Jerome Powell Better Get “Real”
The stock market resumed today where it ended last week — with bears pressing the attack.
The Dow Jones broke below the 24,000 mark today for the first time since March.
It ended the day down 507 total points, to close at 23,593.
Percentage wise, both S&P and Nasdaq were hard on its heels.
We have it on official word:
Not since 1980 have the three major indexes turned in such a woeful December.
By July 1981 — incidentally — the economy was sunk in recession.
Is today’s stock market giving off a recession warning for summer 2019?
This is the question we tackle today…
Let us first sit down with the facts…
In 1980, as today, the Federal Reserve was hard at the business of raising interest rates.
Of course the economic and monetary dynamic was vastly different in 1980.
Annual inflation ran to a menacing 13.3% in 1979, the year new Federal Reserve chairman Paul Volcker came aboard.
By March 1980… inflation roared a mighty 14.7%.
So Volcker was battling to cage a tiger. And he had his whip and chair out…
Volcker drove the fed funds rate (the rate the Fed controls directly) to a tiger-taming 20% by late 1980.
In contrast — violent contrast — today’s inflation is as tame as a tabby.
Official inflation purrs at a domesticated 2% once monthly variations are ironed out.
And today’s fed funds rate squats at a lowly 2.25%.
There is simply no comparison between periods, you say.
Paul Volcker had a raging tiger by the tail. Jerome Powell has a kitten by the scruff.
And today’s interest rates are not within 100 miles of 1980’s.
But could it be that today’s interest rates are actually higher than 1980’s?
A lunatic question, you thunder, worthy of a bedlamite in an asylum.
Your objection is noted and entered into the record.
But we encourage you to get “real.”
The “real” interest rate is defined as the nominal interest rate minus the inflation rate.
Assume a nominal interest rate of 3%, for example.
Further assume that inflation runs to 1%.
In this instance we find the real rate is 2% (3 – 1 = 2).
Now consider the case before us…
Nominal interest rates averaged 13.35% in 1980.
Meantime, 1980 inflation averaged 13.5%.
Let us then apply fingers-and-toes mathematics to arrive at the real interest rate in 1980…
We take 1980’s average nominal interest rate (13.35%) and subtract the inflation rate (13.5%).
We then come to the arresting conclusion that 1980’s real interest rate was not 13.5%… but -0.15% (13.35 – 13.5 = -0.15).
1980’s average nominal interest rate was 13.35%.
But its average real interest rate was -0.15%.
Now roll the reel forward to 2018…
Today’s nominal fed funds rate rises between 2% and 2.25%.
Meantime, official consumer price inflation (again, the distinction is necessary) runs in the vicinity of 2%.
To discover today’s real interest rate, we once again subtract the inflation rate from the nominal rate.
What do we find?
We find that today’s real interest rate ranges between 0% and 0.25%.
That is, despite today’s vastly lower nominal rate (13.35% versus 2.25%)… today’s real interest rate exceeds 1980’s -0.15%.
Shocking — but there you are.
We must then conclude that nominal interest rates lack all meaning absent the inflation rate.
There is a reason why it is called the real interest rate.
It penetrates numerical mists. It scatters statistical fogs.
As explains Jim Rickards, “Real rates are what determine investment decisions.”
A 10-year Treasury bond yielding 7% might reel you in, for example.
But what if inflation averaged 8% over the same period?
Inflation would gobble your 7% yield — and a bit more into the bargain.
You would require a 9% yield just to paddle ahead of inflation.
Meantime, you may balk at a 10-year Treasury bond yielding 3%.
But if inflation runs at 2%… then your 3% Treasury yields you 1%.
A slender gain, yes. But you escape with your skin — and a slight surplus.
Your 3% 10-year Treasury, under these terms, infinitely bests a 7% Treasury if inflation is 8%.
Coming home, we must grapple with the fact that today’s real rate of interest exceeds 1980’s.
And rates will likely increase further when the Federal Reserve concludes its meeting on Wednesday.
Market odds of a rate hike presently rest at 76.6%.
Meantime, the stock market is turning in its worst December since 1980.
The economy was in recession by summer ’81.
Will today’s economy be in recession by summer 2019?
We do not pretend to know… but perhaps it’s time Jerome Powell got real.
Managing editor, The Daily Reckoning