There has been steady criticism in recent months that the agency has gone crazy, putting the market in peril.
Big financial names like Stanley Druckenmiller, Jim Cramer, and Jeffrey Gundlach have been pounding the table, imploring the Fed to slow down its apparent policy of autopilot interest rate hikes. This call for inaction is in response to a feeling in the money community that, as recently as December, the Fed seemed intent on raising rates and shrinking its balance sheet – arguably turning a blind eye to economic realities.
This disconnect sent the market spiraling and was a major cause of the bear market correction we just experienced.
What do I mean by disconnect? How can the Federal Reserve, home to the smartest economists in the room, be behind the curve? If you ask me, the Fed is a little like ill-fated Toys “R” Us, watching the world change before their very eyes and failing to adapt and change with it.
One example of this point is the heavy dependence the Fed puts on the unemployment rate (UE). Currently, we’re at right around a 4% UE, and it’s likely to fall to 3.5% this year. While the UE is an important economic indicator, it is by its nature backward-looking. Similarly, the Fed still relies on the Phillips Curve, an economic model that states that when the UE goes down, inflation must and will rise. So, the Fed has been relying on what has already happened to make decisions about what should happen, as opposed to focusing on the rapidly evolving American economy.
In light of all the controversy, the Fed may be poised to change their tune. While I believe the agency is still resistant to looking at the US economy in a new way, it does seem to be putting the brakes on interest rates. Perhaps they’re listening to what the bond market is saying with its ultra-low rates. And maybe, the Fed has hit a dovish streak, meaning that the rate hike cycle may be close to an end.
In a statement released after their latest meeting, Fed leaders assured Americans that, “Further gradual increases [in rates] are no longer necessary to prevent the economy from overheating.” Instead, the central bank will be patient as it determines when and what kind of future adjustments are needed to sustain growth – all of this in the face of unwelcome developments in the financial markets and muted inflation pressures. This is a step towards seeing our economy as it is now. Thank you!
Where they still have blinders on is in the realm of Moore’s Law, which states that information, data, and processing due to technological advancements is doubling every two years. That’s massive compounding. This principle is relevant because, over the past decade or so, we’ve seen a seismic shift in productivity and technological capability. So, everyone and every company can now do more with less, hence putting a very real cap on inflation. Still, the Fed is either reticent or resistant to factor this reality into their interest rate models.
As recently as December, the Fed was saying there are many more rate hikes ahead – two, three, who knows? But perhaps the answer should be none anytime soon. And for the first time in years, the Fed seems to be letting this truth sink in.
For instance, if you look at the World Interest Rate Probabilities (WIRP) function on Bloomberg, the market says the probability for a hike in March, May, and all the way out to late December 2019/early January 2020 was zero, even after a strong jobs report of less than 5%. In fact, it’s pricing in a cut to rates (meaning a slower economy) of 23% by January of next year. What this tells us is that markets indicate that the economy and interest rates are already at equilibrium. And, that the economy really can’t handle another hike without the real risk of recession.
What we need is a soft landing and some breathing room from the Fed. The goal, after all, is to slow growth or moderate growth, not squelch it. If we listen to the market, the message is low and slow, low and slow. It seems that the Fed and Chairman Jerome Powell are starting to listen. And it’s about time.