It has been a bad half-decade for the experts. From our public health policy to our financial oversight, to our cozying up to the global sponsors of barbarism, the American public is reeling with crumbling confidence in the competence and/ or motivations of our ‘experts’ in leadership broadly. This is the primary cause underlying the concern and in fact growing unease about our nation’s path. I’d like to spend a moment on the financial oversight as practiced by the Federal Reserve Board of Governors (Fed), those responsible for the conduct of our national monetary policy.
The Fed is given the awesome responsibility of largely determining the level of short-term interest rates in this country. This rate in turn is an important signal to monetary authorities around the world on the feelings and forecasts of those shepherding the world’s largest economy. The lower the rate, generally the easier it is to get credit and the funding desired for commerce and consumption. In theory, people would prefer low interest rates forever, greasing the skids for whatever they desire yet need to borrow to attain. Houses and autos come readily to mind, but it also applies to capital investment decisions by businesses.
The reason why short-term rates cannot be maintained at zero forever is that ultimately the misallocation of capital stemming from its oversupply often leads to inflationary pressures and other problems. Inflation is the bane of a stable financial system and should be minimized to the extent possible. This is well understood and accepted.
Keeping interest rates low, which requires in effect the creation and injection of additional Dollars into the system, also will have the impact over time of weakening the purchasing power of each Dollar. Whether through a depreciating value for the Dollar vs. other currencies, or a general increase in prices (inflation), too many Dollars in circulation leads to financial excess and ultimately decline.
It is for this reason that the Fed must always begin the process of raising interest rates at a time when conditions are in place for future inflation, but perhaps have not become visible to all. The time lag between changes in interest rates and the economic impact is the variable which must be considered. Of course, politics can also enter the Fed’s decisions, as raising rates can be seen as politically unattractive to the party in power at any given time, and there can be pressure to keep rates ‘lower for longer’ sometimes.
‘Lower for longer’ lurches into ‘higher for longer’ with the same bravado
Just such a condition existed in the U.S. for almost the entire period from January 2009 to March of 2022. During much of this 13-year period, the federal funds rate, our signal to the world, was near zero. The only exception was a gradual period of rising from zero at the end of 2015 to 2.5% in late 2018. So, a 250 basis points (2.5%) rise over three years. They began reducing rates abruptly in mid-2019 even prior to the Covid outbreak. Rates were slashed back to zero by April 2020 in response to the Covid outbreak, where they remained until March of 2022. Combined with the gargantuan stimulus packages surrounding Covid, it should have been no surprise that inflationary pressures were poised to rise, and they have. Was the Fed able to execute a measured response to anticipate and gently move against these rising pressures? In a word, no. They maintained a confident ‘lower for longer’ approach for far too long.
Since March of 2022, the fed funds rate has hiked from zero to its present 5.3%, up 530 basis points or twice the rise of the 2018 cycle yet in half the time, only 18 months. This was the sharpest, fastest rise in history off such a low rate. This is akin to slamming on the brakes in a vehicle on a wet road. You don’t immediately come to a stop, but the brakes are on. This alone would tend to give one pause as to the wisdom of further increases. Add in the unknown lag effect between monetary policy changes and impacts on the economy and a pause becomes perhaps even wise.
What about market signals of a too-tight or too-loose interest rate stance? I mentioned the value of the Dollar vs. the currencies of our global trading partners. In fact, the U.S. Dollar has been rising quite smartly since mid-July of this year and sits near its highest levels of the cycle going back 15 years or more. Gold is another inflation barometer. If the market is fearful of future inflation and a decline in the value of the Dollar, it is reflected in the Dollar price of gold. At $1,880 per ounce, gold sits 10% below its level of August 2020. Not much of an inflation alarm.
Finally, the yield curve is inverted and has been for more than a year. This means short term rates of 5.3% are above longer term (10 year) treasury yields of 4.6%. An inverted yield curve is not normal, as typically there is more risk in longer dated investments, thus a higher yield is expected on longer term instruments. Recessions are preceded by inverted yield curves in most all instances. The chart at the top of this piece shows the federal funds rate since 1965. The gray areas are recessions. I would expect some gray in the year ahead.
In sum, with a spotty track record of forecasting the proper level of interest rates, and in the wake of an historic tightening over the past 18 months and myriad of market signals that policy is tight, I strongly suggest the Fed pause and cease their aggressive lurching from one side of the policy road to the other before something breaks. Pause, watch and listen, before you realize the next moves will be to lower rates.