Be Prepared for a Violent Fed Reversal
The outlook for rates has taken what I call a U-turn. There’s very little doubt that the Fed is on track to raise rates. This outlook is not in response to any particular piece of economic data or the overall economic picture. In fact there are plenty of arguments why the Fed should not raise rates based on economic fundamentals.
However, they have a separate agenda which is that the Fed has committed, what I think will be viewed in hindsight, as a historical blunder by missing the opportunity to raise rates in 2010, 2011, 2012. That was when the economy was growing, not strongly but those were the early stages of the expansion.
The economy was growing well enough then to justify rate increases. If the Fed had normalized rates in 2011-2012, between 2 – 2.5%, they would be in a good position today to cut rates if necessary to fight a recession. Unfortunately they did not do that. They missed an entire cycle while experimenting with Ben Bernanke’s quantitative easing, which in hindsight will turn out to be a real mistake by the Fed.
Now they’re in the position to move rates after the eighth year into the recovery. While this has been a weak recovery, and people are still struggling with part-time employment, or can’t launch careers on top of other difficulties, this recovery technically started in June of 2009. This makes for a very long recession by historic standards. More than twice as long as the average expansion since World War II, and comparable to the very long expansions we’ve had since 1980.
We’re closer to the end of this cycle than the beginning. The Fed is concerned that if another recession started tomorrow (and I’m not saying it will, but it could) it would have no ability to cut rates.
While they currently have rates at 50 basis points, the Fed could only do two cuts until it was back to zero. This would force the decision to begin talking about negative interest rates. The Fed leadership wants to get rates up to 2 or 3% before any potential recession starts, just so they can cut them.
The problem is, how do you raise rates to that level? How do you raise rates to 2 or 3% without causing a recession that you’re trying to prevent? That’s what I call the Fed’s conundrum, and that’s exactly where the Fed is now. Is this a good time to raise rates? Probably not, but they are going to try to do it anyway.
The Fed has said they’re on track to raise three times this year. The market doesn’t believe it. The market is counting on maybe two rate hikes at most, but not three. My expectation right now is that the Fed will raise rates in March.
First, they have a bias towards raising rates. The Fed is not neutral. The threshold is fairly low. They feel that it’s “mission accomplished” on the job front; unemployment is 4.7%, we’re continuing to create over 100,000 jobs a month. That’s not the 2 or 300,000 jobs that we were creating a year to year and a half ago. It is still positive job growth, and with unemployment low and this rate in expansion, that’s “good enough.”