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The Fed Shows Its Hand

By Robert Frick on September 18, 2015

Conflicting opinions over a Federal Reserve Board hike were flying fast and furious this week, but I had to laugh when I read one economist yesterday say the Fed had decided “it’s steady as she goes.” This in reaction to the board’s announcement yesterday at its September meeting that interest rates would not be bumped up.

The reason our central bank didn’t raise rates yesterday is the economy is anything but steady, so it made the right call. Raising rates would have been a bluff—a signal that the economy is strong enough to start returning to business as usual, when it really isn’t.

Recall that back at the beginning of 2009, when the markets had collapsed and the economy was engulfed in The Great Recession, the Fed lowered its benchmark interest rates almost to zero in hopes to stimulate business.

Since then we’ve been in a state of ZIRP. This zero interest rate policy is an artificial, nurturing environment, kind of like starting your strawberry plants in potting soil, hoping the nutrient-rich earth will spur growth so you can transplant them into normal garden dirt more quickly.

But after six and a half years our economic growth is only tepid. The 17 Fed policy makers’ median projection of GDP growth this year is just 2.1%, and it downgraded its forecasts for 2016 and 2017. To put this in perspective, our average annual GDP growth the last 10 years was 3.51%, and that included the recession year of 2008 and a virtually flat 2009. For the last 20 years that average rate was 4.42%.

Straight Talk
China’s market turmoil and its seemingly abrupt economic slowdown, and the continued drop in commodity prices are weighing heavily on the Fed’s mind. In a statement with the rate announcement, the Fed, in typical econ-speak, said: “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”

Straight talk came from Goldman Sachs Chairman and Chief Executive Lloyd Blankfein. On Wednesday he predicted the Fed wouldn’t raise rates, and said if it did it wasn’t “because there’s a tsunami of evidence of a hardening and quickening economy, tightening of labor, (and) acceleration of inflation.”

Of those three factors – economic growth, unemployment and inflation—you’d be hard pressed to find an analyst who thinks the economy is growing robustly or inflation will grow quickly to the Fed’s 2% target. In fact, inflation seems to be slowing. Inflation rose just 0.2% in the year ended August. Deflation is the real worry.

You will, however, find many who think that our unemployment rate dipping to 5.1% is evidence some real economic heat is building. But that number is deceptive. Yes, historically 5.1% could even be considered full employment. And dipping much below that could cause wage inflation as employers competed for scarce workers. Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, who voted to raise rates this month, was quoted as saying in a statement that “The labor market continues to improve, with solid job gains and declining unemployment.”

But wages are barely rising, if at all. The Fed target for nominal wage growth is 3.5% to 4%, but actual growth in the last year is just 2.2%, according to the Economic Policy Institute. More alarmingly, the percentage of adults employed or looking for a job has fallen to a 37-year low, showing there is a great deal of slack in the labor market.

The Fed is basing its rosy employment forecast on dated numbers. Earlier this year the Associated Press quoted Diane Swonk, chief economist at Mesirow Financial, as saying, “5.5% doesn’t mean what it once did.” Full employment “is always a moving target, and it has moved down,” she said.

The New Abnormal

We’ve had rates so low for so long that many have forgotten what normal is. Last night after the Fed announcement the nightly news celebrated the lack of a hike because mortgage and car loan rates would stay low. Sheesh. What about savers who have been punished for six years and forced into assets they otherwise wouldn’t touch?

If you’re rooting for the economy and our general well-being, you want a rate hike as a symbol that the economy has some real life. Yes, bond prices will drop some, and the stock market may get rocky for a time, but it will be proof positive that we’re out of the woods, at least according to the Fed.

So when will that happen? The Fed hinted it would be before the end of the year, but given it’s delayed and delayed again this year, and everyone’s crystal ball is murky right now given China and the risk of deflation, even that’s not a safe bet.

Our portfolios in Personal Finance reflect this state of uncertainty. We’re not risk averse, but in this environment we’re especially careful to minimize risk in our portfolios by sticking with the most dependable companies. Until there are more cards on the table, we’re placing our bets especially carefully.

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