“With the Federal Reserve (Fed) conducting their regularly scheduled FOMC meeting this Wednesday, we point out an interesting contrast between the current posture of the Fed which suggests they are leaning toward Fed Funds rate hikes versus prior post-crisis policy”.  - Interest Rate Policy Conundrum - March 17, 2015

720 Global penned those words 6 months ago to describe the conundrum inherent in the Federal Reserve (Fed) monetary policy deliberations. Today, the situation is still the same as the Fed is considering raising interest rates against a backdrop of feeble economic growth and weak inflation data at its September 16^th meeting. The prior article highlighted how economic activity, economic expectations and inflation at the time were at similar or lower levels then when the Fed initiated QE2, QE3 and Operation Twist. In this article, those data points are updated, and new charts and commentary are provided. This article concludes with a reminder of how poor market and Fed predictions have been regarding interest rate increases since the financial crisis.

The facts presented in this article may lead one to question the Fed’s comprehension of the debt dynamics restricting economic growth.

The 720 Global Proprietary U.S. Economic Trend Model

The 720 Global U.S. Economic Trend Model aggregates 8 key economic statistics comparing data from the prior 3 months to the average of the 6 months preceding those 3 months. As seen below, the model shows improvement since the results were first published 6 months ago. Despite the improving trend, the current level (green data point) indicates data is worse off today than when the Fed previously took steps to ease monetary policy as denoted by the red data points and the yellow shaded range. The recent improvement in economic trends is driven in part by a recovery from weak economic data witnessed in the first quarter of 2015. As time goes by and the poor data is removed as a model input, the results will stabilize or turn lower barring an unforeseen pickup in economic activity.   

720 Global Economic Trend Model

Citi Economic Surprise Index

Similar to the output from the 720 Global model shown above, the Citi Economic Surprise Index has also risen recently as a result of a relative recovery from the economic slowdown in the first quarter. Citi’s index (graphed below) compares current economic indicators to Wall Street economists’ expectations. Like the 720 Global model, the current index level (green data point) resides at similar levels seen prior to the Fed’s actions to ease monetary policy.  While the indicator has improved, it remains in negative territory implying current economic data is still falling short of expectations.

Citi Economic Surprise Index  

CPI and 5 year x 5year Forward Inflation Expectations

Inflation, as measured by CPI, is well below any other inflationary reading since the financial crisis. While CPI has stabilized it remains significantly lower than the range where prior monetary easing occurred. Additional CPI weakness is likely if the U.S. dollar continues to appreciate and thus forces commodity prices lower and further increase imported deflationary pressures. Recently released data supports this claim. Import price data released September 10, 2015 fell 11.40% (year over year), its 13^th drop in a row. CPI weakness is not just 720 Global’s prediction, implied inflation expectations also point to a similar inflation outlook, as seen in the second chart below.

CPI (year over year % change)

Implied Inflation Expectations (5 year by 5 year)

Illusion or Reality

As was the case in March, the data continues to suggest that the Fed is contemplating actions inconsistent with those they have taken in the past. It is possible the Fed is motivated to increase interest rates to support the illusion that their higher interest rate projections and rosy economic forecasts are finally coming to fruition. In the infamous words of George Bush “mission accomplished”. Based strictly on the facts, 720 Global begs to differ.

It is incumbent upon investors to separate illusion from reality. Economic growth rates of years past are not likely in the years ahead. Enormous amounts of debt amassed over the past 30 years coupled with scant productivity growth will continue to choke economic growth. For over 2 decades Federal Reserve monetary policy has been devoted to the stimulation of debt growth via low interest rates and more recently a sharply increased money supply. It is highly likely the blood has been drawn from this stone and the economy is left with a debt burden that has become too onerous to service. 

Investing in such a misunderstood and distorted economic environment is fraught with risk especially for those failing to grasp this reality. While current Fed monetary policy is clearly unsustainable, the Fed runs the risk of severely damaging asset markets with any deviations from such policy.

Questionable Track Record

This article concludes by highlighting the lack of appreciation by the Fed, many economists and market participants for the debt burden and its deleterious effect on economic growth. We start with a reminder of the incredible lack of foresight Janet Yellen, Federal Reserve Chairwoman, had prior to the financial crisis of 2008/09 and then continue with comments, quotes, charts and statistics that demonstrate the inaccuracy of the “conventional wisdom” that has prevailed through much of the time period after the financial crisis. 

“For my own part, I did not see and did not appreciate what the risks were with securitization, the credit ratings agencies, the shadow banking system, the SIVs — I didn’t see any of that coming until it happened.”  2010 Janet Yellen

Investor Optimism: Fed Funds Futures Expectations vs. Realized Fed Funds –

The red and black line plot the markets over-estimation of Fed Funds versus that which actually occurred. Every point on the graph represents an over-estimation of where Fed Funds were in the future and the degree of the error.

11/12/2009 - Wall Street Journal – “Economists in the latest Wall Street Journal survey, on average, expect the Federal Reserve to raise interest rates around September 2010”.

12/23/2010 – CNN Money- 

4/7/2011 – Fed Governor Jeffrey Lacker  -  “Rate hikes by year end certainly possible”.

5/5/2011 – Fed Governor Narayana Kocherlakota - “Under my baseline forecast, it would be desirable for the (Fed) to raise the fed funds target interest rate by a modest amount toward the end of 2011"

1/25/2012 – CNNMoney – “The economy is improving, the Federal Reserve said Wednesday, but not enough to warrant higher interest rates for at least two-and-a-half more years.
The central bank indicated that it expects to keep the federal funds rate near historic lows until late 2014 -- an extension from the Fed's original pledge to keep rates low through mid-2013”.

2/6/2012 - Fed Governor James Bullard (as reported by Reuters) - “Fed should raise rates in 2013”

2/10/2015 – Fed Governor Jeffrey Lacker (as reported by the Wall Street Journal) -  The Federal Reserve Bank of Richmond President Jeffrey Lacker said on Tuesday that interest rate hike in June is "the attractive option" for him.

Finally, the bar chart below shows the individual Federal Open Market Committee (FOMC) participant projections in the years 2012, 2013 and 2014 of their expectations for the Fed Funds rate in 2015. Only 1 Federal Reserve member in 2012 and 2014 and 2 in 2013 believed the Fed Funds rate would be at its current level.