Extreme Caution Ahead: The Fed Is Raising Rates

You’ve heard a lot recently about the insanity of the Fed’s continuing bias toward further interest rate hikes and ongoing quantitative tightening planned over the next four to six quarters. Their plans for three to four more rate hikes while dramatically shrinking their balance sheet sounds “nutty” to me.

There seems to be a broad consensus opinion that they need to increase the Fed Funds Rate to normal historical levels topping out at 4-5%. This viewpoint discounts the severity and damage caused by the worldwide systemic financial and economic collapse motivated by the Financial Crisis. While leadership at the Fed, Treasury, and Executive Branch avoided a 1930s-style Depression, the depth and breadth of the collapse caused a deflationary plague the world economy is still recovering from. We can see the lingering effects in Europe, Asia, and even in the U.S. In 2018, the U.S. will likely post the best and only 3%+ growth rate in the last ten years while topping off the weakest recovery in history.1 

Beginning in Q4 of 2015, the Fed has hiked rates eight times from 0.25% to 2.25%. While most historians might see today’s Fed Funds Rate level as modest by historical standards, it represents an 800% increase in real rates. The magnitude of the increase dwarfs the 425% rise in rates that led up to the Financial Crisis. The Fed’s obsession to gain more rate-cutting firepower has us on a path to the very recession and crisis they hope to be able to deal with. In my mind, this is backward thinking and their actions will very likely compromise the world’s ability to break free from the chains of deflation and get back to real growth. 

Each rate hike causes capital to be allocated away from economic growth, capital formation, and consumption. Increasing rates drain the cash flow from consumers, companies, and the Federal Government needed to service increasing debt payments. The Fed might want to evaluate the magnitude of changing rates and the weight this has on the economy and financial system before continuing on their current path. Chart 1 shows the effect of rate hikes as the proximate cause and timing of recessions. This is extremely important to investors because bear markets tend to start four to six months before a recession.

Housing is affected early on by rate hikes and has been a reliable predictor of recessions. Existing home sales tend to be one of the first sectors of the economy to falter as rising interest rates constrain buyers. Typically, housing statistics will start to decline about 18-24 months before the start of a recession.2 Chart 2 illustrates the last few peaks in housing which coincided closely with Fed tightening cycles, and the economic recessions that typically follow approximately two years later. Existing home sales post-Financial Crisis peaked in Q1 of 2017, while housing starts hit their high point about a year later in 2018. Historical trends would suggest a high risk of recession starting with the first quarter of 2019.

I’m not sure what the Fed is looking at, but it would seem to me that hiking rates beyond Q1 of 2019 would be a horrible idea. The Fed’s dual mandate focuses on full employment and inflation, but a reasonable assumption is that they would also want to ensure the health of the economy. Recessions cause deflation — not inflation — and people lose jobs when the economy comes to a grinding halt like it did in 2008. The Fed has historically continued to raise rates too high and for far too long, which tips the economy into recession. It’s time for the Fed to stop their insane behavior of continuing to do the same thing while hoping for different results.  

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Sources:

1 “Real Gross Domestic Product.” FRED, Federal Reserve Bank of St. Louis, 26 Oct. 2018

2 “Housing Starts: Total: New Privately Owned Housing Units Started.” FRED, Federal Reserve Bank of St. Louis, 17 Oct. 2018