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The Fed shouldn’t raise rates again too soon.
The S&P 500 and NASDAQ hit record highs the week of May 8, and the Dow closed over 21,000. The “Trump Bump” (as the run up in capital markets is called) remains in full force. In all, I believe the business environment will be more favorable under the Trump administration.
Some factors make maintaining a favorable environment for business less likely, however. For example, the current run up is premature given we are still lacking specifics on many aspects of the new administration’s fiscal policy. In addition, predicting when the new administration’s fiscal measures (and in what final form) will be passed and become effective is problematic.
Another concern for businesses in the current economic climate is the Federal Reserve’s rate-raising intentions. The decisions and narrative of the Federal Open Market Committee demonstrate a heavy bias toward employment measures at the expense of GDP, inflation, the nuances of employment (like participation rate), and even a full appreciation of the unique circumstances of rates near zero for seven years. Notably, the FOMC’s rate forecast has been widely off for five years in a row. In all, this doesn’t lend confidence that the Fed will make the right decision about interest rates during its remaining meetings in 2017.
Interestingly, last month I found like-minded individuals in the most unlikely place—the Fed’s Washington, D.C., economic staff. They said the FOMC is about to wreck the economy again.
OK, that is not a direct quote, but they laid out their concerns—chief among them the fact that the FOMC still takes a preemptive approach to fighting inflation which 1) is still not worthy of fighting, and 2) puts the economy at grave risk of recession.
To understand the Fed economists’ concerns, you have to look at history. In the late ’70s/early ’80s, inflation got out of control. Since that time, if the Fed even suspects inflation is emerging, it will want to raise rates. Remember the Fed’s dual mandate: full employment and price stability (controlled inflation). At this point, the Fed believes the economy is at full employment, leaving only one thing to focus on: inflation.
Data from the Federal Reserve show that the upper and lower bounds of interest rates have been steadily decreasing since Paul Volcker’s day as chair of the Federal Reserve (1979-1987). The Fed’s economic staff (and I) believe this downward trend may be caused by the FOMC’s excessive focus on preemptive management of inflation risk. According to Chris Low at FTN Financial, the Fed has tightened too aggressively since Volcker broke inflation. I agree with him. If the Fed tightens too soon during an expansion, the economy never hits full stride and the economy does not realize the full benefit of an expansion. The net effect of all this is that the expansion gets cut short and the next recession gets pushed forward—requiring the Fed to lower rates to stimulate a recovery.
Instead of preempting inflation by raising rates, the FOMC needs to go back to a reactive inflation management posture. Let inflation prove it’s a problem—don’t act in anticipation of inflation.
The Fed was following post-Volcker canon when it raised rates earlier this year, which I believe was a mistake. Inflation risk is low because GDP remains weak. Employment measures, while improving, are not as strong as the unemployment rate would suggest due to a still very low labor participation rate. It does not matter if the participation rate is low because of retirement or workforce dropouts. A lower participation rate means lower economic potential and lower risk of inflation.
In contrast, the risk of recession is high if the Fed continues to hike rates in an effort to fight inflation (that will likely never materialize). The Fed needs to raise its inflation tolerance and give GDP a chance to run—allowing the economy to expand. It’s the only way to get back the maneuvering room they seek.
Todd Harris is CEO of Tech CU, a $2 billion credit union serving more than 85,000 members throughout the San Francisco Bay area.
