The Fed’s Road Ahead

The Fed raised rates yesterday, as I predicted months ago. I don’t say this to pat myself on the back.

The point is, I use a rigorous scientific method to analyze and predict markets. I don’t guess or take positions just to get attention. I constantly apply new data to test my original hypothesis. If the data confirms my hypothesis, I stick with it. If the data conflicts with it, I step back and re-evaluate. You have to stay nimble.

I’m a big critic of the Fed models, but that’s because they’re obsolete and they don’t record with reality. You need the right ones.

In a typical business cycle, the economy starts from a low base, then gradually business starts expanding, hiring picks up, more people spend money, and businesses expand.

Eventually, industrial capacity is used up, labor markets tighten, resources are stretched. Prices rise, inflation picks up and the Fed comes along and says “Aha! There’s some inflation. We’d better snuff it.”

So it raises rates, usually for a full cycle.

Eventually it has to lower rates when the process goes into reverse. That’s the normal business cycle. It’s what everyone on Wall Street looks at. And historically, they’re right. That process has been happening 40 times since the end of World War II.

The problem is, that’s not what’s happening now. We’re in a new reality.

This is a result of nine years of unconventional monetary policy — QE1, QE2, QE3, Operation Twist and ZIRP. This has never happened before. It was a giant science experiment by Ben Bernanke.

And that’s the key…

You have to have models that accord to the new reality, not the old. Wall Street is still going by the old model.

The new reality is that the Fed basically missed a whole cycle. They should have raised in 2009, 2010 and 2011. Economic growth was not powerful. In fact it was fairly weak. But it was still the early stage of a growth cycle. If they had raised rates, many would have grumbled, the stock market would have hit a speed bump, but it wouldn’t have been the end of the world.

We’d just had a crash. But by the end of 2009, the panic was basically over. There was no liquidity crisis. There was plenty of money in the system. There was no shortage of money and interest rates were zero. They could have tried an initial 25-point rise but they didn’t.

This isn’t Monday morning quarterbacking, either. I was on CNBC’s “Squawk Box” in August ’09. The host turned to me and asked, “Jim, what do you think the Fed should do?”

My response was, “They should raise rates a little bit, just to say they were going to get back to normal.” Of course, that never happened.

Now we’re at a very delicate point, because the Fed missed the opportunity to raise rates five years ago. They’re trying to play catch-up, and yesterday’s was the third rate hike in six months.

Economic research shows that in a recession, they have to cut interest rates 300 basis points or more, or 3%, to lift the economy out of recession. I’m not saying we are in a recession now, although we’re probably close.

But if a recession arrives a few months or even a year from now, how is the Fed going to cut rates 3% if they’re only at 1.25%?

The answer is, they can’t.

So the Fed’s desperately trying to raise interest rates up to 300 basis points, or 3%, before the next recession, so they have room to start cutting again. In other words, they are raising rates so they can cut them.

And that’s what Wall Street doesn’t understand. It’s still operating from its old assumptions about the business cycle.

Wall Street thinks the Fed’s raising rates because official unemployment is low and the economy’s strengthening. But as I just explained, that’s not the reason at all. The reality’s quite different.

The Fed is hiking rates not because economy is strong, but because it’s desperate to catch up with the fact that Bernanke skipped a whole cycle in 2009, 2010 and 2011. So as usual, Wall Street is reading the signals exactly backwards.

The Fed’s actually tightening into weakness.

So now what?

After yesterday’s hike, the Fed still has a long way to get to 3%. That means seven more hikes of 25 basis points each, every other meeting, or four hikes a year. That means the mission won’t be accomplished until June 2019.

What would cause the Fed to back off? Any of three conditions…

Number one is a market meltdown. If the stock market sells off 5%, which would be over 1,000 points on the Dow, that would not be enough to throw them off. But if it goes down 15%, that’s a different story. Ben Bernanke actually told me that not long ago.

Now, if the stock market falls 10%, the Fed will pause. It won’t raise. But it won’t cut either at that point.

Now, markets are complacent right now and are not expecting any sudden moves to the downside. But it’s when markets are most complacent that sudden drops are most likely. August 2015 and January 2016 are good examples. Another drop could be right around the corner.

The second condition is if job creation dries up. Now, job creation does not have to be 200,000 jobs a month, or even 150,000 jobs a month. Their baseline is around 75,000, which is a very low base. If you see jobs go below 75,000, the Fed may pause.

The third condition is disinflation. Now, I’m not talking about outright deflation. I mean inflation falling substantially short of the Fed’s target under a metric called PCE, or the Personal Consumption Expenditure Price Deflator Core.

You may be skeptical of how the Fed measures inflation, and rightly so. But you have to look at what the Fed looks at to know what they’re up to, right or wrong. And they look at the PCE, year over year.

The Fed wants 2% inflation. Lately it’s been getting close. But if that figure drops to, say, 1.4, that’s another reason to hit the pause button. That seems unlikely at this point.

Unless any of these three conditions materialize, the Fed intends to raise rates four times a year, every other meeting, until the middle of 2019. If any one of those three things happen along the way, the Fed will probably hit the pause button. If all three happen, it will definitely pause.

Gold is down today after yesterday’s hike, but I expect it to start heading higher again. Too many  powerful forces are driving it behind the scenes. Dwindling physical supply is a major one.

On a recent visit to Switzerland, I was informed that secure logistics operators could not build new vaults fast enough and were taking over nuclear-bomb proof mountain bunkers from the Swiss Army to handle the demand for private storage.

Geopolitical fear is another. The crises in North Korea, Syria, Iran, the South China Sea, and Venezuela are not getting better. The headlines may fade in any given week, but geopolitical shocks will return when least expected and send gold soaring in a flight to safety.

Fed policy tightening is normally a headwind for gold. But, the last two times the Fed raised rates — December 14, 2016 and March 15, 2017 — gold rallied as if on cue.

Gold is the most forward-looking of any major market. It may be the case that the gold market sees the Fed is tightening into weakness and will eventually over-tighten and cause a recession.

At that point, the Fed will pivot back to easing through forward guidance. That will result in more inflation and a weaker dollar, which is the perfect environment for gold.

In short, all signs point to higher gold prices in the months ahead based on Fed ease, geopolitical tensions, and a weaker dollar.

Regards,

Jim Rickards
for The Daily Reckoning