Fed Dithering Risks Recession

By Vincent J. Truglia

The Federal Reserve did an exemplary job during the financial crisis. The use of innovative monetary policies, in conjunction with stimulative fiscal policies, avoided a depression. The maintenance of a variety of Quantitative Easing programs allowed bank balance sheets to recover. In addition to QE, maintaining short-term interest rates near zero further enhanced bank balance sheets.

Financial Price Distortions

The negative side of these innovative monetary policies included financial asset price distortions. Financial asset prices rose substantially since the nadir of the financial crisis. However, since a loose monetary policy has been maintained for such a long period of time, we are now faced with a situation where most market participants recognize the need for financial asset price adjustments. The problem is that no one is sure where asset prices should be in a more normal monetary policy environment.

Excuses, Excuses

The Fed has been finding excuse after excuse for postponing the beginning of a return to a more normal monetary policy. It has kept short-term rates near zero for nearly a decade. Such a policy was important for much of that time. However, today, unless the Fed begins raising rates ASAP, it risks all the gains made during the recovery.

If the US economy can’t withstand a 25 basis point increase in short-term rates, then it is far sicker than the evidence suggests. Frankly, there is no justification for postponing a rate rise. In fact, it is imperative that rates start to rise in December. If the rate rise is postponed, then the US economy faces the risk of a recession beginning as early as the end of 2016, and more likely by mid-to-late 2017.

Interest rate rises need to begin ASAP in order to avoid the need to raise rates more sharply in 2016-2017. The reason rates need to begin a normalization process is that two important economic developments occur in 2016 and 2017.

By mid-2016, the US economy will be at or very near full-employment. As we approach full employment, wages will rise at a faster pace than we have seen for some time. We are already seeing wages increase at a faster rate than in recent years.

Rising wage pressures will already be set in place by mid-2017, when it is increasingly likely that the US economy will be reaching capacity constraints. As the economy approaches full capacity, domestic prices will be under upward pressure.

Inflation

Inflation is a lagging indicator. Inflationary pressures won’t clearly emerge until they have become somewhat entrenched. As a result, once we begin to see higher prices as a result of rising wages and rising final prices, it is already too late to stop the inflationary cycle without a strong monetary policy response.

By that time the Fed will not be able to stop inflation with small 25 basis points increases in interest rates. It will need rates to rise by 1 or 2 percentage points, if not more, to break the inflation cycle. Depending on how high short-term rates rise, we would easily face a flattening of the yield curve. It will become increasingly likely that we could actually see an inverted yield curve. As we all know, a flattening and/or an inverted yield curve would likely presage an economic downturn.

Despite negative external developments, there is little reason to believe that the largely closed US economy will not continue to grow over the next 18 months, even if at a moderate rate, to a point where we achieve full employment. Moderate growth will also bring the economy ever-closer to full capacity.

A slow rise in short-term rates, starting in December, should allow the economy to adjust to a rising rate environment, and to help keep growth at a level consistent with the economy’s ability to increase capacity. Yes, such an interest rate policy may slow growth, but at least it avoids a downturn.

Overly cheap money is analogous to a patient taking painkilling drugs. Painkillers are great to ward off pain in the short-term, but if continued too long, the body becomes addicted. By that time, detoxing becomes far more painful than the original pain the patient was trying to avoid.

Summary

The Fed cannot delay raising short-term rates. A further delay in raising rates risks pushing the US economy into recession over the next 12-18 months.

As always, Clear and Candid.