by Jim Rickards, Daily Reckoning:
The Fed raised rates yesterday, as I predicted months ago. I don’t say this to pat myself on the back.
The point is, I use a rigorous scientific method to analyze and predict markets. I don’t guess or take positions just to get attention. I constantly apply new data to test my original hypothesis. If the data confirms my hypothesis, I stick with it. If the data conflicts with it, I step back and re-evaluate. You have to stay nimble.
I’m a big critic of the Fed models, but that’s because they’re obsolete and they don’t record with reality. You need the right models.
In a typical business cycle, the economy starts from a low base, then gradually business starts expanding, hiring picks up, more people spend money, and businesses expand.
Eventually, industrial capacity is used up, labor markets tighten, resources are stretched. Prices rise, inflation picks up and the Fed comes along and says “Aha! There’s some inflation. We’d better snuff it.”
So it raises rates, usually for a full cycle.
Eventually it has to lower rates when the process goes into reverse. That’s the normal business cycle. It’s what everyone on Wall Street looks at. And historically, they’re right. That process has happened dozens of times since the end of World War II.
The problem is, that’s not what’s happening now. We’re in a new reality.
This is a result of nine years of unconventional monetary policy — QE1, QE2, QE3, Operation Twist and ZIRP. This has never happened before. It was a giant science experiment by Ben Bernanke.
And that’s the key…
You have to have models that accord to the new reality, not the old. Wall Street is still going by the old model.
The new reality is that the Fed basically missed a whole cycle. They should have raised rates in 2009, 2010 and 2011. Economic growth was not powerful. In fact it was fairly weak. But it was still the early stage of a growth cycle. If they had raised rates, many would have grumbled, the stock market would have hit a speed bump, but it wouldn’t have been the end of the world.
We’d just had a crash. But by the end of 2009, the panic was basically over. There was no liquidity crisis. There was plenty of money in the system. There was no shortage of money and interest rates were zero. They could have tried an initial 25-point rise but they didn’t.
This isn’t Monday morning quarterbacking, either. I was on CNBC’s “Squawk Box” in August ’09. The host turned to me and asked, “Jim, what do you think the Fed should do?”
My response was, “They should raise rates a little bit, just to say they were going to get back to normal.” Of course, that never happened.
Now we’re at a very delicate point, because the Fed missed the opportunity to raise rates all those years ago. They’re trying to play catch-up, and yesterday’s was the seventh rate hike since December 2015.
Economic research shows that in a recession, they have to cut interest rates 300 basis points or more, or 3%, to lift the economy out of recession. I’m not saying we are in a recession now, although we could be close, much closer than many think.
But if a recession arrives in a few months, how is the Fed going to cut rates 3% if they’re only between 1.75% and 2%?
The answer is, they can’t.
So the Fed’s desperately trying to raise interest rates up to 300 basis points, or 3%, before the next recession, so they have room to start cutting again. In other words, they are raising rates so they can cut them.
And that’s what Wall Street doesn’t understand. It’s still operating from its old assumptions about the business cycle.
Wall Street thinks the Fed’s raising rates because official unemployment is low and the economy’s strengthening. But as I just explained, that’s not the reason at all. The reality’s quite different.
The Fed is hiking rates not because economy is strong, but because it’s desperate to catch up with the fact that Bernanke skipped a whole cycle in 2009, 2010 and 2011. So as usual, Wall Street is reading the signals exactly backwards.
The Fed’s actually tightening into weakness.
So now what?
After yesterday’s hike, the Fed still has four rate hikes to reach 3%. That means the mission won’t likely be accomplished until June 2019.
What would cause the Fed to back off? Any of three conditions…
Number one is a market meltdown. If the stock market sells off 5%, which would be over 1,000 points on the Dow, that would not be enough to throw them off. But if it goes down 15%, that’s a different story. Ben Bernanke actually told me that not long ago.
Now, if the stock market falls 10% again like it did in February, the Fed will pause. It won’t raise. But it won’t cut either at that point.