Feeble Arguments Against a Rate Hike
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We look forward to a week filled with data including CPI, the Empire Manufacturing report, Housing Starts, Industrial Production, and Existing Home Sales – not to mention the important primary election contests in Ohio and Florida tomorrow. But at the top of the list of important events is the FOMC meeting on Wednesday.
The consensus of Wall Street economists right now is that the FOMC will leave interest rates alone. The consensus is almost universal that the Fed will choose to skip this week’s meeting. So, in keeping with my general role as a gadfly, I want to give some reasons why the Fed might very well choose to raise rates.
One place to start is by examining the arguments for not raising rates. Before I do that, let me assure readers that I have not changed my opinion that this is the most dovish Federal Reserve in history. But, since they have broken the skin on the milk we can no longer consider the possibility that there is no way this Fed would ever hike rates. Prior to the December meeting, it was plausible to think that the hurdle for hiking was very high and that it was possible that 2016 might end with rates still at zero. The question is, though, no longer whether the Fed is willing to hike rates, but whether they currently want to hike rates…and when.
Here are what I see as the main arguments for skipping a rate hike at this meeting:
(1) While the US economy is doing okay, the global economy is weak especially in Europe.
I will take here a somewhat different tack than some other observers might. The standard answer here is “the Fed is not responsible for the global economy, but for the US economy.” This is true, but since I don’t think changing interest rates 25bps in an environment of abundant liquidity has any meaningful effect on domestic or global growth my perspective is different. The ECB just lowered rates, in large part to put downward pressure on the Euro versus other currencies and hence to help Euro growth and inflation. By raising rates, the Federal Reserve would actually reinforce that move, since doing so would tend to strengthen the US dollar and other pegged or semi-pegged currencies against the Euro and other units. So in my view, if the Fed wants to help other economies and is not worried about the domestic economy so much…the solution is actually to raise rates, not to keep them stable or lower.
(2) The Fed needs to remain wary of the risk of deflation.
With inflation at the highest levels since the crisis, with median inflation above the stated FOMC target (and core CPI inflation at the target, with core PCE below but rising rapidly), this seems like a crazy thought process that doesn’t really require a lot of discussion to dismiss. If inflation at 2.0%-2.5% and rising is representative of an economy at risk of deflation, then up is down, down is up, and we should just forget the pretense that we care about the data. If 2.5% and rising is at risk of deflation, then where are we safe? 3.5% and rising? 4.5% and rising? If the Fed doesn’t want to stop inflation now that it has reached the target, what does it mean to have a target?
(3) Domestic growth is not yet strong enough to sustain higher rates.
If near-zero rates for the better part of a decade has not healed the economy, then maybe the low rates are the problem and not the solution. In any event, how much stronger is the economy likely to get than a 4.9% unemployment rate? Yes, the forward indicators aren’t looking great but if the Fed won’t hike when Unemployment is at 4.9% then they probably aren’t going to hike when Unemployment is above 5% either. This is actually an argument for getting another tightening in before the Fed needs to consider reversing policy later in the year.
(4) Asset markets can’t take it. Hiking rates would push stocks and bonds lower.
Even though the Fed tries to persuade us that they don’t worry much about markets, we know that’s not true. But it would seem to be odd to worry about them now when the S&P is down 1.2% on the year, and the cyclically-adjusted P/E is in the top 5% of historically recorded values. Bond yields are near the lowest levels of the last hundred years, real yields still well below 1% out to 10 years (and negative inside of 5 years, and remember I think these are much cheaper than nominal bonds). Real home prices are the most above trend, excepting only for the late lamented bubble, on record (see chart, source Shiller, Irrational Exuberance, 3rd edition as updated by author).
Some would say that it would be a good thing for asset prices to be lower, so that the people of this world who are going to be net investors for the next 20 years get better future returns. But in any event, it is hard to argue that asset markets are ailing in any particularly terrible way.
(5) The market isn’t expecting the Fed to raise rates.
Well, why the hell not? The Fed has said “as conditions warrant.” Well, they warrant. True, the FOMC doesn’t want to surprise the market and they haven’t done any work at suggesting they’re about to hike rates…other than putting the rate-hike campaign in motion in the first place…but in this case it is hard to understand why we should not be expecting the Fed to raise rates. If not now, when?
Look, the Fed has set the hurdle on growth and inflation, and it is hard to argue the economy hasn’t cleared those hurdles. I think, therefore, that the market is under-appreciating the probability of a rate hike on Wednesday. Yes, if they raise rates the very next thing they will do is move those hurdles farther away. But if they don’t raise rates at this meeting, the only argument can be “it’s March and people aren’t expecting one until April.” That seems to me to be a fantastically feeble argument, although one must grudgingly admit that feeble arguments are the stock in trade of central banks these days.