Fed Hike and It’s Implications.

The Federal Reserve has this following mandates: keep unemployment low (under 6%), keep inflation low (under 2%), and keep interest rates moderate.

If one looks only at these, then indeed the FOMC’s hike in Fed Funds was justified.

The problem is that if one looks at all economic fundamentals especially GDP and Labor Participation Rate two things are evident: 1) economic growth is sluggish and 2) the problems are structural making them beyond the reach of what Fed monetary policy can accomplish. Perhaps the Fed is no more capable of solving what is wrong with low GDP growth than it is capable of achieving peace in Syria.

There are only two reasons why the Fed should have considered raising rates: 1) low rates and increased money supply will cause inflation without a hike or 2) the Fed fears that with near zero rates they could not stimulate the economy in the event of a recession because rates were at bottom already. The first point is extremely doubtful and the Fed did not have to act now to forestall possible inflation.

The second point makes some sense. The Fed has painted itself into a corner with its massive increase in money supply and a prolonged period of near zero rates. If it does not raises rates it cannot lower them. I grant that this sounds foolish but maybe foolish is where we are at present.

The reasons why the Fed should not have increased were, in my view, much more compelling.

1) GDP growth is slow. We have been averaging 2.068% annual growth for the past 17 quarters. That is GDP in actual (inflation adjusted dollars) but it does not take into account population growth. Per Capita GDP growth is about 1% annual for those 17 quarters. Increasing rates will not help GDP.
2) world economy is hurting: EU, China, India, Venezuela, many emerging nations in South America and Africa. An increase in interest rates in the US could provide more incentive to convert investments to US$ and hurt most everyone else.

 

A big problem is China. The U.S. economy is driven by consumer spending which makes up 70% of GDP. In most EU countries consumer spending makes up about 60% of GDP. In China consumer spending makes up about 36% of GDP. The economy of China is driven by exports and investments. An announcement last weekend showed China’s exports falling 8.9% year over year. In 2012 China’s investments made up 46% of GDP. Exports are about 27% of Chinese GDP.

 
Chinese equity markets have been hard hit lately. They are up substantially year on year but have been propped up by government buying of equities. In the U.S. the affected parties have likely been hedge funds heavy in Chinese equities. There is, as yet, no indication that this has had any contagious effects on a wider set of financial entities. Events such as this trigger memories of the LTCM crisis of 1998.

 
China’s problems effect nations which depend on exports to China for a significant portion of their GDP. These include Australia, South Korea, Taiwan, New Zealand, Japan, and Malaysia.

 
Raising US interest rates will make what is happening with currencies worse by strengthening the US$ at the worst possible time. A stronger US$ would hurt US GDP by making exports more expensive and imports less expensive. It will also hurt the economies of the EU nations, weak economies in South America and most of the economies of African emerging nations.
Many nations depend on exporting commodities for survival and a stronger US$ would lower commodity prices and hurt the cash flows of these nations. This has the potential to create political instability with consequences that we cannot possibly foresee.

 
My concern is that the Fed ignored this and instead raised rates to assert that its monetary policy had successfully worked.
What’s wrong is that the goals which make up the Fed’s charter are too narrow. Goals should include keeping GDP growth closer to 4.0% and maintaining the Labor Participation Rate. The problem with adding these two goals is that these goals may be structural rather than cyclic. The Federal Reserve cannot solve structural issues. It needs to work with the rest of the government.

 
The biggest problems out economy faces are 1) the increasing National Debt 2) the underfunding of Social Security and Medicare and 3) costs associated with government regulation. We folks in the home loan business are well aware of the last item. The Federal government mandated that the GSE’s reduce their lending standards, blamed everyone else for the results and then imposed more regulations and more associated costs.

 
What Will be the Effects of this Hike?

 
The Fed had been actively working on its facility to keep Fed Funds within it mandate range for the past two years so it is unlikely that they will not be able to keep control over Fed funds. That said the big problem that the Fed will face is the enormous size of the money supply and excess bank reserves. Yesterday 12/17/2015 was the first day of Fed Funds trading post-hike and Fed Funds had a weighted average of 0.37% wich is precisely 0.25% above where they were a few weeks ago.

 
Banks immediately increased Prime which will cost homeowners with Prime-based HELOC’s more each month. Fixed rate home loans were not immediately affected and I do not believe that they will move up in harmony with the anticipated 4 hikes in Fed Funds target next year. Bank savings rates will remain low while Money Market funds move up. What we will see is a significant move of people’s money from banks to Money Market Funds. In part, this is due to government regulations and the Basel capital accords which do not encourage banks to take in savings.

 
In general Money market funds invest in short-term Treasury debt and Commercial paper. Since the excess reserves of banks is gigantic ($2.5 trillion) this movement of funds from banks to Money Market Funds should have little immediate effect of bank lending because it is already depressed.

 
When FOMC raised the Fed Funds target it also raise the interest paid on excess bank reserves. This is something I simply do not get. Paying interest on excess reserves encourages banks to not lend and that does not exactly stimulate GDP growth.

 
There are, at present, a lot of moving parts to monetary policy and banking and I do not believe that anyone really has a good idea as to how this will play out. The things to watch are: 1) the Fed Funds rate which is updated daily by The New York Fed at https://apps.newyorkfed.org/markets/autorates/fed%20funds 2) Monetary Base https://research.stlouisfed.org/fred2/series/BASE and 3) Excess Bank Reserves reported monthly at http://www.federalreserve.gov/releases/h3/current/
Media talk this week which always seems to me to present a too-rosy view of the economy suggested that since lower rates did not lead to significant economic growth then perhaps higher rates would. While I do not completely discount to possibility that we could have higher GDP growth with higher rates I cannot see a causal relationship.

 
For those concerned about home loan rates it is my belief that they will be relatively unaffected by this and subsequent Fed hikes. They may rise but not in harmony with Fed Funds. What we will likely see is a change in shape of the Treasury yield curve with both the long (30 year) and short (1 year and less) yields increasing with a flattening in the middle.
The bigger economic problems are probably not solvable by the Fed. Irresponsible fiscal policy (the deficits and the underfunding of SS and Medicare) and the fact that too much government regulation impedes economic growth are the big problems with the economy.

 

After the Great Recession the Federal government essentially did 2 things: 1) create more money and a near-zero Fed Funds rate to encourage lending and simultaneously 2) created policies and an entity (CFPB) to discourage lending.