Wednesday, March 14, 2018

Why Can’t Fed Rate Policy Inflate Main Street?

Investors are currently watching Fed rate hike policy closely as well progress into 2018 as a signal that the “Goldilocks” economic scenario, where economic growth continues while the Fed hikes rates, may be brought to an abrupt end.   I find the repeat episode of this Wall Street ritual every time the Fed increases interest rates comical today because it presumes that the Fed actually is impacting the real US economy with its rate policy in a way that higher rates would actually hit the intended mark.  And by intended mark, I mean the Main Street US economy and a resulting correlation to US CPI-inflation. 
The evidence that I will share in this article is pretty strong that the Fed is not the controlling force when it comes to taming US inflation, and thereby by extension, the US main stream economy.  In fact, its rate policy gymnastics show very little correlation to inflation changes over the last 20 years.   And it may be surprising to many that the entire Treasury yield curve has become increasingly disconnected from the monetary waste measure.  And this fundamental “conundrum” which dates back to Greenspan and the late 1990s from a historical data standpoint is important for investors to understand because it means that the impact of Fed Policy moves do not have the intended outcome for the Main Street American economy.  

If the Fed rate policy was truly a controlling force in managing inflation, we should expect that the short end of the rate curve would be highly inversely correlated with inflation as real rates rise and fall due to Fed rate moves – rates up, inflation down, and visa verse.  This outcome is etched in stone in the expectations of Wall Street, Congressional and a majority of investors.  However, this outcome is not what the data say is happening for the past two decades. 

Let me explain.

Fed Policy and CPI Inflation – Sterile for the last 20 Years


What if in the current economic situation, one where the stock market has been inflated by almost 10 years of continuous global central bank asset buying, the Federal Reserve is politically put into a position in which it believes that it must counteract the growing threat of consumer based inflation?  And, as it has done in the past dating back to 1980, it believes that it must continually raise interest rates on the short end of the curve in order to eradicate the inflation nemesis, even if it is a phantom threat?     What is the likely outcome?    

This is an important question since the Fed “dot plots” [excuse me if I don’t view the Fed as a bunch of children when I use this new terminology] all point to the fact the likelihood that the FMOC is going to raise short-term interest rates 3 to 4 times in 2018, and then continue hikes in 2019.  And the rational put forward is that they are trying to get ahead of inflation.  

My personal assessment is that they are just being driven by the international market price to finance the exploding US Debt level.  If I am right in my assessment, the Federal Reserve 3 to 4 rate moves, which look very likely for the remainder of 2018 will negatively impact the stock market, but are likely to do little in affecting the trend on overall inflation, which continues to be low.  

The reason is that the Fed does not create inflation through its policies unless corresponding government factors out of its direct control (Fiscal and Trade Policy primarily) are conducive to creating consumer goods and services inflation.   And, for the better part of the last 30 years, these policies have been counter consumer inflation, and pro international current account trade deficit now at a cumulative $11T since 1992 which oddly enough, is roughly equal to the US public debt level change over the same time period, imagine that! 

The consumer inflation rat lives, he has just been sequestered overseas by US trade and fiscal policy.  And, as a consequence of conscious government policy choices, management of US