June 2017. Another press release. Another press conference by Janet Yellen, the Chair of the Board of Governors of the Federal Reserve. Another rate hike has come and gone.
This is the second hike this year and the fourth since the Fed dumped the Zero Interest Rate Policy in December 2015. The markets had been well sensitized of the hike so stocks, bonds etc pretty much carried on as normal.
Ho Hum. Good job everyone said, sitting up on their hind legs and smiling with a sigh of relief. Steady hand at the wheel. No surprises. Very transparent. Go Janet!!
But we should be asking questions. Like where does Yellen get the confidence to raise rates when both inflation and economic growth are lackluster?
Her explanation is that the jobless rates are at a 16 year low of 4.3%, that job gain have been solid, that economic recovery is on track and that the recent drop off in inflation is a one off.
Is she crying Wolf?
Because Yellen has mostly ignored the key numbers (the politically correct term for this is “less data dependent”). Just look at the counter arguments.
Core inflation has been pathetic. And wage inflation is insignificant- companies have been hiring but people are so desperate for jobs or to keep their jobs that they bargain less.
The decline of union power due to automation, temporary workers, more women and the shift from manufacturing to services in the US means less wage increases.
These are structural, long lasting trends, not one offs.
And economic growth? Since the 50s the average US real GDP growth per decade has been 4.25% (50s), 4.53% (60s), 3.24% (70s), 3.15% (80s), 3.23% (90s) and 1.82% (00s) and the average so far this decade has been (hold your breath)… 1.33%!
There is a clear downward trend.
One key driver has been the slow but inexorable demographic change.
The 75 million Americans born between 1946 and 1964 (aka Baby Boomers) are the biggest cohort we have seen in the last 100 years. They have substantially retired and hence spending has been hammered. Add the fact that the Boomers had fewer kids so spending falls even further.
One other factor for declining demand is the maxing out of Women’s participation in the workforce which happened in the 80s.
Yet another reason is stagnant labor productivity.
All this means we are headed for a long period of low growth. With no inflation or strong growth in sight why is Dr Yellen acting so weirdly?
I have a theory. Let’s first get some fundamentals right.
The Government NEEDS inflation.
Because if you and I think prices will increase we will spend more now. Based on this increased demand, companies will make more profits and pay more wages. Companies will also invest in capital equipment.
Inflation also makes it easier on borrowers who repay their loans with money that is less valuable than the money they borrowed. This encourages borrowing and lending, which again increases spending on all levels.
But perhaps most important to the Fed is that the U.S. government is the largest borrower in the world, and inflation helps soften the blow of its massive debt. If you owed 19 trillion dollars, you’d love to see inflation rise, even by a few bips.
In the current macroeconomic world, inflation is not a disaster. Inflation is Government policy.
But here is the issue- Yellen is NOT seeing any real inflation! However, she is a loyal Government employee with a mandate. So what do she do? Cunningly try to convince everyone that there is inflation and that inflation is rising. By hiking rates.
There could be another good reason for raising rates. And that is simply to “normalize” it to a higher level that will allow the Fed to slash rates in case of an emergency. She is building a buffer.
There is one downside to all this.
The forward rate curve has flattened recently, indicating that the market believes future interest rates will be lower than before.
If the markets don’t believe her, and/or if her claims of rising inflation turn out to be incorrect, this could erode credibility in the mighty Fed. And a central bank with reduced credibility is less effective.
What many may not realise is that like most of her illustrious ilk, Dr Yellen has been disastrously wrong before.
In a 2005 speech in San Francisco, Yellen argued against deflating the housing bubble because "arguments against trying to deflate a bubble outweigh those in favor of it" and predicted that the housing bubble "could be large enough to feel like a good-sized bump in the road, but the economy would likely be able to absorb the shock”.
We all know how THAT ended.
We also know what happened to the boy who cried Wolf once too often. This time it’s an old woman, albeit an ex-Harvard Professor with a PhD from Yale. But it may not matter – if she cries wolf once too often, people may simply stop believing her.