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Fed Punts, But It Should Have Hiked

By Jim Pearce on September 23, 2016

I’ll give this to the Federal Reserve, it is independent. The Fed turned a deaf ear to a growing chorus of economists and Wall Street analysts saying that the economy can withstand a modest uptick in short-term interest rates, and it didn’t feel compelled to raise rates this week.  Instead it left the target range for the federal funds rate at 0.25% to 0.50%, acknowledging the economy had strengthened but not quite enough, particularly given the health of the labor market.

But don’t confuse independence with decisiveness. The Fed’s wishy-washy behavior over the past month reminds me of its stance last September, when it punted on a rate hike after China unexpectedly devalued its currency, which sent the stock market into a correction. The Fed didn’t raise rates until December, after the stock market had fully recovered from its summer swoon.

But, surprise, China devalued its currency again a few days after the hike, triggering a second correction early this year. So once bitten, twice shy; the Fed is being extra cautious now.

But during the summer of 2016 the economy and financial markets could not have been more different than the summer of 2015. The summer of 2016 was remarkably placid, as the S&P 500 racked up 43 consecutive days with less than a 1% move in either direction, so the Fed can’t use market volatility as an excuse. Plus, China’s economy appears to have stabilized, settling in to grow at a healthy 6% to 7% rate. As for the Brexit vote, the European economy has yet to slide down a rabbit hole, as many feared it would.

Fiddling While Prices Rise

With little evidence that the global economy is hanging by a thread, why is Fed Chair Janet Yellen is sitting on the fence? One theory is that the Fed is reluctant to raise rates just before the U.S. presidential election and possibly influence its outcome. As the thinking goes, if the stock market crashes because of higher rates, voters may blame the party currently in power.

Also, by waiting until after the election to raise rates, the Fed can give the markets time to settle down before the new president takes office. Regardless of who the next president is, I’m sure he or she would prefer that the stock market go through a correction on the previous administration’s watch.

So maybe the Fed deserves kudos for sensitivity. But its unwillingness to act decisively ignores signs that artificially low rates are hurting the economy. According to Zillow, in July the annual change in U.S. home values was +5.1%, more than four times the rate of change in the “all items” Consumer Price Index reported for August (+1.1%). So low rates are distorting prices.

Ironically, some Fed voting members justify their reluctance to raise rates by pointing out that the CPI is well below its 2% inflation-trigger rate. This though prices for critical components of the index, such as medical commodities (+4.5%), medical care services (+5.1%) and shelter (+3.4%), are higher than average.

Even worse, some economists note that food prices didn’t increase at all the past year while energy costs actually dropped, as if the cost of living should only be measured in those terms. What the Fed fails to mention is that when those two commodity-sensitive categories are removed from the equation, CPI jumps above the 2% threshold that the Fed claims to defend.

Another Bubble?

If that doesn’t worry you, it should. Continuing Fed inaction could inflate a housing bubble. That’s bad enough, but, low rates have pushed up housing prices to the point that prospective home buyers are sitting on the sidelines waiting for another real estate crash before they can afford to buy. Zillow also reported that the U.S. share of income spent on rent jumped to 30% from 26% the past year, an increase of more than 15% when wages grew less than 3%.

Unfortunately, the next Fed meeting is scheduled for Nov. 1, a week before the election on Nov. 8, so don’t expect a hike then. After that, the Fed won’t meet until Dec. 13, which falls right in the middle of the critical holiday-shopping season, when the Fed will feel pressure to not play Grinch.

For all those reasons, now was the time to raise rates. This would have been the least disruptive time to shift our economy back on a more sustainable path.

By the time the Fed figures the political, economic and retails risks are past, another shock might send it back to its safe space. Meanwhile, savers continue being punished and the economy is distorted further. Better to take our medicine now and start getting back to normal than to wait and risk that a new economic malady will develop.

 


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  1. avatar
    Randy Reply September 24, 2016 at 11:33 PM EDT

    The Fed is independent? It may be independent from the pundits and economists, but it is not politically independent. The Fed has bolsters this economy for Obama the last 7 years. Any thought of increasing rates would send the economy into the tank. That would be bad for a democrat president and certainly hurt lying Hillary’s chances.

    Yes, they will wait until after the election. There decision will be based on who wins. No rate hike for Hillary, and a hike for Trump. Politically? You better believe. Corrupt? Look at the evidence!