When the Fed raised rates on Wednesday and changed its outlook to include two more rate hikes for 2018, the decision was met with some concern. The market sold off after the decision and statement as investors feared the rate hikes could be too much and the possibility that the action would cause the yield curve to invert.
While those concerns are certainly warranted, the Fed really doesn’t have much of a choice. The three main goals the Fed is tasked with as directed by Congress are:
- Maximum sustainable employment
- Stable prices
- Moderate long-term interest rates
Even though it wasn’t directed by Congress, there is a fourth goal that is sort of unwritten and that is to provide a stable and calm financial market.
You could say that goal one is being taken care of with flying colors, maybe even too well right now. The unemployment rate is at 3.8% and that is the lowest it has been since 2000. It is debatable whether that low of an unemployment rate is sustainable, but we won’t argue with it being that low.
The third goal is being met as well. While the Fed directly controls short-term rates via the target Fed Funds rate, the long-term rate is set by the market. The Fed can make open market investments that influence long-term rates, but they can’t set the rate. The 30-year bond rate has been trending lower since 2000 and hasn’t been above 3.5% since 2014.
The problem for the Fed is goal number two. Up to this point, inflation has been held in check for some time now. The Consumer Price Index hasn’t been above 4% since 2008. Unfortunately the CPI has been rising in recent months and there are several factors at work that could cause inflation to jump.
In fact, there are three very clear actions at work that could cause inflation to jump far more than the Fed would like to see. The incredibly low unemployment rate is starting to create wage inflation. Employers have to increase wages in order to attract the new talent that is needed to grow or maintain their business.
The second factor that is pushing prices higher is simply the growing economy. The expansion has been slow but steady and GDP growth has been above 2% for each of the last four quarters now. The tax cuts that went in to effect this year are also helping by increasing spending.
The third factor that will cause inflation is one that is playing out right now, and that is the trade battle. When the U.S. started placing tariffs on goods from Canada, China, the EU, and Mexico, this causes an immediate jump in prices for those goods. Where wage inflation and the growing economy (demand-pull inflation) will both cause prices to rise gradually, placing tariffs on imports has an immediate impact on prices.
I saw a great deal of Fed Chairman Powell’s press conference after the FOMC meeting on Wednesday, but I didn’t see all of it. From what I did see, I don’t recall him discussing tariffs and the trade battle and the possible impact on inflation. It will be interesting to see if these items are discussed when the minutes of the meeting are released next month.
When you look at the three goals assigned to the Fed, they are in an unenviable position given the current situation. Yes the economy is doing well, but not great. Yes, long-term interest rates have been moderated. The problem is looking at the potential for rising prices and trying to get ahead of them.
There is also another unique issue at play currently. We are in a rising interest rate environment while deficit spending is also on the rise. The tax cuts that were enacted this year are will increase the deficit and this means that the borrowing costs are going to rise. The government is borrowing more money while rates rise—that isn’t how you would want to handle things if you were running the government as a business.
Noted hedge fund operator Jeffrey Gundlach commented on the situation ahead of the Fed meeting. “Here we are doing something that almost seems like a suicide mission,” Gundlach said Tuesday. “We are increasing the size of the deficit while we’re raising interest rates.”
He makes a good point. But what is the Fed supposed to do? They aren’t in charge of spending, but they are task with the four goals mentioned above—the three assigned by Congress and the unwritten one. It seems like a no-win situation for the Fed.