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
consumer price inflation has been transferred to International Central Banks, with the PBoC and BOJ being the biggest controlling forces.   Federal Reserve policy since the year 2000 with respect to having an impact on consumer price inflation as the data shows has been sterilized.

The inflation discussion is important for investors because it is “usually” a critical component in how high or low interest rates will go, and therefore whether investing in longer term bonds at historically low interest rates is a sound decision.   As you can see in the information contained in the graph below, historically the 2 Year Treasury rate has been a good rate to follow in order to determine the direction and magnitude of consumer pricing pressures in the US economy.  Since 1952, the relative correlation of inflation to the 2 Year Treasury  rate has been .70, which means that movements in recorded “Main Street” inflation explain a high degree of the movement in the yield on the 2 Year Treasury  (other Treasury maturities have a similar correlation, but the 2 Year has the highest correlation).

But the data thru time shows an interesting twist.  Post 1980, when Fed monetary policy was set on a course to contain the rampant inflation that materialized in the 1970s, the 2 Year Treasury rate remained steadfastly above the rate of inflation, and was very strongly correlated for 20 years as the two moved in virtual lockstep downward.  However, since the year 2000, the correlation has broken down substantially.   For the past 18 years, the rate on the 2 Year Treasury has been a much weaker indicator of the on-going changes in inflation.  And the reason the poor correlation has existed can be linked to the underlying Fed monetary policy “attempt” to push consumer prices higher, and thereby avoid a deflationary economy, through the use of negative interest rate policy on the very short end of the yield curve. 

Historically in the 1950s and then again in the 1970s, when negative interest rates on the short end of the yield curve materialized, consumer price inflation was a strong certainty.  In fact, the correlation of real interest short-term rates (nominal Fed Funds rate minus inflation) to the inflation rate in the 1970s was -0.368.  This factor means that although not a perfect policy tool to generate inflation, as a transmission mechanism, negative real short-term rates were a factor that led to high rates of inflation in the 1970s. 

However, post-2000 the ability of the Fed to use the short-end of the curve to impact inflation up or down changed.  In fact holding real rates negative for the better part of the past two decades, first under Fed Chair Greenspan in the 2001-2006 time frame, and then under Bernanke, Yellen and now Powell ultra-low short-term rates has not transmitted through to the overall interest rate complex to a degree any greater than the correlation witnessed from 1952 to the present day.   This data points to the fact that US has become a price taker, not maker in the world economy for a large portion of its consumer goods and services.  I found a telling chart which put together by Carpe Diem at which is a great summary of what has happened in the U.S. economy over the past 20 years.

What this chart tells me is that in areas where US fiscal policy has focused on shoveling more and more money into the pockets of consumers to buy domestic based services, consumer price inflation is strong, and even rampant in certain cases.  Evidence can be found in college tuition and textbooks (student loans, grants), hospital and medical services (Affordable care Act), childcare (dependent care tax allowance) and even housing up until the 2008 mortgage crisis, which has since reflated thanks to various government programs and ultra-low mortgage rates.  

However, in markets where foreign markets have a sizeable market share of domestic demand the price trend has flat-lined or even been negative. 

International Bankers Currently Control the US Inflation and Real Growth Outcome


This data leads to the conclusion that there must be other structural causes in the financial market that influence the relative price of consumer goods which effectively neuters the current Fed interest rate policy.  Imagine the Fed having to admit that all the gyrations they have gone through over the past 2 decades to fight deflation using interest rates has been complete nonsense, and that it has been the International Banks that are dictating American Main Street economic outcomes.  

The Fed is faced with being an inflation taker, not maker, and therefore its policy responses miss the intended mark entirely, unless you want to argue that they want to drive stock valuations to unsustainable highs, only to eventually bust or they intentionally try to cause real economic growth to continue to trend lower and lower through time.   

Unfortunately this is what the data show, although no one in Washington (other than Trump it seems) wants to address the root cause of the problem.  Why?

Because the rate policy and the programmed Fed responses have been very good for stock and long-term bond holders, as evidenced from the reflation of the stock market post collapse in 2001-2003 and in 2008 and early 2009, and the tremendous boom in stock prices and decline in interest rates since 1980.   But, heaven forbid that real rates jump back above 0% and approach the 2%-3% zone as they did in 2007 because this will almost assuredly deflate the stock market.  (See article, Overfed Stock Market Going on a Crash Diet)

The financial stability issue is why abdicating control of the effect of consumer price inflation to foreign markets is a dangerous foreign policy position for the US.  The legislated response by the Federal Reserve to any hints of CPI “expectation” increases above 2% is an increase in short-term interest rates.  However, as the data show, this response does not have the intended impact on inflation (or deflation in the case of pushing rates to zero) because it does not change the price of overseas goods which are a major part of the CPI calculation.  Why? Because the International Bankers use the financial flow market to adjust their currency relative to the USD to negate any US policy moves – which is the rub. 

If the US wants to favor its own Main Street economy through fiscal or trade policy to the detriment of the Asia-Pacific tech industrial base, the International Bankers can just sit back and let the Fed raise rates to kill the threat of US industry taking back US market share.  Once the market goes bust, like it did in 2008, the PBoC and BOJ step forward and bail-out the US Debt, with strings attached that it go to consumers who are hooked on foreign manufactured goods.

Crazy you say?  Here again, the data do not lie.  Where do you think the money came from to fund the US debt explosion higher post the 2008 financial crisis?

As you can see, the funding came directly from the PBoC, which printed Yuan, converted it into USD and simultaneously allowed Apple Inc. (AAPL) to have slightly greater access to the China market   in exchange for doing its production of I-Phones in China.  Many other similarly structured deals of this nature have been done by multinational companies.  That is why they are so vehemently opposed to Trump trade policies; however, Main Street America is not ignorant to how this game is rigged against them, as Trump's election proved.

Don’t take my analysis of the data as a statement that I am an advocate for rampant consumer price inflation or even against international trade.  However, I do expect that US policy makers that oversee the financial stability of the US markets actually implement policies which produce the intended outcome that they are purported to have, not indirectly cause financial market instability or favor international markets at the expense of the US economy.  If the Federal Reserve interest rate policy has little to no control over the Main Street US economy, and only manipulates the stock and bond market up and down, then there must be an inherent structural problem that is not being addressed somewhere else in government policy.   And, the fact that they can move their interest rate policy into an extreme zone in terms of negative real rates, as they have done since 2008, and not produce a measurable change in the CPI inflation trend is a pretty good indication that the system is broken. 
As investors, it is important to understand how it is broken, and what to look for that might actually cause a change in interest rates and the underlying inflation trend going forward.

You can review my analysis of this important question in my next scheduled article on the subject, What Will Make America Inflate Again?

Daniel Moore is the author of the book Theory of Financial Relativity.  All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell. 

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