Hawks, Doves, Bulls and Bears - Oh My!

There's a lot I'd like to post about tonight, as I find myself in yet another hotel room, in yet another city (my fourth week on the road in the last five, and my fifth hotel room in the fifth city during that span, during which I also experienced the loss of my Mom, and all that went with that sad but beautiful experience - however, that's another topic for another day).  It's easier for me to post when I'm on the road, because when I'm home, I like to just cherish the simple joy of holding my pups on my lap, being with my wife, or seeing my daughter, son-in-law and grandson.

But here I am in another hotel room, so here goes.  I'm leading with this post because the Federal Open Market Committee (FOMC), the body of the Federal Reserve (Fed) that sets monetary policy, began its regular two-day meeting today, and the new Chairman will speak tomorrow at that meeting's conclusion.  So to wait until tomorrow for this post would be anti-climactic.

First, a primer.  The FOMC has a dual policy mandate: maintain "full employment" and "stable prices."

"Full employment" is a moving target.  The last Fed Chair, Janet Yellen, defined it as 5% unemployment.  I'd say that's a tad below an historical definition of the term, as the unemployment rate has only been at or below 5% about a third of the time throughout the history of the measure, dating back to 1948.

(By the way, for what it's worth, since Paul Volcker was Fed Chairman in the 1970s - what we call the "Monetarist Era" of the Fed - every time the jobless rate has hit or fallen below 5%, then increased, a recession has ensued within seven to 18 months of when the rate first hit 5%.  The cause behind this effect is that when unemployment falls below 5%, a level that is historically very low, the economy heats up too much, bubbles are inflated, the Fed ultimately has to begin slowing things down, and inevitably they get behind the curve and the economy suffers a downturn.  There's a penalty to be paid for pegging the target "full employment" rate too low, in other words.  So with unemployment at 4.1% currently, when it starts back up, get ready to pull your retirement money out of stocks within a year or so.)

"Stable prices" means that the inflation rate doesn't get out of hand.  Again, the Yellen Fed defined it as a 2% year-over-year increase in the core PCE deflator.  The deflator is a price measure based on Personal Consumption Expenditures, and is a bit more reliable than the more familiar Consumer Price Index (CPI), which is used as a benchmark for cost-of-living increases in everything from government and private-sector salary increases to certain pension payments.

When we refer to a "core" inflation measure, we mean excluding food and energy prices.  Why do we exclude those price measures, when the reality is, as one well-known economist has noted, inflation excluding food and energy only matters to people who don't eat or drive?

It's simple: food and energy prices tend to be more volatile than other components of the price measures.  So in search of a more stable measure for its target, the Fed focuses on core inflation measures.

Currently, the core PCE deflator is up 1.5% year-over-year, well below the Fed's 2% target.  It's been below that target since 2012.  Yet, the Fed is raising interest rates already, a move it would normally make only when the economy reached both its full employment and stable price targets.  Why?

Well, first, let's take a look at why the Fed raises and lowers interest rates.  The rate it uses is the Fed funds rate, the rate at which banks borrow and lend excess funds to each other (a bank with lots of excess money lends to a bank with less excess reserves at that rate).

When the Fed raises rates (tightens), it makes it more expensive for banks to borrow.  Banks pass those borrowing costs along to businesses and individuals.  So it gets more expensive for companies to borrow funds to expand and invest and hire, and it makes it more expensive for you and me to borrow money to buy houses and cars.

Here's why this is important: when everyone is buying lots of cars and houses and other stuff, we have a situation in which "too much money is chasing too few goods," the classic definition of inflation in layman's terms.  In other words, there's so much demand for "stuff" that the price of "stuff" goes up, and those increasing prices introduce inflation.

So the Fed tightens (raises rates) to slow down that purchasing and lending activity, hoping to engineer a "soft landing" in which demand slows enough to curb inflation, but doesn't produce a recession.

They rarely succeed at that.

On the flip side, when the economy is weakening, or a recession has ensued, the Fed cuts rates (eases) to make borrowing cheaper, so that businesses expand and invest and hire, and that creates jobs, and that job creation makes us all more confident to borrow money at now-cheaper rates to buy more "stuff," which creates further business expansion and investment and hiring, and on and on it goes until inflation rears its ugly head.

Okay.  So what does this all have to do with this post, and the FOMC meeting that will close tomorrow?

FOMCs - and Fed Chairs - are characterized as either "hawkish" or "dovish."  The hawks are more aggressive in raising rates to curb inflation; the doves are more aggressive in cutting rates to stimulate demand and promote uber-low unemployment.  (There's always a problem when we try to influence a mean-reverting data series to a level below its mean - see the homeownership rate and the housing crisis of 2008.)

Ben Bernanke, Fed Chair from 2006-14, was a dove.  Janet Yellen, Chair from 2014-18, was a dove.

Jay Powell, the current Fed Chair since Yellen's term expired in February, is a hawk.  And we haven't seen a hawk at the helm of the Fed since Alan Greenspan was appointed in 1987.  (Greenspan morphed into a dove over the term of his chairmanship, largely due to political reasons that had to do with him wanting to appease more liberal Presidents who would likely re-appoint him.)

Hawks like Powell are more likely to raise rates more aggressively.  Doves tend to keep rates low, longer.

So why is this important now?  The markets want to keep rates low.  They're scared to death that rates might increase, even modestly, even if it's necessary to keep a bubble from inflating, even if it's overall good for sustained growth without a spike in inflation.

Why?

The markets are like a crack addict.  When the economy tanked in 2008, the Fed cut rates to zero.  0%.  Zilch.  Nada.  Never happened before.

That made money essentially free.  Banks could borrow at no cost, and lend at not much more, and make scads of money.  You and I could buy a house with a 3% mortgage, deduct a third of the interest on our taxes, and thus pay an after-tax rate of 2%.  We could buy a car with a 2.5% loan.  Heck, we could do a cash-out refi on our home of 3% for 30 years, and at some point, arbitrage the cash equity we took out into an overnight savings account that will likely earn well north of that, if history is any indication.

That's what sustained the stock market from 2009 until 2013 at least, when the Fed began slowing its monetary easing.  (It deployed another means of easing during that period, but we won't get into the nuances of that here - suffice it to say that monetary policy was easier than it's ever been in history, and likely easier than it will ever be again.)  The economy became addicted to the crack that is free money, and it feared that it couldn't sustain itself without that ongoing fix.

So now that the Fed is returning to the "old normal," as we discussed in my last post, the addict is afraid its fix will be taken away.  "Oh no, what if we don't have free money any more?  However will the economy survive if rates aren't zero?"

Folks, rates have been well above zero for most of the history of our economy, and most of that time, it's done just fine.  Just as crack addicts have come off cold turkey and survived - and thrived.  Such is the nature of addiction and recovery: the addict becomes dependent on the drug, but is healthier when it's withdrawn.

So that's why the market is on pins and needles the day before Chairman Powell's first FOMC announcement.  Yes, they're likely to raise rates as expected.  What has the market skittish is what he'll say.  Will he be hawkish?

I sure hope so.  See, the Fed only raises rates (i.e., the hawks only rule the roost) when the economy is strong.  A strong economy is good - good for the markets, good for consumers, good for business, good for the country.

In other words, hawks are associated with a bull market, and if the hawks are in charge, the market should be bullish.

The doves, on the other hand, associate with the bears.  They jump at any hint of weakness and give away money to try and stave it off.  But in so doing, they create the bubbles that wreak havoc on the economy.  Greenspan did it with the dot-com and housing bubbles, and Bernanke/Yellen threatened to do it in a number of asset classes, until Powell was appointed.  Hopefully he can avert another bubble.  The Fed seems unable to foresee them.  Yet somehow the Curmudgeon has been able to, as have many others.

It could be that the markets will force the Fed's hand, by creating weakness through the panic of a sell-off and thus slowing the Fed's progress in tightening.  That may not be a terrible thing, but there is some risk in the Fed following the markets in executing monetary policy, instead of leading the markets.

Stay tuned.  The next year or so will be interesting.  But in the interim, don't get too fearful over market anxiety related to the Fed doing its job: raising rates to maintain "full employment" (which is probably more like 6% than 5%) while avoiding an inflationary spiral (which is far more damaging, and harder to reverse, than high unemployment).

In other words, remember that 4% unemployment, 1.5% inflation and zero interest rates are the exception, not the rule.  Invest on strength.  Sell on weakness.