Most Dreams Are Not Real … Like the Fed’s Dream

December 11 2018

It is September 26, 2017. The FOMC has just announced that it will hike rates to 2.25 percent. The Fed’s interest rate committee foresees strong economic growth for the years coming, unemployment declining even further, as well as subdued inflation. In other words, economic wonderland. According to my view, this was too good to be true, as I have explained earlier along these lines.

Days later, at the beginning of October, the Fed Chief Jerome Powell points out that an interest rate of 2.25 percent “still remains far removed from its neutral level.” The neutral rate is a level at which the Fed neither stimulates nor puts the breaks on the economy. According to the central bank, the neutral rate lies somewhere near 3 percent. A “rate that is still far from its neutral level” amid conditions of continuous strong growth and declining unemployment would imply that the Fed would continue to raise the most important benchmark rate of the country. More precisely: that the Fed would raise rates once more in 2018, three times in 2019 and twice more in 2020.

I argued time and time again that the market's interest rate outlook was wishful thinking. I do see another rate hike this year happening. But three more rate hikes in 2019? No way! Two, more, at most, was my forecast. And what about the rate hikes that were scheduled for 2020? Well, let me put it this way: I think it is more likely that the Fed will organize an open-house event at Fort Knox to exhibit its alleged gold reserves, in which visitors are not only allowed to view the bullion, but even to touch it. No, far from expecting rate hikes in 2020, I would rather expect lower rates by the Fed.

But there was also another reason why Powell would leave it at tough words. If stock prices in the U.S. were to decline, it remained to be seen whether the Fed Chief would stick to raising rates. At his press conference after the FOMC meeting on September 26, Powell said that he would adjust the Fed’s rate-hike path in case of a “significant and lasting correction in financial markets.” He added that “(…) one of the most important lessons from the financial crisis is really the importance of the stability of the financial system.”

Loosely translated from central-bankers speech, this means that as soon as the Fed starts to fear financial instability, the bank will radically adjust its rate-hike path. Financial stability is at stake when stock prices begin to correct drastically. Adjusting the Fed´s rate-hike path would mean less rate hikes or even a lowering of rates.

When he became Fed Chair earlier this year, Powell repeated multiple times that he, contrary to his predecessors, was not planning on coming to the rescue of stocks if stock markets would began to correct. All well, but something easy to say as long as stock market prices are reaching new all-time records day in and day out. Powell's real test was yet to come.

On Wednesday evening (Central European time), Powell came to stage at the Economics Club of New York. In his speech, he said – among other things – that the official Fed rate was “slightly below” its neutral level. Huh! In just a few weeks' time, he changed his stance on the Fed rate – which stood both in October and last Wednesday at the same 2.25 percent-level – from “far removed from its neutral level” to “slightly below its neutral level.” That is the largest U-turn that I have seen over the last twenty years that I have been following central bank policy. What is behind this U-turn? Why did the Fed shifted so abruptly and sharply?

A couple of days after Powell's comment that the Fed rate was far removed from its neutral rate, stock market prices in the U.S. began to fall. And they kept on falling, resulting in a fall that we can surely describe as “significant.” This was the first thing that gave Powell sleepless nights.

While he could counter his sleepless nights with a handful sleeping pills, there do no exist strong enough sleeping pills for what was yet to come.

Earlier this week, the Fed published its first release of its Financial Stability Report. In this report, we can read – among other things – that a significant fall in stock prices can get companies into trouble. This with all the consequences it entails for the economic outlook of the U.S. economy for 2019.

What could cause a severe and persistent collapse in stock prices? According to the Financial Stability Report, the plans for future rate hikes by the Fed itself! Even if the planned rate hikes were completely expected and therefore no longer a surprise to the public, stock prices can easily and abruptly adjust to higher rates, something which would increase volatility on U.S. and international markets and could lead to pressure on corporate businesses. Loosely translated: you can communicate whatever you want, but that is not a guarantee that the changes you are communicating beforehand will not ripple through financial markets.

It was the recent decline in stock prices and the risk that this would result in financial instability that led Powell and the Fed to change its course. If Powell says that the Fed rate of 2.25 percent is “just below its neutral level,” then he is in fact saying that after a rate hike in December we can expect no more than two rate hikes in 2019.

What we are faced with, is high economic growth, inflation already slightly above target that possibly goes up even further, but with a Fed that will raise rates only a couple of times and that’s it. In light of this, it remains to be seen whether the European Central Bank (ECB) wll raise rates on our side of the Atlantic and whether it will do so more than once.

Our economies are built upon debt and that economic model is in danger if rates, after a period of low interest rates, are raised toward the level at which the rates were lowered. Put differently, this economic model only works when rates remain structurally low. Yet, we have ended up in a situation in which rates are not only structurally lower than in previous economic peaks but are also too low in absolute terms. History teaches that this could lead to rising inflation or large economic bubbles. History also teaches that sooner or later these bubbles burst. History also teaches that a bursting bubbles goes hand in hand with turbulence and economic suffering. History teaches that inflation inevitably surfaces. And lastly, history teaches that precious metals prices are strong performers amid such conditions. No, I will not be surprised if 2019 turns out to be a golden year for precious metals. And, as a result, people will look back upon 2018 s a golden opportunity to purchase precious metals at a highly attractive price.

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