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What We Can REALLY Learn From the Fed

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What We Can REALLY Learn from the Fed

David brought up an interesting point this week. While polite, reasonable, and respectful behavior (definition compliments of merriam-webster.com) is not typically the topic of conversation in financial circles, I submit that it should be. Whether “we” are in business, finance or government, “we” are people and people get things done by first building relationships with other people. Without civility, relationship building is impossible and the result of that, sadly, is being played out before our eyes in real time.

Thank you, David, for your words and example. Even over the years when you and I have disagreed, our mutual respect and behavior in a polite and reasonable manner had led to the building of a very enjoyable relationship.

David’s views are his own. But my guess is that all of us are somewhat frustrated with the political drama regardless what “side of the aisle” we are on. I’m sharing to emphasize the importance of looking beyond what we see on the surface or read in the headlines to ensure that what we are gleaning is reflective of what the speaker truly conveyed, instead of a version of what someone else wanted us to hear. 

Perception, after all, is equally or perhaps even more important than reality.

As you read through, keep our “Don’t be afraid to ask” motto in mind. If you have a question for David or any of our 20+ expert instructors just ask@fixedincomeacademy.com.

A Note on Civility

By David Horner, Ph.D., Chief Economist, Fixed Income Academy

Note the difference between the mud slinging that is characterizing two of the Republican candidate’s campaigns and the demeanor of Fed officials debating monetary policy.

Worse than the controversy surrounding the childish “food-fight” between Trump and Cruz’s over their wives is the most recent “dirty trick” associated with the Republican establishment. The desperation of less right-wing Republicans such as Jeb Bush has now spread to the legal arena. As I view the video associated with the charge against Trump’s campaign manager, this is an attempt of “anti-Trumpers” to further derail the Trump campaign, nothing more. Indeed, Trump’s secret service guard was so concerned about the reporter filing the suit that they too were trying to prevent the reporter from “attacking” Trump. Although I am not a Trump supporter, it is clear that the mainstream of the Republican Party has been co-opted by a group of corrupt operatives.

In contrast, consider the policy debate over monetary policy between the hawks and doves. When Charles Evans, perhaps the most dovish FOMC member, defends his position, he always shows respect for the hawks who disagree with him. Moreover, he weighs the pros and cons and, unlike lawyers and politicians whose “job” is to present only one side of the equation in order to boost their client or candidate’s chances, he admits the factors that do not support his position. Hawks likewise are every bit as civil, both sides trying to debate and determine what policy is best for the country. 

Frankly, the media has, in many cases made the situation worse rather than better. They seem to want to promote a fight. Several commentators interpreted Yellen’s recent speech as a “smack-down” of the hawks. This is simply not true. Rather, she made her case forcefully. And, as indicated in the Fed section below, much of what she said clearly went over the heads of the media pundits. But her words were not lost on the Fund managers and financial economists that I respect. Hence the positive market response to her speech.

Monetary policy and the Fed 

Chair Yellen’s speech before the Economic Club of New York reiterated the points made in her March 16 press conference following the most recent FOMC meeting. However her talk, made in the presence of economists and business leaders was more detailed and supported by a number of research and clarification footnotes. On balance, investors took the speech as being even more bullish than the press conference.

Although gratified by the economic recovery, Yellen’s main theme was that a premature hike in policy rates is the most dangerous policy mistake that the Fed could make and Yellen is very clear on this! As I have written a number of times, the best way to get nominal rates up to a more “normal” rate in the longer run is to keep policy rates “too low” in the short term. Moreover, as Yellen also points out, although it seems lost on the CNBC commentators, when rates are already near zero, the danger of raising rates prematurely swamps the danger or getting behind the curve (the footnotes in her speech to the economic clubs documents the research in this regard). Extraordinary measures are needed to get the economy out of a recession if policy rates are zero. Conversely, the measures needed to get inflation under control are straightforward and well understood.

Another error I hear over and over from smart but seemingly deaf commentators, is that the Fed keeps telling us the economy is in “terrible” shape. Are they not reading or listening to Fed officials? They constantly cite that the economy is on a slow, but positive track. They underscore the robust job increases and low inflation that has characterized the recovery (these are their mandates). Yes they acknowledge that growth is slower than they would like, productivity is weak and wages are not increasing as fast as they would like. But they have little to no control over these factors which are affected by fiscal and tax policy and by regulation. So the Fed is not saying the economy is in terrible shape. Rather they are saying that a policy mistake at this point, most notably, hiking policy rates too quickly, could put the economy into a slide and this is the worst possible outcome. It is better “goose” the economy and to accept a higher than optimal rate of inflation to that market rates rise to a point where they once again can serve the normal function of allocating capital efficiently. 

Having made the case for and agreed with Yellen’s cautious and gradual policy, I still think the Fed will raise rates at the June, September, and December meetings, one more hike than the recent median of FOMC members expectations and one less than their expectations at the end of the year. 

My reasoning is straightforward. I think that:

  • Given recent aggressive policy moves and coordination by G20 countries, the world economy will gradually move to a better footing than the most recent IMF downgrade (see my political note at the end of the report),
  • Following the yearend slowdown, the U.S. economic growth is beginning to improve,
  • Inflation will be higher than the current Fed forecast. 

In other words, the Fed will raise rates for optimistic economic reasons

Whether you agree or disagree, we’d love to hear from you. Cheers!

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