Economy - The Finance Gourmet

Neutral Interest Rates

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Fed Chairman Jerome Powell made some very interesting remarks where he said he thought that interest rates were “just below” neutral. This is bizarre on many levels.

First and foremost, neutral interest rates are perfect interest rates unless your economy is in a recession in which case you want stimulating interest rates, or if you are trying to control inflation in which case you want interest rates that have a constricting effect on the economy to stop price increases. So, if interest rates were close to neutral, and inflation was not increasing, then wouldn’t you want to keep interest rates at neutral?

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But, Powell and the rest of the Fed have been telegraphing a December rate increase as loudly as possible. In other words, event though interest rates are “just below” neutral, Powell and company want to raise them. Why?

Economy is Teetering

The other weird bit is that everyone can see the economy is slowing down, and quickly.

Housing starts are way down. Housing sales are decreasing. Both are very much affected by higher rates.

The stock market is falling, having erased the whole year’s gains. Also, in very large part due to rising rates and their affects on customer spending and corporate profits.

Then, for added fun, the automotive industry has begun announcing big layoffs, and major plan closures. Why? Falling car sales. Anyone want to guess what makes it tough to sell a product that most buyer depend on a loan to purchase? Rising rates!

So, in other words, all of the signs point to interest rates having a negative, or constricting affect on just about every part of the economy that is sensitive to interest rates. How in the world can that possibly be construed as “neutral”.

Fed Going to Start the Recession

I’ve gotten closer and closer to saying it over the last few months, without actually saying it, because predicting things isn’t really what I do, but now I’m going to say it.

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The Fed will cause the next recession with its compulsive interest rate increases. If the December rate increase doesn’t do it, one of the ones next year will. The time for the Fed to pull back and be cautious is now. No one is sure if the inflation is real, but everyone can see that the coming slowdown is real. In that case, the prudent thing is to wait and see, but the Fed doesn’t want to wait and see, it wants to be “hawkish,” and so it will over-raise rates, and dunk the economy.

If they don’t change course, the only thing we can hope for is that the recession is light.

Fed Raises Rates On Schedule

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The Fed has been telegraphing a September rate hike for quite some time now, and they followed though with another 0.25 increase today. They also anticipate a December rate hike still this year as well.

I mentioned last time, this increase marks the end of the “free” rate increases that really didn’t do much to affect the economy as the rates were laughably low so much so that getting any commercially available rate meant a lot of “padding” in the rate from the Fed rates. This rate increase pretty much ends that.

From here on out, ever quarter percent increase goes right into the economy as an increasing headwind. Between political uncertainty, a burgeoning trade war, and an economic expansion getting long in the tooth, it’s my opinion that the Federal Reserve is acting recklessly here pushing ahead with its rate increase timeline without any evidence of inflation, and no evidence of wage growth. In other words, the Fed is raising rates despite there being almost no inflation.

Traditionally, this does not work out for the American economy. Every time the Fed starts raising rate for reasons OTHER than fighting inflation, the result is a recession, often a big one. There is no reason to believe this time will be any different. If the Fed follows through with a December rate hike, things will start to wobble. Another one in the first quarter next year is probably pushing the donkey cart off the ledge. Unfortunately, we’re all still attached to the cart.

Someday, we’ll get around the “my Dad is stronger than your Dad,” version of being an inflation hawk and go back to managing for full employment with a 2 percent inflation target (meaning that’s were we want inflation to be) rather than forgetting all about employment and looking at any increase in inflation, no matter how small, or how far away from 2 percent, as a command to act.

Time to play defense, financially speaking.

Stock Market Is a Leading Indicator

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Remember, the stock market is a leading indicator.

What Is a Leading Indicator?

This should probably get its own post, along with what is a lagging indicator, but that isn’t the point of this article, so let’s hit the highlights.

At the most basic level there are leading indicators and lagging indicators. A leading indicator is a measurement of what is to come. A lagging indicator is a measurement of what has already happened. At a metaphorical level, the display on your car that says you have 80% of the life of your oil left is a leading indicator. It is measuring the future. Note that it does NOT predict the future. It’s a best guess effort based on available data.

Contrast that with a lagging indicator, which measures something in the past. Metaphorically, this might be the sticker on the windshield that says the mileage of the last oil change, or your maintenance log.

In the world of economics, most lagging indicators are big data compiled by the government. You may have noticed that the June Labor Report comes out in July. That’s because you have to wait until the end of June for all the data to even exist. Then, you have to compile it into a report.

This doesn’t mean it has no value. On the contrary, it is a valuable piece of information about how the economy is doing.

A leading indicator is one that is a measurement of the future. Since the future is unknown, leading indicators are, by definition, not 100% accurate. The stock market is a leading indicator. It is a measure of the expected value of business and companies. So, while the stock market is moving up, it means that investors think the economy is still growing.

Are they right?

Based on the data right now, probably so, but what people forget is that things change. Not just the market being wrong, but the actual world around the market changing. Things like new tariffs change the status quo. Things like rising deficits, tax changes, and interest rate moves all change the status quo. So far, the investors in the stock market think things still look fine.

But, it won’t take much to change their minds. Everyone has one eye on the exits at this point. Whether or not they need to use them, and when, is anyone’s guess.

Interest Rates Rising Into the End of the Year

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The Federal Reserve did not increase interest rates at its August 1st meeting. That was widely expected after the increase from the pervious meeting. Traditionally, the Fed tries not to raise rates in back to back meetings unless it feels like the economy is getting away from them. It allows the markets, and just as importantly, the economic data The Fed relies on to adjust to the previous hike before implementing another one.

Rate Hike In September

The Federal Reserve Bank did try and telegraph that it is currently looking at another rate hike for September. While the Fed did not raise rates, it did repeatedly say how “strong” the economy was, and how strong all the economic data was.

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And, for the first time in a long while, inflation is actually running near the Fed’s so-called target rate of 2%. While the Fed’s actions seem much more like 2 percent is a ceiling, rather than a target, recent data does suggest that inflation is running solidly near the two percent mark, so action is likely warranted.

Will Higher Rates Trigger the Recession?

Here is where things get tricky.

While the Federal Reserve cannot let inflation run wild, the fact is that the current expansion of the U.S. economy is coming up on “longest ever economic expansion” territory. Add to that the uncertainty of the mid-term elections in the United States, an wobbling international economy, and the thundering bull-style tariff implementations of the Trump administration, and there are a lot of winds buffeting the economy. Any one of them could knock it off course, and trigger the next recession.

Fate has a heck of sense of irony some times.

The Great Recession was arguably caused by the Federal Reserve raising rates to cool off an overheating economy powered by unrealistic real estate market reaction.

The big internet bubble pop recession was also triggered by a Fed raising rates into the “irrational exuberance” of a stock market where valuations no longer made any sense.

And, here we are, an economic expansion on its last legs with plenty of uncertainty all around and here comes the Fed with — you guessed it — a series of interest rate hikes.

Will history repeat itself?

Unfortunately, the answer is almost uncertainly yes. This next rate hike, and maybe even the next may be tolerated and absorbed into the enormity of the U.S. economy, but the Fed can’t seem to contemplate what it might be doing OTHER than fighting inflation. Other Feds preached the value of the soft-landing, but this Fed hasn’t even THOUGHT about the fact that its own actions might causes circumstances that require a soft landing.

As always, I am not a fan of market timing for long-term investors. I do encourage you to rebalance your portfolio if it has been longer than a year, and take a real hard look at your risk tolerance. In the next year or so, it is VERY likely that you will be looking at your portfolios’ expected LOSS rather than your portfolio’s expected gain.

The one thing we have going for us this time around is that no matter how much politicians have tried to ruin the progress made in securing better capitalization for banks during the Great Recession, the fact remains that most banks are in a much stronger position to help withstand the winds of a market crash this time around. That doesn’t mean it will be fun, it just won’t be a complete and total threat to our entire economic system.

In the next month I’ll be building up a series of articles on how to prepare for the imminent recession. Bailing out of the market for long-term investors is not one of the steps, but there are things you can do now. For starters, make sure the job you have is the one you want for the next few years. Finding a new job is always harder during a recession. If you’ve been thinking about moving the time is now. Just be sure that wherever you land will both be able to weather the storm, and will be willing to keep you during it. Now isn’t the time for risky, companies that might not make it.

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If you are thinking about buying a house, make sure you are not reaching for the payment. Your next raise is likely the last for a few years. Same thing with car payments, or any other payments for that matter.

If you don’t have an emergency fund, bump the priority for saving one up to the top. You just might need it soon.

Don’t panic, but be smart. Make conservative financial decisions for the next 12 months.