The Fed Decides… No Surprise

The Federal Reserve is one of the most powerful economic engines in this country, if not the world. Its power and influence is such that any meeting or quote, no matter how seemingly banal or inconsequential, can have dramatic consequences (or so it likes to believe!). The Fed meets eight times a year to decide if a change in monetary policy is needed, and yesterday it had one of those meetings.

Remember, the Fed hiked rates in December 2015 for the first time since before the financial crisis in 2008. It didn’t raise rates again until December 2016 and then in March. These hikes are supposed to a big deal.

Yesterday’s meeting was important because the Fed was expected to deliver one of these important hikes for the third time in six months and bring interest rates closer to “normal” – despite recent softening economic data, including today’s consumer inflation data which came in lower than expected.

Specifically, the May Consumer Price Index (CPI) actually went negative month over month, and the core CPI (less food and energy) fell to 1.7% on the year. That’s going the wrong way and not at all what the Fed wants to see.

Additionally, May retail sales data was also pathetic. The market expectation was for a slight rise in spending, but instead it fell a substantial 0.3%, and that’s excluding auto sales. Retail sales accounts for half of all consumer spending, so this is, again, not what the Fed wanted to see just ahead of Wednesday’s policy decision.

So what how did all that bad news affect the meeting yesterday?

As you know, the global economy slowed after the financial meltdown of 2008. In response, the Fed lowered its key rate to zero and implemented the much-ballyhooed policy of quantitative easing (QE) in hopes of stimulating borrowing, inflation (prices), and jobs. Following the Fed’s lead, central banks around the world also lowered their key rates to zero (or negative) and initiated their own versions of QE to try goosing their own economies.

But the Fed was only copying the failed policies of the Bank of Japan,  which started its stimulus programs over 20 years ago. Japan’s central bank tried everything in the book to fight years of deflation and financial crisis after crisis! Memories are short, but you don’t have to look that far back to wonder why the Fed thought a policy that failed in Japan would work here.

In 2013 the BoJ announced another massive stimulus program that made the Fed’s QE program look paltry. But, by last year, it was apparent the move had little effect on deflation brought on by an aging population that spends less, low immigration, and a low fertility rate… a demographic catastrophe.

But that’s nothing new; Harry has been talking about Japan’s losing battle for years!

But the BoJ isn’t the only major non-U.S. central bank to rely on monetary stimulus. The European central bank (ECB) has its own version of QE and negative rates.

The ECB met just last week and basically confirmed that its EUR60-billion-per-month ($67 billion) bond-buying program isn’t working as expected (surprise, surprise…), and also revised its inflation expectations lower.

Not only is the ECB running out of German bunds (bonds) to buy to stimulate inflation. It’s also failing to stimulate inflation! ECB credibility could be at risk…

OK. Let’s get back to the Fed and yesterday’s decision. Yes, it hiked the federal funds rate by another quarter point, as promised.

The Fed’s explanation about falling inflation is that it’s a temporary phenomenon and it will turnrn higher by next year. How that will happen is a fair question. The Fed forecasts GDP growth this year at 2.1% and back to 2% in 2018 and 2019.

So the economy still has a pulse, and the Fed still plans to hike another time this year and expects three to four hikes next year…

Another five rate hikes in the next 18 months? I doubt it. Not unless the economy does a U-turnrn and starts gaining steam. The employment situation seems to be solid – that is, if you just look at the unemployment rate and not the labor force participation rate.

The Fed also plans to reduce its $4.5 trillion balance sheet later this year by decreasing reinvestment in maturing securities.

The Fed’s outlook for the economy seems to be rosy, even in the face of data saying that’s not the case. If the data doesn’t improve like the Fed thinks it should, the path of the fed funds rate will reflect that.

In other words, instead of hikes there could be rate cuts. And if the fed funds rate could go to zero again, and QE could be back! That’s straight from the addendum to the Fed’s most recent policy statement.

We’re either going to get five or so rate hikes in the next year unless the economy tanks. If the latter happens, the Fed could again implement yet another version of its failed QE policy.

Fed Chair Janet Yellen thinks the strong labor market will eventually translate into higher inflation. She doesn’t believe that it’s wise to overreact to a disappointing inflation reading or two, and that even though the 2% inflation target has slipped, it will eventually turnrn around.

Chair Yellen was asked a couple times if central bank credibility and, specifically, the Fed’s credibility, has been damaged because global inflation is too low. Can you guess what her answer was? Yeah, she doesn’t think their credibility has been impaired.

The bottom line is that it doesn’t matter what I think or what Chair Yellen thinks. The market thinks the Fed is wrong.

Not only are long-term Treasury rates falling. The yield curve continues to flatten, and that’s a much more accurate reflection of the state of our economy. As I wrote last month, a flattening yield curve means the market doesn’t believe there’s much risk of rising inflation or accelerating economic growth.

And sorry, Chair Yellen: that means central bank, and especially Fed credibility, is impaired!

You can prepare for and profit from surprises in the financial markets, and specifically in the Treasury bond market, with Treasury Profits Accelerator.

Good investing,

Lance Gaitan

Lance Gaitan

Editor, Treasury Profits Accelorator

Lance Gaitan

Lance has a unique ability to find big gains in the most boring of market. He manages to turn sleeping giants into a monster gain-makers – some of the most profitable investment opportunities of a lifetime.