"The Boy Who Cried Wolf" (Or, The Fed Who Keeps Crying "Higher Rates") | Crouch
I’ve been reminded recently about Aesop’s fable, "The Boy who Cried Wolf," about the shepherd boy who repeatedly tricked the villagers into thinking a wolf was attacking his flock of sheep. Eventually, the wolf actually does appear but the villagers ignored his cries, thinking he was again just crying a false alarm. This was fatal not only for the sheep, but also for the shepherd boy.
Many of you will remember how we "peel back the layers of the onion" to try to understand what might be affecting various segments of the market, and I believe it is helpful to peek underneath the surface of "The Fed" to understand the dynamics of Fed policy.
The Politics of The Fed Policy
I have lost track of how many times various Fed presidents have predicted that the Federal Open Market Committee (FOMC), the Fed committee responsible for regulating our interest rates, would be raising interest rates over the next several months. Usually the forecast is for three or four hikes over the next year in an effort to "normalize" interest rates however, with one exception, they have had to back off from taking action when disappointing economic news makes that appear foolish.
Historically, the FOMC has used higher rates (almost exclusively) to cool off an overheated economy in efforts to avoid the issues associated with higher inflation. Over the past few years however, there has been no overheated economy but the cries for higher rates continue to be heard. So what is going on?
I believe it is helpful (and important) to understand the makeup of the FOMC and the agendas that are likely behind some of these cries. The FOMC is normally made up of seven members of the Fed Board of Governors (appointed by the President and confirmed by the Senate) and five of the Regional Fed Presidents (elected by the regional boards which are elected by the commercial bankers in each region) out of the 12. This arrangement meant that Washington appointees (confirmed by the Senate) would make interest rate decisions for the nation with the direct input from the commercial bankers out in the "real world." Sounds good so far, right?
Another important point to consider is that commercial bankers really want interest rates to go higher! Many of the loans in the bank's portfolios have their interest rate tied to the "prime rate" which usually floats up and down with the rates set by the FOMC, so higher rates generally mean higher profits for the banks! Profits have been very difficult for banks to come by since the great recession because of the low interest rates, the litigation expense and new regulations to comply with, so the banks are desperate for higher interest rates.
This means that with five of the regional presidents on the committee, you automatically have a bias of five voices for higher interest rates. In recent years when you hear an FOMC member voicing a rationale for raising rates, it is usually one of the regional presidents (remember their bosses really want higher interest rates!). You can be sure they are lobbying their Washington counterparts on all the reasons that rates need to be higher.
So what is different these days and why are we "peeling back the onion" here? The difference over the past couple of years is because of the toxic politics going on in Washington these days, resulting in the Senate being unwilling to approve some of the President’s appointees. As a result, we are now operating with only five members of the board of governors instead of seven … five Washington appointees and five regional presidents.
The impact of the empty seats has proven empirically to be a more bank-friendly FOMC than Janet Yellen would probably prefer, according to a recent The Wall Street Journal article. The balance of power has shifted slightly in favor of the bankers and therefore their voices seem to be louder these days and this is probably not going to change before the elections.
What's the Point?
Why spend so much effort (and ink) digging into the Fed dynamics? The point in all this is, because of the power shift toward the bankers, we are more likely to have an ill-timed interest rate hike, just like the one in December. The dismal employment report on June 3 has cooled the momentum toward another rate hike for the time being, but if the economy regains its legs again watch out for the Fed presidents trying to push for another increase in rates.
This would be a mistake with the economy teetering on the edge of recession and could cause the next big problem with our markets, just like after the December hike. That’s the point of all this detail and what I believe we need to be watching. If, on the other hand, the FOMC stays on the sidelines I believe the markets will continue to enjoy the low interest rates, and more than likely we will have a good year.
It is important to understand the motivation behind all the comments you hear on television. We understand that you are depending on us to sort through all the noise and focus on what is really important, but occasionally I like to "peel back the onion" and simplify things so that maybe you won't fret about the noise so much.
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