The 4% Club

Aaron, put me in the 4% club (give or take 25 basis points) for where the Federal Open Market Committee stops for this cycle.

Four percent will be just enough to leave the yield curve flat as a potato chip and to slow down the growth in housing prices the way that the central banks in the U.K. and Australia did it. Further, 4% fits in nicely with market expectations as measured by the eurodollar and fed funds futures markets.

I am a big believer that economic data tend to move two steps forward, one step back, or vice versa most of the time. There is a lot of noise. The only time this is not true is immediately after turning points; that's where the data tend to trend. Oh, also, at tops and bottoms, economic data releases seem to be 50/50 random.

In the last month, the economy seems to have shifted from a "one forward, two back" mode to a "two forward, one back" mode. Hence, the more negative perception baked into the market's reaction to FOMC policy since the last FOMC meeting.

One thing does bother me about 4%, though. It puts me in the middle of the forecasts that economists have made for the end of the cycle. I don't like being in the middle of the pack; it feels wrong, because forecasters are particularly bad at calling turning points. But to be "out of consensus" here would mean saying that the FOMC stops now, or that the FOMC wants to invert the curve. The former is untenable from its most recent statements, and the latter would leave the FOMC open to serious criticism if something blew up.

The Fed is already out of step with most other central banks. Most of the rest of the world has stopped tightening, and some central banks, like Sweden and Hungary, have begun loosening. In a regime of floating exchange rates, countries tend to mimic each other's monetary policies. This makes me think the FOMC would not invert the curve, or else the dollar, which has been remarkably strong, would strengthen further.

Last, to avoid Amateur Fed Governor's Syndrome, I ask myself the question, "Is this what the FOMC should do?" My answer is no, it should have stopped at a fed funds rate of 3%. Looking through the windshield, rather than the rearview mirror, the FOMC has already tightened a significant amount, and the effects of its moves on the "real economy" are only 10%-20% felt because of the lag in the way that monetary spreads out to the economy on the whole.

So because 4% isn't what it should do, I feel more confident that my logic isn't biased by thinking that the FOMC should do what's best for the economy. It rarely succeeds at that.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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