There has been a lot of discussion lately around the subject of interest rates in the US and the rate at which the US Federal Reserve should set its primary instrument of monetary policy, the Fed Funds rate. Most all interest rates in the US, particularly longer-term interest rates, are determined by investors and savers, consumers and buyers, in the free market. Everything from the much-publicized yield on the 10 Year Treasury Note to 30-year mortgage rates and even credit card rates are determined in the free market. The Fed, however, sets the extremely short-term Fed Funds rate based on their own expectations about future inflation and the relative health of US labor markets.
The Fed Funds rate is a very powerful tool at the Feds disposal as most all overnight lending from the Fed to the US Treasury and the large US financial institutions in this country is based on that interest rate. In turn, those large US financial institutions will base the interest rate on loans they issue (Prime Rate) upon a proprietary function of the Fed Funds rate. In addition, most variable rate mortgages and other variable rate loans are based on either the Fed Funds rate, or some derivation of the Fed Funds rate. Consequently, when the Fed raises the Fed Funds rate, even 0.25%, it removes a tremendous amount of liquidity from the US monetary system. Conversely, even a small reduction of 0.25% in the Fed Funds rate will have a tremendous stimulative effect on liquidity.
Generally, if the Fed’s expectations around future inflation are subdued, they can be more supportive of cutting the Fed Funds rate. Conversely, if labor markets are seen to be tight, the Fed will likely assume a more “hawkish” tone and be more inclined towards raising the Fed Funds rate. This “dual mandate” of the Fed to balance the pursuit of full employment while also defending the currency against inflation was assigned by Congress and was intended to give the Fed complete autonomy from both the Legislative and the Executive branches of government in determining interest rates.
Currently, however, the long standing and generally accepted relationship between unemployment and inflation seems to be, at best, dormant. For instance, during past periods of economic expansion, unemployment nearly always approached the Feds target for full employment as the Fed maintained stimulative monetary policy. Currently, that target is around 4.0% unemployment. Normally, as unemployment falls closer and closer to that full employment target, inflation has very predictably heated up as more consumers draw paychecks (income) and spend that income thereby driving up prices at the margin. However, through the current economic expansion, unemployment has not only fallen to the Feds target, but substantially exceeded that target and currently sits at a 30-year low level of 3.7% unemployment. Under historically normal circumstances, inflation should be considerably higher than its current level of roughly 2.5% (CPI).
The breakdown of this normally very predicable relationship has created a real conundrum with everyone interested in where interest rates are set and in which direction they might be moving. Particularly with the Federal Reserve members themselves. The Taylor Rule is an equation derived by Stanford economist John Taylor that has been very useful in the past by all parties involved to help set the Fed Funds rate. And even that long standing tool has proven problematic throughout this expansion by consistently suggesting higher Fed Funds rates than what the economy could reasonably tolerate.
Numerous explanations have been put forth to account for the apparent breakdown in unemployment vs. inflation. Most notably are (much) higher productivity levels than what are being accounted for and reported to the Federal Reserve by the Department of Labor. Personally, I find this explanation hard to accept. When compared to the amazing advances in labor productivity of the 1980’s and 1990’s from the innovations and commercialization of semiconductors, cell phones, networking, and the internet, the relatively paltry innovations of this expansion seem hapless.
My sense is that the best explanation for this breakdown is that the labor pool is a lot bigger than what the Department of Labor is reporting. And every time that the strong US economy absorbs a few 100,000 unemployed workers, a few 100,000 more workers emerge from the shadows of underemployment or materialize from the ranks of those who weren’t previously counted as unemployed (as they had given up looking for work altogether and were therefore not counted in the roles of the unemployed). Under that scenario, were the US to somehow more accurately count the unemployed, it is conceivable that the unemployment statistics could be as much as twice their reported numbers, or 7.4% versus the reported level of 3.7%.
Another factor that I believe is contributing to a larger work force than what is being counted is the tendency for older workers to continue working beyond their anticipated retirement date, typically considered to be age 66 or 67.
The fact that the stated rate of unemployment stands at 3.7% fully explains the Feds current predisposition to raising the Fed Funds rate. I would submit that were the Fed acting in a vacuum and with the full independence that Congress had intended, the Fed Funds rate would currently be materially higher than its current 2.5% target. However, owing to a good deal of confusion around this apparent breakdown, as well as a good deal of lobbying by the President for lower interest rates, it seems the Fed has backed away from a more aggressive posture in recent months preferring to see actual evidence of real price inflation before executing a more hawkish stance.
As with so many things in the financial and economic realm, lower interest rates will be good for the economy and the associated financial markets until they’re not. Markets and investment returns should be fairly robust and the economic expansion should continue for the foreseeable future under the current stimulative interest rate policy. Selloffs should be rather muted and mundane types of affairs (absent some black swan event) with the support of relatively low interest rates underpinning price levels. As a firm, we continue to remain fully invested with client accounts and are predisposed to investing in the more economically cyclical type of industries.
However, once inflation does finally reemerge, it’s very likely that the Fed will find themselves behind the interest rate curve, possibly substantially so. In that type of environment reminiscent of 2003-2004, the Fed may be forced to raise interest rates much faster than what might be considered an orderly process and very likely create a severe imbalance of credit.
We are certainly guarding against that type of scenario in watching many inflation gauges beyond the popular CPI. In addition, we continue to hold relatively short maturities in those accounts that we manage bonds or other fixed income vehicles. These more defensive tendencies within a more aggressive macro strategy should allow us to manage ahead of any real inflation problems if they occur.
As always, please feel free to contact us if you have any questions or if you need to schedule an appointment to discuss your account or financial plan with us. This is particularly important if you have experienced a big change in your life recently (got married, retired, changed employment, bought/sold a business, etc.).
2018 Form ADV Notice and Offering – the firm’s 2018 amended Form ADV Part 1 & Part 2 filings with the Securities Exchange Commission was filed timely 02/21/2019. If you would like a copy of this important disclosure document, please contact us at (303) 442-3670 or firstname.lastname@example.org and we will be happy to deliver it to you at no charge.
Mark P. Culver
Culver Investment Company, LLC
360 Interlocken Blvd
Broomfield, CO 80021
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