A Strong Economy, Interest Rates, the Fed, and the Stock Market

This post will prove that the Curmudgeon can and does write about economic topics from time to time, and isn't just a political curmudgeon. Kudos to a good friend - I'll call him Martin Gibson; he'll appreciate the inside joke - for inspiring this post with a very good question.

He inquired as to the Curmudgeon's thoughts regarding the impact of the Fed's interest rate actions on the stock market, and that's a very valid concern. My own retirement portfolio has taken quite a hit over the past several days. And yet I still sleep at night. I'll explain why toward the end of this post.

But first, some discussion of the role of the Fed and why they manipulate interest rates is in order. Mr. Gibson went on to note that some pundits are of the opinion that one man (presumably the Fed Chairman) shouldn't have so much power over the markets, and wonder why a strong economy needs to be slowed down by raising rates to begin with.

The short answer to Mr. Gibson's questions is that one man does not wield exclusive power over interest rates, the economy and the markets; that a strong economy needs cooling down to avoid runaway inflation; and that the stock market is overreacting to the Fed's interest rate actions. If you don't want to learn any more than that, stop reading here. But if you're curious as to how all of this works, and why the Fed does what it does, read on.

Herewith, a primer on the Fed, its policy mandate, and how and why it uses interest rates to influence economic activity.

Let's start with the fact that one man, in fact, does not wield such extraordinary power over the economy and the markets. Rates are set by the Federal Open Market Committee (FOMC), which holds scheduled meetings every six weeks or so to set policy. The Federal Reserve Board Chairman does chair the FOMC, but all members vote. (The Federal Reserve does a number of other things, including regulate banks, along with the Office of the Comptroller of the Currency and other regulators.)

The FOMC consists of the Fed Chairman (currently Jerome Powell), the other six members of the Federal Reserve Board, the President of the Federal Reserve Bank of New York (note that the Federal Reserve System consists of 12 regional Federal Reserve Banks), and a rotating group of members that serve one-year terms on the committee. Those rotating members are filled by one President each from each of the following groups of regional Fed Banks: Boston, Philly and Richmond; Cleveland and Chicago; Atlanta, St. Louis and Dallas; and Kansas City, Minneapolis and San Francisco. This ensures that the FOMC isn't "stacked" with, say East coast Fed Bank Presidents. The remaining Fed Bank Presidents participate in the FOMC discussions, but do not vote.

(Note that the FOMC can meet at other times than the scheduled meetings if conditions warrant; for example, during the housing/financial crisis, the FOMC held several unscheduled meetings to adjust rates lower in an effort to keep the economy from going completely off the rails. This only happens when the economy is in trouble; I've never seen, nor can I imagine, the Fed holding an unscheduled meeting during a period when it's raising rates. Note also that I just used the term "Fed" interchangeably with "FOMC." That's not uncommon, and it's probably why there's so much mystery around the Fed and the FOMC. But when we're talking about raising or lowering interest rates, it's technically the FOMC doing it.)

Next, let's discuss the FOMC's policy mandate. The Humphrey-Hawkins Act (technically, the Full Employment and Balanced Growth Act) of 1978 was passed in response to the high unemployment and runaway inflation of the 1970s. It set forth four broad policy goals: full employment, production growth, stable prices, and trade and budget balances. It also explicitly stated that the federal government will rely primarily on private enterprise to achieve these goals; if not for that, a statist/Socialist regime could develop.

Now, clearly the government can't directly influence production growth. And it's done a poor job of ensuring trade and budget balances. So it's generally accepted that Humphrey-Hawkins gave the Fed a dual policy mandate: full employment and price stability (meaning low inflation).

These two mandates are at odds with each other. The lower unemployment goes, the higher inflation is likely to go (I'll explain that shortly). So the Fed's mandate requires a balancing act. It also requires some definitions around what is meant by "full employment" and "stable prices." We'll get to that, too, but generally this results in policy targets set by the Fed, and those targets may vary depending on who's Chairman.

(I won't get into Keynesian vs. Classical, Austrian or Supply-Side economics here. Suffice it to say that the authors of Humphrey-Hawkins were Keynesians, and the Curmudgeon is decidedly not. The only thing that Keynes ever got right was his assertion that, in the long run, we're all dead.)

Regarding the conflicting link between unemployment and inflation, there are a couple of ways inflation can manifest itself, and they're usually happening at the same time. One is cost-push inflation; the other is demand-pull inflation.

With cost-push inflation, the scenario goes like this. As the economy improves, business activity increases, and companies hire more people. At first, there's no wage pressure, as unemployment is still relatively high. (Recall the initial period of recovery from 2009 to 2016; there was job growth, but wage growth was stagnant, because unemployment during that period ranged from 10% down to about 5%.)

However, as unemployment moves ever lower, at some point, companies are going to have to pay workers more to attract them, typically from other companies. In other words, the available labor pool from those without a job is drying up, so I have to hire my new workers away from other companies, and that's going to require paying them more than they're currently making.

Now, companies are in business to generate profits (and we won't get into the politics of whether that's evil or not - suffice it to say that if you have retirement or other funds invested in the stock market, you want companies to make a profit). So they aren't just going to absorb those higher wages, they're going to pass them along to consumers in the form of higher prices. So the cost of higher wages pushes prices higher - ergo, cost-push inflation.

In the demand-pull scenario, as more people go to work in a falling unemployment environment, they're going to be more comfortable buying stuff. As the demand for stuff rises, given that productive capacity isn't unlimited, at some point that's going to pull prices higher, hence demand-pull inflation.

Think of those periods of time when there's been extremely strong demand for certain auto makes and models, like the Honda Accord or the Toyota Camry. During those periods, dealers not only didn't discount those models, they sold them above the sticker price. Or think of the current housing market in some locations, like San Francisco. Desirable homes often sell the day they're listed, with so many buyers showing interest that they're willing to pay more than the listing price to get the house. That's demand-pull inflation: those rising auto or home prices result in higher prices overall for autos and homes, leading to inflationary pressures.

So again, the Fed has a balancing act: don't let unemployment get too high, and don't let prices increase by too much.

Now, what represents "full employment" and "stable prices?" Well, the previous Fed Chair, Janet Yellen, defined full employment as 5% unemployment (there's always going to be some unemployment - people who just can't get or hold a job, people who are between jobs, etc.). Yellen also set an inflation target of 2%, measured by the personal consumption expenditures (PCE) deflator, excluding food and energy prices - the "core" deflator. Rather than define it here, let's just accept that it's a measure of inflation.

Sidebar: why exclude food and energy prices? As one economist has noted, "core" inflation - excluding food and energy prices - only matters to people who don't eat or drive. However, food and energy prices tend to be more volatile. Weather conditions can affect food prices, for example a drought in wheat-producing states, or a freeze in citrus-producing markets. And energy prices can be affected in the short run by everything from holiday travel to hurricanes in the Gulf of Mexico. So a stable price measure should exclude those categories.

Chairman Powell hasn't stated any different targets for full employment and stable prices, so we'll assume that 5% unemployment and 2% inflation are still in play as policy targets.

Now, we're going to talk about why and how the FOMC uses interest rates to influence the economy, including a little history lesson; then we'll take a look at where we are today relative to those targets, and where we've been historically; and finally, we'll examine what it means for the stock market, and why the reaction of the past few days has been so dramatic, and whether it'll bounce back.

First, we'll talk about why the Fed, in general, influences economic activity. Then we'll take that stroll down history lane, before talking about how the Fed uses interest rates to manage the economy.

As noted above, when the economy really gets rolling, inflation can ensue, and that can be disastrous (just ask Venezuela, where the inflation rate is more than 650% - meaning that the loaf of bread that costs you a buck today will cost a buck-fifty in less than a month, and will cost $6.50 in a year). So the Fed seeks to slow down economic activity to bring inflation in check. Conversely, when the economy is going in the tank, the Fed seeks to stimulate economic activity, providing an artificial boost in hopes of reducing unemployment and bringing the economy out of recession.

The economic cycle goes like this, starting with the low point of a recession (defined as two consecutive quarters of negative output growth, as measure by GDP, or gross domestic product): trough, expansion, peak, contraction, trough, etc. What the Fed tries to do is smooth out that cycle, so that the troughs never occur, or at least aren't as severe, and the peaks aren't as lofty. We want stable growth, with peaks and valleys to be sure, but they don't have to be Mt. Everest and the bottom of the ocean.

As you probably surmised in 2008, the Fed has a lousy track record of eliminating the troughs, largely because they have an uncanny track record of fueling bubbles, but that's a topic for another day.

Now, the history lesson. Prior to 1979, the Fed primarily used the supply of money to influence the economy. The Fed has a virtually unlimited supply of money, and can always use the Treasury to print more (which would lead to inflation if left unchecked, but I digress), so during slow economic times, the Fed would inject more money into the economy by making more money available for banks to lend. And when the economy started to overheat, the Fed would simply rein in the money supply, leaving less money available to lend to businesses and individuals, thus slowing economic activity.

In 1979, President Carter appointed Paul Volcker as Fed Chairman (the smartest thing Carter ever did, by the way). You younger folks may know Volcker as one of President Obama's economic advisors (whom the President unfortunately ignored).

Two things characterized Chairman Volcker. One, he was a monetarist, whereas most of his predecessors had been Keynesians. What that means is that he believed that interest rates, rather than the money supply, were the best lever to influence the economy.

Two, Volcker was a tough old cuss who wasn't afraid to give the economy whatever medicine it needed in order to cure its ills.

The 1970s were marked by high inflation, primarily as a result of prolonged oil shocks that resulted in then-astronomic gas prices. To rein that in, Volcker knew that the Fed would have to slow the economy. Since he favored using interest rates, he began to increase the Federal funds, or Fed funds rate. This is the interest rate at which banks lend to and borrow from each other; banks with excess funds from deposits loan money to banks with excess loans and a shortage of deposits, and the going rate on those overnight loans is the Fed funds rate. (Consumer rates, like the Prime Rate that is the basis for credit card and commercial and other loans, are based off the Fed funds rate, thus it affects all economic activity.)

So Volcker "hiked," or "tightened" - meaning his FOMC raised the Fed funds rate. And boy, did they. The funds rate went as high as 20%, nearly doubling in a month. Mortgage loans were in the high teens. You could get a ten-year certificate of deposit paying 16% interest. The economy slowed rapidly, and inflation came down from 10% to a manageable rate.

The Fed funds rate remains the primary arrow in the FOMC's quiver today. The committee sets a target level for the rate (now, they use a range). At the depth of the 2008-09 recession, they moved the target to a range of 0%-0.25%. Yes, dear reader: zero. Money was free. Banks could borrow funds at no cost.

To put that in perspective, in 1992, when the Curmudgeon was just beginning his journey in the world of economics, the FOMC under Chairman Alan Greenspan cut the funds target ("eased") to 3%, and those of us who watch the Fed swore we'd witnessed history in the making; we'd never see rates that low again.

Then, in response to the dot-com bubble recession of 2000-01, the Greenspan FOMC cut the funds target to 1%. And we Fed-watchers said, "Okay, this is it - we'll never see rates this low again."

And then the FOMC under Chairman Ben Bernanke went to the zero-to-twenty-five-basis-point range (a basis point is one one-hundredth of a percent).

There's a lesson in this that you need to save for later, especially if you're under 30: the rate environment we were in from 2008 until December 2015, when the Fed began raising rates again (or "hiking," or "tightening"), was highly, highly unusual - abnormal, even. So if you're a millennial waiting for rates to return to "normal" before you buy a house - don't. This isn't the new normal, it's the old normal. The rates of 2008-2015 were the new abnormal, and we may not go back there in our lifetimes (though I'll never say "never" again).

Okay, now about where we are relative to the targets of 5% unemployment and 2% inflation. First, let me say that the unemployment rate has only been at or below 5% about a third of the time throughout the 70 years it's been tracked. That's one-third of more than 800 months of data. So it's somewhat unusual to see 5% unemployment.

Today, we're at 3.7% unemployment, the lowest rate since 1969. Only 70 of those aforementioned 800+ months of data have seen the unemployment rate at or below 3.7%. That's less than 10% of the time throughout history, and it all happened more more than 49 years ago. So unemployment is extremely low today.

And that raises the risk of inflation. We're well below the Fed's target, so the FOMC felt comfortable beginning to raise rates in 2015, and it continues to do so today, at a very measured, gradual pace. Rates aren't skyrocketing. The FOMC has raised the upper bound of the funds target range from 25 basis points (bp) to 2.25%. That's still extremely low, historically. Mortgage rates today for a 30-year fixed-rate mortgage are below 5%. That's still extremely low, historically. Ten-year certificate of deposit (CD) rates are around 3%. That's still extremely low, historically.

Get it? Rates are low.

Now, beginning with Chairman Yellen, the Fed began being very transparent in what they were going to do with regard to interest rates. They provided "policy guidance" to the markets, essentially telegraphing the path of rates in the future based on their expectations regarding economic activity. The current Fed guidance suggests an upper bound of the target Fed funds range of around 3.00-3.50% by 2021, before they expect to have to start easing again.

Remember when I said Fed-watchers were shocked at a Fed funds rate of 3% back in 1992? Even at the projection in the previous paragraph, interest rates will be very, very low, historically speaking. Keep that in the back of your mind for a few minutes, while we talk about inflation.

An inflation target of 2% is also historically low. The long-run average inflation rate is just over 3%, and the current rate is right at the 2% target. Future expectations are that the inflation rate will remain tame.

Okay, now let's consider the impact on the market, especially after the last few days. The FOMC raised the funds target last Thursday. But, you know what? They told the market they were going to do it. It was in the policy guidance. So the market shouldn't have been surprised. That's lesson one.

Lesson two has to do with whether, with rates at these levels, economic activity is going to slow dramatically, if at all.

The idea is that at higher rates, people will stop borrowing to buy homes, cars and trinkets, and the economy will tank. But if you correlate borrowing against interest rates, you'll find that borrowing frequently increases as rates rise. Why?

The single most important indicator of consumers' willingness to borrow is their confidence in their employment outlook and their income growth. If I'm pretty sure I'm going to have a job for the next three years, and I'm going to get raises, I'm willing to borrow, whatever the going rate (up to a point, and given the historically low level of rates today, we're nowhere near that point). However, even if rates are 1%, if I think I may lose my job in the next six months, I'm not going to take out a loan.

So when rates are rising, it's generally because the Fed is tightening. When the Fed is tightening, it's because the economy is strong. When the economy is strong, consumers are confident in their job outlook. And when they're confident in their job outlook, they're willing to borrow. And that's why higher borrowings correlate with rising rates.

So given that inflation is historically low, the labor market outlook is incredibly strong, and rates are still historically low, there is nothing to suggest that economic activity is going to tank.

In other words, based on Lessons one and two, the market is totally overreacting. Plus, it had reached successive records, and was probably due for some profit-taking. That's healthy.

So fear not: the market will be back. Your IRA will recover. The economy is fine, rates are low, the job market is strong, inflation is tame, and the Fed is doing what it's supposed to do - and telegraphing it to the market in advance, so there's no need to be surprised by any of this.

Now, an extra credit lesson for those who want to read just a bit further, and have a good laugh in the process.

I said that one man doesn't wield exclusive power over the economy. However, sometimes the FOMC doesn't need to raise or lower rates to influence economic activity. The Fed Chair, or one of the other FOMC members, will sometimes give an interview and drop clues as to what the Fed could or might do. This is known as "jawboning," and it can wield extraordinary power to move the markets. And that's why FOMC members are very careful about what they say, and they all stay on the same page in saying it.

I've always thought that power would be an extremely cool thing for a young, single Fed Chairman. Can you imagine the pickup line? "Hey babe, in two sentences, I moved the market by 500 points today."

One final bonus for those who've read this far. Throughout history, every time the unemployment rate has reached or gone below 5%, once it started rising again, within seven to 12 months, the economy entered recessionary territory.

Every. Time.

I don't know what that means necessarily, other than that at some point the economy so overheats that an expansion has run its course, the Fed has tightened to the point that economic activity begins to slow dramatically, and that a recession ensues.

But I do know that once the unemployment rates starts moving back up, I'm going to be shifting my portfolio to a much more conservative stance.