What if the FED Has Done the Right Thing?

What if the FED Has Done the Right Thing?

The consensus view in the blogosphere seems to be that the FED has made a policy error by both talking and walking like a hawk. The consequence of this error — according to the consensus view — will be a bear market and a fall into recession. In this article, we provide a dissenting opinion.

The FED has the dual mandate of keeping unemployment below 5%, and inflation at 2%. The former is at 4.3% (whether you believe it or not, it is the number that the FED uses), and the latter is in no danger of breaking 2% — considering that CPI and core CPI both missed for the month of May (-0.1 and 0.3, respectively). Because inflation is sub-par, many commentators have concluded that the FED has made an error in raising rates, and that this error will snuff-out the nascent recovery and push the economy into recession. We disagree with this conclusion.

The FED raising the interest rate by 0.25% and releasing a specific plan to reduce its holdings of Treasury and agency securities at a time when the business cycle is gathering momentum and unemployment is near lower limits ,is completely appropriate; GAAP earnings and industrial production have been rising since the start of the year. The FED, for its part, is looking past the recent slowing of inflation and focusing on the tightening labor market which it sees as front-running wage increases; wage-growth follows employment.

The construction industry is a case in point. Both housing permits, and housing starts were down in Friday’s report, but while the obvious reaction from analysts is to consider this as a leading indicator of an approaching recession, we see it differently. It seems that the construction industry is experiencing something of a labor crunch. According to Briefing.com, construction workers are quitting their jobs at higher rates than in other fields (chart below), which means they are confident of easily getting replacement jobs. It is possible that this is a major reason for the drop in planned activity. If you are a player in this industry, and you are having trouble maintaining the workforce you require for on-going projects, you certainly are not going to start as many future projects as you might like… even if you know demand is there.

This may be the result of a labor bottle-neck in construction, which makes some sense since building construction has not robotized like other manufacturing has. The drop in permits and housing starts could be a leading indicator, not of recession, but of the coming wage inflation that the FED is trying to get ahead of.

The FED is trying to stay ahead of the inflation curve, as it should. Wages should naturally increase in the future and provide the bottom of the pyramid, where the real economy is, with much-needed spending power. Since it doesn’t look like the American government will be able to implement infrastructure spending any time soon, it must be wages that will increase the velocity of money and keep the business cycle moving forward.

The reduction of the FED’s “book” (Treasuries and MBS holdings) has been telegraphed to start at the end of this year, which gives the markets time to get used to the idea and adjust accordingly. The FED has been diligent in its communication so as not to surprise the market. The FED needs to normalize rates, and we agree that they now have an opportunity to start fulfilling that need. The chart below is a favorite of ours because it illustrates how the business cycle is moving away from recession, not towards it.

It is a false urban legend that increasing rates kill bull markets and cause recessions. As the chart shows, three of the last four bull markets were accompanied by increasing rates. The FED is staying ahead of the curve by correctly raising rates at this time.

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Source: Nicholas Gomez