The Fed continues to execute according to plan.
The market had largely anticipated the recent move by the Fed to raise short-term rates by 0.25%. They liked the more the even-keeled and cautious tone that Fed chairwoman Janet Yellen conveyed in the press conference. Per Binyamin Appelbaum of the New York Times:
Figure 1: Ebullient(adj.) – Cheerful and full of energy
The market rallied on this news because they have a higher confidence that the Fed won’t be too quick to take away the punch bowl. Recent good news in economic numbers, such as the positive jobs report last Friday, made many market participants worried that the Fed might move too quickly. Meanwhile, just like every time the Fed is on center stage, there are plenty of armchair quarterbacks who suggest numerous reasons why they are wrong.
But really, what has changed? Janet Yellen and the Fed have been remarkably consistent in their messaging and execution, especially since the first rate increase back in December of 2015 (remember the market frenzy that caused? Lucky for you I have a reminder… see the chart below)
Figure 2: Price Chart of the S&P 500 Index
Back then the market was freaking out and saying either that, either 1) the Fed was behind the curve and should have moved sooner, or 2) that they were premature and were trying to raise rates too soon. Famous market prognosticator Jim Grant even forecasted that after the first hike in 10 years, the next move the Fed would make would be to take it back!
Figure 3: Jim Grant tries to convince Kelly that real men wear bow-ties
What Janet Yellen said in that press conference was “this process is likely to proceed gradually.” And gradually it has proceeded. While many people point to the fact that the Fed was over optimistic about the economy and predicted that they would raise rates 3 or 4 times in 2016, they held off and raised rates next in December 2016. This is fully consistent with what their message has been. The Fed, and Janet Yellen especially, never said they were going to raise rates ‘come hell or high water’. They have always said that they would need to see meaningful economic progress, and that future interest rate hikes would be “data dependent”, meaning if the data did not fully back the case for raising, they would wait. Sure, they thought the economy would grow a little faster than it has, but so did everybody! They have to be optimistic. The crystal ball at the Federal Open Market Committee, where the Fed decides interest policy, is not any better than anyone else’s.
What armchair quarterbacks of Fed policy fail to understand, is that it is perfectly rationale for a Fed president to come out and say something to the effect of “given what we see in the economy, our base case is for growth of (X), and if we do indeed see growth of (x), it would be appropriate to raise rates (y) number of times in the year.”
Think about it like the old favorite analogy of Wall-Street when we were still nursing major injuries from the financial crisis, where the economy was the patient, and the Fed, as the doctor, is trying to diagnose the malady, and prescribe the cure.
The Fed predicted that they would raise rates 4 times in 2016, they have no credibility.
Imagine you go to your doctor, and he says “take these pills for 2 weeks, and I expect that after that your condition should be improving and you will be able to go to a lower dose after that.”
You do as prescribed, and go back to see your doctor after the 2 weeks are up. He checks you out and says “hmmm, you’re not progressing as well as I would like. Let’s keep the same dose for another 2 weeks and we will hopefully lower you after that.” Would you immediately rail the guy for being wrong in his forecast on your progress? Of course not.
But the Fed is moving too slowly and savers are getting punished by these low rates!
You go to your doctor and tell him that the pills you are taking are causing you abdominal pain and you read that long-term exposure could cause problems for your liver.
“Yes, I realize that this cure has some potential negative side-effects, but unfortunately, until we are certain that you are over the condition that nearly killed you, it is safer to error on the side of continuing to use the pills. We will continue to gradually lower the dose as we can, until you are 100%”
I see your silly doctor analogy and I say, why doesn’t the Fed just rip the Band-Aid off and raise rates back to a more normal level?
Were you around in the 2013 taper-tantrum? Did you see the chart above that showed the first time the Fed raised interest rates? The response from the doctor might be as follows:
“Taking you off the medication too quickly can be dangerous. Your body has exhibited some withdrawal symptoms as we have been lowering doses and we do not want those withdrawal symptoms to get so severe that they cause a relapse.”
This 0.25% increase in rates from the Fed was widely expected due to the improving economic conditions, and Janet’s press conference afterward confirms that the Fed has not deviated from their strategy. They will raise rates gradually, as economic conditions allow for them to do so. The Fed does not drive economic conditions, but rather responds to them. The Fed haters from all sides should concede this point, and that if nothing else, the Fed has done exactly what they told you they were doing and it has been a very appropriate strategy.
Jim Grant was wrong when he signed the “Open Letter to Ben Bernanke” warning that the easy monetary policies were going to cause hyper-inflation like that from the Weimar Republic. He was wrong in 2015/2016 when he thought the Fed would have to reverse course and lower interest rates again. He was wrong in July of 2016 when he recommended to buy gold at $1,350 (it’s down over 11% since then). And finally, he is completely wrong when he said in September that markets are losing confidence in the Fed! They have since risen rates twice and the markets are taking them at their word for expected increases in 2017. If anything, the Fed has gained credibility.
The Fed is steering monetary policy back to normal over time; and they are doing so in the exact way they said they would – as conditions allow. This latest increase of 0.25% is another step in that direction… a baby step, but one of more to come.
Until next time…
“Do what you feel in your heart to be right – for you’ll be criticized anyway. You’ll be damned if you do, and damned if you don’t.” – Eleanor Roosevelt