Depending on what you read, the Fed's street cred took a hit after Tuesday's announced retreat from intended rate hikes. But really, the Fed's credibility should have increased with Tuesday's messaging, and the shift was totally predictable.
The Fed had clearly signaled its inclination to continue the process of normalizing the fed funds rate begun in December, largely to position itself to respond to the next crisis or recession. Concern over systemic risk levels after seven years of zero-bound rate policy was surely part of the calculus as well. But that posture was at odds with the Fed's mandate and almost all the data (which I've pointed out before).
So, what prompted the Fed's sudden concern over factors that have been apparent for several quarters to anyone paying attention? UBS economist Drew Matus sneered on CNBC, "the Fed has become data-point dependent," suggesting the abysmal May jobs print was the singular reason for the Fed's shift. Umm, what?
The Fed should be criticized for being woefully out of step with the data during its "hike-or-bust" messaging phase prior to Tuesday. But not only is there a multi-factor case for holding off on tightening, to do otherwise would have been historically unprecedented. Here are five incontrovertible reasons why the Fed's window to hike had passed and it had little choice but to back off from that intention.
1. Gross private domestic investment, the single most important driver of employment and real wages, has been a negative contributor to GDP growth for three straight quarters and the first quarter of 2016 was the weakest in four years. Capital spending rebounded after the financial crisis, but it has been anemic by recovery standards.
US Capital Spending Drives Total Employment
2. The real unemployment rate exceeds 7%, not counting over six million underemployed (1.5 million above the historical "peak-employment" average) and real household income continues to languish at 1997 levels. To reach historical levels of full employment, corresponding to an unemployment rate of roughly 5%, would require 41 straight months of 160,000 net new jobs added per month.
U.S. Unemployment Rate Needed for Sustained Real Income Increases
3. Inflation is trending at half the Fed target of 2%, despite a 4.6-times increase in the monetary base since January 2008. All bank credit is up only 1.3-times in that period, reflecting the deflationary pressure of private sector deleveraging. As discussed before, recessions caused by financial panics historically have resulted in deflation and low long-term rates lasting 20 years or more.
Core PCE Index YOY % Change Quarterly
Banks' Leverage of Monetary Base Has Still Not Recovered from Fin Crisis Collapse
4. Record, unsustainable U.S. corporate profit margins have portended earnings declines for the last several years. S&P 500 earnings were down 16% in 2015, first quarter 2016 was the fourth straight decline and the second quarter of 2016 will be the fifth, but still only driven by top line declines. Normalization of corporate profit margins is caused by capital spending and new capacity in the economy (the business cycle). Weakness of latter helps explain sustained record levels of former. Margin rollover will exacerbate prevailing earnings declines caused by revenue erosion.
Corporate Profits as Percentage of GDP and Subsequent Earnings Growth
5. Gross world production growth for the top-10 economies (U.S., China, Japan, Germany, France, UK, Brazil, Russia, Italy and India), representing roughly 65% of the global economy, will likely extend a downward trend into a sixth year in 2016. This trend exacerbates a negative U.S. net exports trend (first quarter 2016 was the eleventh worst in last 17 quarters) driven by the strengthening dollar.
Weighted Average Growth in Top-10 World Economies (~65% of WGP)
Not only has U.S. growth during the current recovery been the worst in the post-WWII era, the last six years rank as the twelfth worst six-year period of GDP growth of any six-year-period since WWII (81 total observations). Other headwinds facing the U.S. economy, and more importantly, discouraging private sector capital spending, include the ongoing spiking costs of the U.S. regulatory compliance burden and persistence of uncompetitive corporate tax rates.
The ultimate effect of easy money is not likely to be pretty, and investors would do well to get defensive in the face of bubble formation in both risk assets and fixed income. I would still favor the latter given my unwavering expectation of low long-term rates for years to come. It should not be hard to understand why the Fed pulled the plug on raising rates.