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December 17, 2015

The Real Reasons Fed Raised the Rate

After a year of waffling and flip-flopping, the Fed finally decided to raise rates, a decision that had the surprise of a sunrise. Yet there is a behind-the-curtain drama of clashing hopes and fears by the Fed’s governors and staff.

This conflict does not appear in their statements or press conferences, but in their economic projections. Let’s start with their hope for continued economic growth: the predictions released today for GDP and the fed funds rate…  

This paints a mildly optimistic picture. They have abandoned hope of a “take-off” – of growth accelerating above the 2.2% average of this expansion – but still have faith that no recession ends this already old expansion during the next 3 years, or actually ever.

But look at the Fed’s dashed hopes!

In June 2011, the Fed predicted that real GDP growth would peak in 2013 at a booming now unimaginable 3.5% to 4.2%, overheating vs. their hoped-for long-run rate of 2.5% to 2.8%.
After years of slowly lowering expectations, now they hope GDP growth for this cycle will peak in 2016 at half that. Worse, they believe that the US economy’s long-term growth rate is one-quarter slower than they believed four years ago (2.0% vs. 2.6%). That creates a sad symmetry, with 2% both their inflation target and their expectation for US growth.

We see the Fed’s growing desperation in their decision to raise rates now, despite forecasts that have been darkening during the past four years:

They did not raise rates because the economy has improved; they did so because it has not improved.

They act now, fearing that the recession will arrive before they can raise rates enough to give them the monetary ammo to fight it. So the Fed governors have begun the gradual process of raising the fed funds rate in tiny increments to 3.3%, which would restore a more normal relationship between the fed funds rate and GDP.

Good luck with that.

Jacking up rates will slow both domestic consumption and exports; raising rates while other central banks are lowering might send the US dollar into orbit. Worse, large parts of the US economy are already slowing (e.g., exporters and manufacturers), as are the economies of key trading partners, such as the oil exporters (including Canada) and many emerging nations, especially the big ones: China and Brazil.

As the economies of commodities producing countries around the world weaken due to the commodities rout, they also import less from the US, and in this way, falling commodity prices will further damage the US economy.

Some key sectors of the US economy have grown rapidly, such as the auto sector, but only because it was funded by excessive, loosely underwritten debt, including a large portion of subprime debt. This boom in auto loans is one of the symptoms of the imbalances and weaknesses typical of an old cheap-credit-based expansion shortly before the end.

Why don’t they tell us all this?

The US economy is in a peculiar situation. To use a pilot metaphor, it has flown into the “coffin corner“: it cannot grow faster, and slowing down probably starts a recession.
Politicians and government leaders have a long history of managing the expectations of the public. They consider it the most powerful tool they have. However, once leaders start on that path, they will find themselves routinely lying before they reach its end [see the Big List of Government Lies and add your favorites in the comments].

Fed leaders too have figured this out. They believe that managing the expectations of the public, and particularly the expectations of big business and Wall Street, to be one of their most powerful tools. So they “talk up the economy,” regardless of how mediocre it is, and regardless of what economic misjudgment that will produce, as Governor Lockhart did last week, to accomplish whatever their goals may be. 

Even as they’re raising rates, Yellen once again put negative interest rates on the table. In Europe, negative interest rates have already morphed from sheer impossibility to solid reality. 

Courtesy of Larry Kummer, Editor of the Fabius Maximus website, via Wolf Street

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