Fed Policy Statement: A Change of Heart?

For some time now I have been advocating for a more normal short term interest rate policy from the Federal reserve vs. the ZIRP (Zero Interest Rate Policy) that they have been pursuing. My reasoning was, although the US GDP was not humming along at a more normal 3% real trend-line growth rate, things were not that bad at 2%+ with unemployment at 5.5% (down from 10.5% in 2009) … we could stand a one or two percent Fed Funds rate. Sooner or later rates would have to move back up. Why not move now, to slowly raise rates, rather than wait for an emergency?

But wait! OMG! They dropped the word “patient!”

Indeed they did, but the Fed inserted some really open-ended guidance when they indicated that the unemployment rate wasn’t to be a key determinant of their policy. Remember 5.5% was always, in the past, considered to be ‘full employment’ (as there would always be a portion of the population in transition). Below that level was considered to be inflationary, as it would put upward pressure on wages, causing employers to pay up for qualified employees.

This gets into the nuances of what unemployment really means. The Bureau of Labor Statistics has several gradations above the ‘unemployment rate (U3)’–U4, U5 and U6. The ne-plus-ultra is U6, which adds to the unemployment rate discouraged workers, marginally attached workers and part-time workers for economic reasons. Louis Efron, in Forbes, 8/24/14, gives a good account (“Tracking the Real Unemployment Rate … “). At that time the U6 unemployment rate was 12.6%, more than double the U3 rate of 6.2%. Why this huge disparity exists is not certain. Maybe it is a residual effect of the great recession and crash of 2008; or, possibly globalization. Whatever the reason, it appears that the Fed has decided to zero in on the quality of jobs and wage growth (which has been very scant) and not the old standard U3 unemployment rate, as benchmarks for setting rates. Who can know with certainty what is on their mind? This is what I surmise. Bottom line: Rates look to be lower longer. These comments from Fed governor Charles Evans may back up my contention– “Fed statement doesn’t rule out lengthy stay at zero (for rates) …”.

My change of heart: Rates lower longer is not such a bad thing

I heard a presentation last week by a very successful fixed income money manager, whose name will remain anonymous, since much of his thought process may not have been disseminated to his own firm and clients. None-the-less the thought process rang true.

Why no need to rush higher rates:

• The US economy is not setting the world on fire. Europe is still a mess and Asia continues to grow, but at a moderating rate … no signs of overheating globally.
• Inflation does not appear to be an issue as we are, and have been, in a commodity bear market for the last six years.  “The typical commodity bull market lasts about 13 years followed by a 21 year bear market” — Tony Caldero, “the ELLIOT WAVE lives on”. Another source pointed out that a 13 year bear market in commodities was shortest on record. Assuming the current bear goes 13 years, we still have a long way to go without a lot of commodity price inflation. This is very pro stock market, pro equity, as raw material costs are lower and will remain in check for some time if these metrics hold true.
• One of the Fed’s concerns is the lack of wage growth, a continued sign of low inflationary bias.
• Europe, after years of resistance to quantitative easing and a strong adherence to economic austerity, is just beginning to grudgingly loosen up. The past austerity may make it very difficult to reignite growth. This is very much akin to what happened in the United States during the Great Depression. The New Deal (a massive stimulus program) beginning in 1933, pulled us out of the worst of the depression; but in 1937 we slipped back in as the Fed began to tighten. This was in part due to the damage the economy suffered in the early 1930’s via austerity. Importantly, interest rates here in the US (even at today’s pitifully low level) are still very attractive. Raising them now would further harm Europe, syphoning funds from their economies. These numbers are really stunning (just take a look at this table from Bloomberg Business).

I have seen the light!

And, it is not that of a freight train coming at me from the other end of the tunnel. Our economy is not in perilous straights. Rates may be lower longer because of qualitative judgements on the part of the Fed regarding employment quality issues, wage growth and distressed Europe. Also, inflation, the other part of the Fed’s dual-mandate seems to be well in check (and may remain well in check).

Yes, rates will eventually head North, but based on the way the Yellen Fed couched its comments last Wednesday, it could be much later than many expect. Ergo, stocks continue to be the place to be. And, unless inflation comes roaring back, they may continue to be attractive well after rates begin to rise in the ‘Great Lift-off’.

What do you think?

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