Full Steam Ahead

It’s common knowledge that the Federal Reserve has its tentacles wrapped around the global financial system. Aside from trying to run the U.S. economy on its own, the Fed promotes a stable financial system, champions safe and sound banks, fosters payment and settlements systems that facilitate U.S. dollar transactions worldwide, and advocates for consumer protection, promotes community development, and performs sophisticated research!

In other words, the people appointed to the top decision-making positions within the Fed wield a lot of power!

I mention all this to underline the fact that there are a total of 12 people charged with guiding our economy. It’s somewhat comparable to the Supreme Court, where only nine justices hold the final say over any and all matters related to the interpretation of the Constitution.

Seven of the 12 people in charge of the Fed are appointed by the president and serve on the Fed’s Board of Governors (BOG).

President Trump recently appointed Jerome Powell, who is currently on the BOG, to succeed Fed Chair Janet Yellen. He also appointed Randal Quarles to fill a vacancy on the BOG. Quarles was also sworn in as the Vice Chairman of Supervision. Trump expects Quarles to lead the way in loosening banking regulations put in place after the Great Financial Crisis.

Late last month, President Trump also appointed Marvin Goodfriend to the BOG. He’s a former Fed official and is currently a professor of economics at Carnegie Mellon University. Goodfriend is a conservative who’s been critical of Fed policies both during the GFC and after.

Even with the recent flurry of activity, there are still three vacancies – one more than the BOG had at the beginning of last year. If Trump wants to fill the Fed with his appointees, he still has a lot of work to do!

According to recent testimony from both Powell and Yellen, the transition will be smooth and policy decisions will stay on track. That includes the current rate-hiking cycle as well as the reduction of the Fed’s balance sheet. Of course, if the economic data changes, so could monetary policy.

Investors, as well as central bankers, study a number of data points and other factors before deciding on a course of action. Since our economy seems to be going in the right direction, investors are more focused on the likelihood of a major overhaul of the Internal Revenue Code. Stocks have been flying high on potential corporate tax reductions.

The Fed’s monetary policy committee focuses on the growth of our economy. It looks at factors that contribute to overall growth, employment, and wages. According to the Fed (its own best friend), its course of action is still stimulating growth. The other side of that coin, of course, is that interest rates are too low and the Fed balance sheet is too bloated.

As long as the economy grows, wages rise, and inflation moves up toward its 2% target, the Fed intends to hike interest rates and shrink the balance sheet until a neutral policy is achieved. “Neutral policy,” in this context, means the Fed does nothing to assist or impede economic growth.

You’re probably wondering when the magical neutral rate is achieved… Or maybe laughing to yourself with the thought that the Fed would ever take its hands off the wheel…

Let’s take a look at the data the Fed sees and take a stab at deducing its logic.

Gross domestic product (GDP) is the broadest measure of the economy, and the first revision of third-quarter data shows the economy grew at an annualized rate of 3.3%. Not too bad since consumer spending helped propel the move higher. There are even higher expectations for spending in the fourth quarter.

For consumers to spend more, they usually have to make more (unless they do what Fed policy encouraged: borrow more). Wages and income have been slow to move up, despite low unemployment, but October’s personal income data moved up higher than expected. That’s good… but we’ll have to see if the trend continues.

The “zero interest-rate policy” – a consequence of the GFC – really didn’t encourage people to borrow and spend more. ZIRP did encourage people to invest in riskier assets, though, and that’s why stocks have been on a tear for years. Free money and trillions of dollars in quantitative easing (QE) didn’t create inflation the Fed expected, either.

To this day, Fed officials are still confused about low inflation.

A healthy economy will eventually show signs of pricing power, or inflation. The Fed’s preferred measure is the personal consumption expenditures (PCE) price index. The core (excluding food and energy) PCE price index was recently measured at 1.4% annually, which is well below the Fed’s target rate of 2%.

One sector of the economy that’s benefited from ZIRP is housing. The housing bubble popped well before the financial crisis because risky home loans – based on no income and no verification – came home to roost. Since then, however, new home sales have been on the rise and made a new, post-crisis high last month. New home sales are a fraction of total home sales but are more important to the economy because of the ripple effect of related sales of appliances, furniture, and other items purchased for a new home.

Even though our economy is rotating into being more service-driven, manufacturing remains an important gauge of our economic health. According to the Institute for Supply Management’s (ISM) manufacturing index, the sector has been in a healthy growth mode since the third quarter of 2016. The ISM manufacturing index is closely watched by investors and the Fed.

So, we can conclude that the U.S. economy is doing OK, except for stagnant wages and stubbornly low inflation. We can also conclude that ZIRP and QE were failures because they didn’t spur inflation or wages. At the same time, neither halting expansion of Fed’s multi-trillion dollar balance sheet created by QE nor raising interest rates back toward a neutral level has put a damper on our tepid economic growth, yet.

The Fed might be able to continue the current path of normalization as long as the financial markets go along. Since global stocks are near record highs as a result of the Fed’s easy-money policies, it’s less clear how the Fed will react to a severe pullback or worse – say, the stock bubble finally popping.

You can prepare and profit from surprises in the financial markets, and specifically in the Treasury bond market with Treasury Profits Accelerator.

Good investing,