It All Comes Down To This

After months of speculation, debating and postulating, the Federal Reserve will hold their two-day Federal Open Market Committee confab to make their decision on raising the overnight "Fed funds" rate.

Morgan Stanley postulates four potential outcomes:

• A Hawkish Pass (60% Probability): The Fed passes on liftoff in September, citing the recent tightening in financial conditions, while keeping the door open for liftoff at the October or December meetings. 
• A Dovish Pass (30% Probability): The Fed passes on liftoff in September, citing both the recent tightening in financial conditions as well as a lack of confidence that inflation will move back to 2 percent over time. 
• A Dovish Hike (9% Probability): The Fed hikes rates at the September meeting, but strengthens expectations for a gradual path thereafter by significantly lowering the 2016 and 2017 dots, introducing 2018 dots that are below the longer-run dots, and further lowering the longer-run dots. 
• A Hawkish Hike (1% Probability): In this scenario, the Fed would hike at the September meeting while not decreasing the expected pace of hikes in 2016 and 2017 very much.

This outlook very much corresponds with my own recent analysis where I have suggested the data simply doesn't support hiking rates now.

"The Federal Reserve raises interest rates to slow economic growth to keep an economy from overheating which would potentially lead to a sharp rise in inflationary pressures. Since commodities are the basis of everything that is bought, consumed or other utilized; if there were indeed inflationary pressures on the rise commodity prices should be on the rise. As shown, this is clearly not the case."

"In fact, declines in commodity prices have historically been associated with declines in economic activity as shown in the highlighted boxes. While not every decline in commodity prices led to a recession, and I am not making that case, there is a high correlation between the ebb and flow of commodity prices and economic activity, as would be expected"

Yet, despite mounting evidence that the economy and global financial markets too weak to offset a further tightening of monetary policy, there are many economists, including those working at the Federal Reserve, that are expecting rates to rise. To quote Richard Fisher:

"Monetary policy, too, operates with a lag. If the Fed waits for full employment and then has to throttle back sharply, there will be a nasty shock. The upcoming Fed meetings present a timely opportunity to start slowing down the engines, however slightly, so as to maintain the confidence of markets, businesses, and consumers alike."

Fisher believes that inflation is running a bit hotter than more commonly watched measures suggest. He also believes the current deflationary build is solely due to the decline in oil and commodity prices which he believes to be transient and inflation will begin to track more closely to target levels by year end. 

This outlook was echoed by Fed Vice Chair Stanley Fischer at the recent Jackson Hole Economic Summit:

"Given the apparent stability of inflation expectations, there is good reason to believe that inflation will move higher as the forces holding down inflation dissipate further. While some effects of the rise in the dollar may be spread over time, some of the effects on inflation are likely already starting to fade. The same is true for last year's sharp fall in oil prices, though the further declines we have seen this summer have yet to fully show through to the consumer level. And slack in the labor market has continued to diminish, so the downward pressure on inflation from that channel should be diminishing as well.

With inflation low, we can probably remove accommodation at a gradual pace. Yet, because monetary policy influences real activity with a substantial lag, we should not wait until inflation is back to 2% to begin tightening."

While Fischer/Fisher are correct that inflation is low, there is NO SIGN that inflationary pressures will substantially rise, and stabilize, at 2% in the future. As shown the deflationary problem has existed since 1980 and continues today. While the fall in oil prices, and surging US Dollar, are certainly putting downward pressure on inflationary readings, that doesn't really explain the long-term deflationary trend.

(Note: The current debt/GDP ratio is inaccurate due to the debt being capped at the current debt ceiling limit. The debt ceiling will rise in September which will send this ratio substantially higher.)

So, while the Fed keeps suggesting the economic growth and inflationary pressures are "just around the corner;" such hopes have remained elusive over the last few years. 

If we look at both GDP growth and Fed Funds data, which dates back to 1943, and calculate both the average and median for the entire span, we find:

• The average number of quarters from the first rate hike to the next recession is 11, or 33 months.
• The average 5-year real economic growth rate was 3.08%
• The median number of quarters from the first rate hike to the next recession is 10, or 30 months.
• The median 5-year real economic growth rate was 3.10%

However, note the BLUE arrows. There have only been TWO previous points in history where real economic growth was below 2% at the time of the first quarterly rate hike – 1948 and 1980. In 1948, the recession occurred ONE-quarter later and THREE-quarters following the first hike in 1980.

In other words, the Federal Reserve is considering tightening monetary policy at a time when average real economic growth is less than half the level of previous rate hiking campaigns. 

Think about it this way. If it has historically taken 11 quarters to fall from an economic growth rate of 3% into recession, then it will take just 1/3rd of that time at a rate of 1.2%, or 3-4 quarters. This is historically consistent with previous economic cycles, as shown in the table to the left, which suggests there is much less wiggle room between the first rate hike and the next recession than currently believed.

It is there that we find the Fed's dilemma:

"There is clearly something amiss within the economic landscape, and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get out of the potential trap they have gotten themselves into without cratering the economy, and the financial markets, in the process.

…the Fed understands that we are closer to the next economic recession than not.  For the Federal Reserve, the worst case scenario is being caught with rates at the "zero bound" when that occurs. For this reason, while raising rates will likely spark a potential recession and market correction, from the Fed’s perspective this might be the 'lesser of two evils.'”

The real risk for the Federal Reserve is keeping interest rates at zero and the deflationary feedback from the collapse in commodity prices, and the Chinese economy trips the U.S. into a recession. Given that "QE" programs have no real effect on boosting economic growth, the Fed would be left with virtually no "effective" monetary policy tools with which to stabilize the economy. For the Fed, this is the worse possible outcome.

Therefore, while the data clearly suggests the Fed should remain on hold in September, they are clearly keeping the "door open" to lifting interest rates anyway. With the financial markets beginning to lose stability, my expectation is that things are likely not to end as well as most mainstream analysts currently expect. Therefore, if the Fed is at all uncertain as to whether they should lift rates in September, the data clearly gives them an excuse not to.

For investors, it all comes down to this.