The Hawks are Getting Louder, but the Bulls Don’t Care

A sudden flurry of positive economic data this week may provide support for the more hawkish comments coming out of the Fed.  Among others, we’ve received the following reports so far this week:

  • Retail sales, excluding autos & gas, were up 0.7% in January, well above the consensus estimate of 0.3%
  • The Empire Manufacturing survey for February came in at 18.7, well above the consensus estimate of 7.0 and January’s reading of 6.5
  • The Producer Price Index (PPI), excluding food & energy, accelerated to 0.4% in January from 0.1% in December
  • The Consumer Price Index (CPI), excluding food & energy, accelerated to 0.3% in January and was up 2.3% on a year-over-year basis
  • The NFIB Small Business Optimism index came in at 105.9 compared to the consensus estimate of 105.0
  • The strongest reading for the Philadelphia Fed Business Outlook Survey (43.3) since 1984

There were some offsetting data points, like Industrial Production (-0.3% in January, down from a downwardly revised +0.6% in December), but the combination of strong retail sales, improving business confidence, and rising inflation is clearly spooking some Fed participants.  Fed Chair Janet Yellen used her first day of testimony to Congress to convey an incrementally more hawkish view.  She said that “waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.”  These sentiments were echoed, only more forcefully, by Richmond Fed President Jeff Lacker in a presentation at the University of Delaware on Tuesday.  Lacker went so far as to say that “significantly higher rates are warranted”.  And finally, Dallas Fed President Robert Kaplan made similar comments about the need to act sooner rather than later.

Notably, the Fed’s prognostications continue to call for three interest-rate hikes this year WITHOUT incorporating the effects of possible fiscal stimulus.  It makes sense that the Fed does not want to get bogged down in trying to predict events on Capitol Hill.  But the new administration’s campaign promises were heavy on initiatives that would likely increase the pace of economic growth.  What would the Fed’s interest-rate outlook be, for instance, if it were to assume a large infrastructure spending bill?  How about big tax cuts for businesses and individuals?  How about a dramatic decrease in regulatory red tape?  Any or all of these initiatives could change the calculus meaningfully, but the Fed is right to assume nothing until it gets done.  The Republicans hold both houses of Congress, but many GOP Congressman are loathe to implement policies that add dramatically to the nation’s debt.

So, notwithstanding the potential for fiscal stimulus over the next couple of years, our view continues to be that the economy cannot withstand meaningfully higher interest rates.  Continued high levels of debt, coupled with almost eight years of near-zero interest rates, will likely mean that interest-rate increases will be much more difficult to overcome compared to past tightening cycles.

First, low interest rates have led to a dramatic spike in asset values, which has supported growth through the “wealth effect.”  (The wealth effect simply means that consumers will spend more if they feel richer).  Will a reversal of loose monetary policy lead to the opposite fate for asset prices?  Not so far, but it’s hard to believe that a potential 50% increase in mortgage rates won’t affect the pace of housing sales and housing prices.

Perhaps more importantly, low rates have also pulled forward future demand for goods and services that are generally bought using credit, and this would include houses, cars, durable goods like appliances, education, and many other sectors of the economy.  Will consumers be as likely to spend so freely if the cost to borrow rises meaningfully?  Probably not, and definitely not if they’ve already taken advantage of low interest rates to make those purchases.

Corporations, for their part, have taken advantage of the low-rate environment to buy back stock, increase dividends, and make acquisitions using debt.  Will these actions be suspended in favor of capital investments when interest rates rise?  It doesn’t seem likely absent a meaningful increase in demand for their products and services.

Higher interest rates will also increase the debt-service burden for the US government, which has unwisely failed to take advantage of the low-rate environment to extend bond durations and lock in low interest rates for many years.  This issue becomes much more pressing as more baby boomers retire and entitlement spending increases.

Higher interest rates could also lead to additional gains in the value of the dollar, which would further expand the trade gap, act as a drag on GDP growth, and hinder corporate profits for multinational corporations.  The currency markets ensure that a dramatic decoupling in economic growth between the US and the rest of the world is unlikely.

The latest data lend incrementally more support to the idea that the Fed might be getting behind the curve with regard to containing inflation.  If this is indeed the case, the Fed may have to accelerate the pace of tightening going forward.  The urgency may increase still further if stimulative fiscal policy is enacted.  However, given the economy’s heavy dependence on low interest rates, an acceleration in interest-rate hikes could dramatically decrease growth prospects and introduce the risk of stagflation.  Stagflation describes an economy in which growth is slowing and inflation is high.  Given that large percentages of the population are already living paycheck to paycheck without significant retirement savings, the Fed would obviously like to avoid this scenario at all costs.

So what’s the correct policy response to these challenges?  I was asked a similar question during my presentation at the University of Delaware on Tuesday.  I believe the question was something like, “What is the one single development that would make me more optimistic about economic growth prospects?”  My answer was that our best chances for navigating this very difficult backdrop are to address the problem of entitlements.  Though most politicians believe entitlement reform is political suicide, a quick show of hands during my presentation yesterday revealed that a very large percentage of the roughly 400-strong audience would be willing to accept reduced entitlement benefits (Social Security, Medicare) for the good of the overall economy.  Addressing this problem would provide much more flexibility to enact short-term fiscal stimulus without the threat of a bond “tantrum” (which would lead to a dramatic spike in interest rates and tank the economy).  And while Trump did promise during the campaign that he would leave entitlements unchanged, it is conceivable that he would be willing to reverse his position if he could be convinced of its importance.  Time will tell.