal Reserve’s recent change of heart, an earnings outlook for 2016, and an uncertain election outcome, we hope this issue of Farr View is an interesting and informative one.

The Federal Reserve yet again demonstrated its unbridled dominion over the capital markets during the first quarter of 2016. Following an abrupt 10% drop in stocks to start the New Year, Fed members dutifully backtracked on their prior forecast of four interest-rate hikes in 2016. And, in a script we’ve seen repeated numerous times, investors responded approvingly to the Fed’s dovish rhetoric and bid the S&P 500 index up to within spitting distance of all- time highs by the quarter’s end.

The impetus for the Fed’s umpteenth change of heart was “tighter financial conditions” – a catch-all phrase encompassing a strengthening dollar, capital flight from emerging economies, widening credit spreads, falling stock and commodity prices, and increased market volatility. Apparently, the Fed’s stewardship of the domestic economy now extends beyond its dual mandates of maximizing employment and maintaining price stability. This propensity for “mission creep” remains troublesome.

It is absolutely appropriate for the Fed to react to the various incoming economic data. If economic developments threaten the Fed’s mandates, it should have the flexibility to respond. But this isn’t really what’s happening. Domestic economic growth has been running at a fairly consistent pace of 2.0%-2.5% since the recession ended. Moreover, the Fed has pretty clearly met its policy objectives. Yes, Chair Yellen has articulated some concerns about the labor market, including low labor participation, weak wage growth, and a surge in involuntary part-time jobs versus full-time work. But she and others at the Fed are generally quite gratified by the halving of the unemployment rate from 10% to 5%, which is below the Fed’s stated target. Regarding the inflation side of the Fed’s dual mandate, most metrics show that inflation now exceeds the Fed’s target of 2% as well. In particular, inflation is running hot if we exclude the volatile categories of food & energy (as the Fed tends to do) or if we look solely at non-discretionary and service categories.

At some point along the way, the Fed’s realm expanded. Capital-markets volatility, or the lack thereof, became central to Fed decision-making. When volatility increases and capital markets swoon, public comments from Fed members become dovish. When asset prices start to get frothy, the Fed becomes hawkish. The Fed’s support of asset prices through “forward guidance” has left investors with false senses of security and infallibility. Economists refer to this as a “moral hazard”, and it’s the stuff bubbles are made of. For sure, the increasingly integrated global economy has complicated the Fed’s job and influenced its policy in unforeseen ways. In a nutshell, America’s rising dependence on foreign economies and markets will not allow for a dramatic “decoupling” in growth rates between the US and the rest of the world. In other words, the US is unlikely to be able to sustain robust economic growth while the rest of the world remains in the doldrums. As it relates to the Fed, the economic weakness outside the US prohibits too much of a policy divergence without serious and disruptive consequences, particularly in the currency markets. As the Fed sees it, its hands are tied by the weak state of the global economy. The bottom line? The Fed continues to believe it is too early to take the training wheels off in earnest. Unfortunately, though, this also means that the risks associated with eventual policy normalization will increase. There is never a good time to raise interest rates because it always results in some degree of pain. The corollary to this rule is that the longer interest rates are held artificially low, the greater the pain. Why? There are several reasons. First, artificially low rates encourage the assumption of more debt at a time when we need to be deleveraging. Second, low rates act as a lifeline to uncompetitive entities or projects that would otherwise be allowed to fail, while in the process cleaning the slate for the next expansion. Third, ultra-low interest rates pull forward future demand, which will act as a cap on the economy’s growth potential in the future. And finally, sustained low interest rates create asset bubbles.

To continue reading the entirety of this issue of Farr View, click here.