Will Yellen Signal a Change in Policy?

At the end of this week central bankers from around the world will be meeting in Jackson Hole. The conference has attracted a lot of attention over the years as both Alan Greenspan and Ben Bernanke have used the occasion to signal major shifts in policy.

We are now seven years into an economic recovery, the fourth longest economic expansion in history and the Fed has only managed a single rate hike. We are of the view that the Fed’s job is done and that a continuation of ultra loose monetary policy could have harsh negative implications.

In our opinion, the preconditions for Fed interest-rate increases have expanded well beyond their Congressional mandate of maintaining price stability and maximizing employment and now include an improvement in the quality of new jobs; better wage growth; a meaningful acceleration in inflation, even beyond its stated goal of 2%; high equity prices and narrow credit spreads; and a stable geopolitical backdrop.  It is our view that the Fed should stop waiting for everything to be perfect and should start the process of normalizing interest rates now.

First, economic growth isn’t great, but it is generally in line with the pace since the end of the recession. True, GDP growth has averaged just under 1% over the past three quarters. However, consumer spending, which makes up nearly 70% of GDP, grew at a robust pace of 4.2% in the second quarter and averaged 2.7% over the past three quarters.  The GDP weakness we’ve seen in recent quarters has been mostly attributable to weak business investment, including huge inventory drawdowns, and weak net exports.  Most expect that inventory drawdowns have now been exhausted and that business investment will benefit from impending fiscal stimulus (infrastructure spending, tax incentives and a lowering in the corporate tax rate) enacted by a new presidential administration and Congress.  The weak net exports in recent quarters, largely the result of a stronger dollar, will be transient, especially now that the dollar has stabilized.  Outside of those troubled areas, current economic trends remain supportive of a return to economic growth of 2%+ in the third quarter.  In any case, “acceptable economic growth” is not one of the Fed’s mandates!

Secondly, the unemployment rate at 4.9% is lower than it has been 79% of the time over the past 50 years. Wage growth, the number of discouraged workers, the number of long-term unemployed, and the number of those working part time that would like to work full time have all shown improvement. In addition, weekly initial jobless claims have now been below 300,000 for 76 weeks – the longest streak since 1970.  Suffice it to say that it is becoming harder and harder for the Fed to use the labor market as justification for the deferment of policy normalization.

Thirdly, let’s address inflation.  The core Personal Consumption Expenditures (PCE), the Fed’s preferred inflation measure, increased 1.6% year-over-year in June.  Although this inflation metric is still tracking well below the Fed’s target rate of 2%, we don’t think it tells the whole story. Core PCE excludes food and energy prices. If you were to include food and energy, it’s likely that inflation will head higher in the second half of this year as we lap the 2014 drop in oil prices. Also, core PCE doesn’t take into account the massive appreciation in asset prices such as housing, which have increased the cost of living.  The increase in stock and bond prices to today’s lofty valuations also increases the cost of saving for retirement as expected future returns go down and savers have to set aside more in order to achieve their retirement goals.  For the things that matter to consumers, inflation is NOT too low.

The Fed needs to consider the possibility that proceeding with policy normalization (ie, hiking interest rates) could actually be good for the economy.  By increasing interest rates, consumers would get a boost in interest income that will more than offset any increase in interest expense. Short-term deposits are currently at a record high of $12 trillion, and many homeowners have taken advantage of low rates to lock in low fixed mortgage payments.  If consumers were finally able to generate some return on their savings, maybe they wouldn’t feel the need to save so much.  Higher interest rates would also incentivize prospective home buyers to get off the fence prior to meaningful rate hikes. Municipalities and corporations would benefit from higher interest rates as it would improve future returns on their pension funds, decreasing the need to divert resources into plans that are underfunded.

It is strikingly obvious to all but the Fed that the level of interest rates is not what is holding back corporate investment.  A lack of revenue visibility is to blame, which could be partially addressed by more aggressive fiscal policy.  We hope that a new presidential administration and Congress will see that obvious need.  In the meantime, the Fed needs to get going on the path of normalization.  By moving away from near zero percent interest rates the Fed could begin to mitigate some of the negative long-term effects of artificially low interest rates, including misallocation of resources in the economy, the discrimination in favor of borrowers over savers, and the potential for asset bubbles. Let’s get on with it.