The Fed is set to hike into Economic slowdown
The Fed hiked for the ninth consecutive session, raising the Fed Funds rate to 3.25%. The statement gave no indication that the Fed was finished and even ratcheted up the inflation rhetoric a bit more. The market took that for its face value, avoided the Christmas rush and sold off. The Fed Funds Futures contract is pricing in a 100% certainty for another 25BP hike and is well over 50% for one after that. That would push the rate up to 3.75%. Bonds did not fall on the news but rallied, driving the yield even lower. That has basically flattened the yield curve; if it continues to act as it has (falling as the Fed hikes rates) then it will invert at the next Fed meeting and hike if not sooner. It is also important to note that the Fed Funds Futures contract now indicates two more rate hikes, but it indicated two more rate hikes before today’s raise. The point is, the further out you go with the FFF contract the less certain it is.
There are signs the Fed should seriously consider pausing its hikes. First, as noted above inflation pressures have not increase but have leveled off and are even decreasing of late. When the Fed said they were elevated many economists were scratching their heads. The manufacturing sector has been slowing its expansion and it is getting close to contraction. Freight levels in Europe and Asia have dropped sharply this year. Commodities prices have peaked and have been sliding back down. Business investment is tailing off, dovetailing with the declines in the manufacturing sector (the Chicago PMI came in at 53.6 versus the 54.0 expected). The yield curve, perhaps the most reliable economic indicator despite Greenspan’s ‘conundrum’ and others attempting to explain it away, is flattening and threatening to invert.
Why keep hiking?
There are a lot of reasons not to continue with rate hikes right now, but the Fed preferred to cite what it called a ‘firm’ expansion and an improving labor market as reasons to hike rates. The expansion is not so firm and the labor market is improving just modestly. Those hardly outweigh the litany of issues cited above, at least as a reason to continue hiking interest rates.
What is the real reason? It just might be the Fed taking on what it sees as another bubble in the economy, this time in the housing sector. Greenspan has reversed course on this over the past four months, first laughing off a bubble in front of Congress and now suggesting there are a lot of ‘mini-bubbles.’ The Fed has started talking about housing in its minutes. Fed governors are talking about bubbles.
This sounds very familiar to the late 1990’s when the Fed started talking frequently about asset bubbles, i.e. the stock market. The Fed denies it to this day, but it is clear that it was not raising rates to stave off inflation (which it admits was non-existent but just around the corner) but to slow down the stock market. This is just what the central bank in the late 1920’s did in strikingly similar conditions, and the result was the same: a market crash followed by a world economic recession. Not on the same scale, but the cause and effect were the same.
There were some inflationary pressures this year, but as noted they have been slowing and even starting to fall. Without a doubt the real rate of inflation, the PCE index (at 1.6%), and other indicators show very tame inflation. How can the Fed call this ‘elevated’ when it is below long-term norms?
No, the Fed is once again talking one game while playing another. The Fed is trying to slow down the housing market to avoid a collapse. Of course it is highly speculative that there would be a collapse if left alone. We have noted many times the past few months that the housing market is cooling off on its own. For every ‘mini-bubble’ area you can point to ten that are not and indeed have been cooling off of late.
What the Fed seems to be fearing is a further reduction in long term rates that will set off another refinancing boom and overheat the market. It is thus raising rates in order to increase mortgage rates, but in the paradox of the market, longer term rates are falling even as the Fed raises rates because as the Fed hikes the bonds see the chance of an economic slowdown increasing. In other words, the bond market does not see the economy as strong as the Fed does, and believes the Fed’s attack on money supply is only going to weaken it further. That makes money out in the future less valuable because there will be less demand for it. Talk about a conundrum; that is the real problem with the bond and the Fed.
The Fed does have something of a point with the housing market. After all, 70% of the recent mortgage initiations have been for no interest ARMS (adjustable rate mortgages). Does this represent a wave of new buyers who are trying to buy more house than they can afford? No. These are the speculators who are buying to flip. They don’t want to put any money down or pay any principal because they are going to turn it over rapidly. Thus a lot of the market right now is involved in speculation, but just how big is this market? In relative terms it is not as big as it was the past few years when the average Joe was refinancing or buying a new house to live in. As we said before, when the worm turns in the market it will be the fringe that gets hurt just as in every market.
We don’t view that as a bubble, just the normal course of a market that runs its course. The Fed, however, continually goes beyond its mandate of long-term price stability and meddles in the workings of every market whether it is the stock market or the stock market. Hell, it would get involved in soybeans if it felt there was a bubble there. The Fed has no business trying to micromanage the housing market and thus impacting the entire economy as a result.
The Fed may say it is worried about inflation, but that is what it said in 1999 when there was none to be seen. We all know better about that episode, and we know better about this move as well. The Fed has amazing credibility for having no credibility. Once more mainstream economists are being blinded by their faith in Greenspan even as he takes off on another tangent outside of the Fed’s mandate. The signs are there that the Fed should get off of the economy even if it wants to slow housing. Heck, housing is in its ninth inning right now and is ready to fade away. If the Fed keeps jacking up rates and draining money supply into a slowdown it is going to cause a sudden drop just as it did back in 2000.
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