The Fed’s Dilemma: To Raise Or Not To Raise (Rates)

Please refer to IMPORTANT DISCLOSURE INFORMATION at the end of this note.

The markets are bracing for a potential Fed rate rise this September.  Last week, the Dow Jones Industrials index fell 3.5% before reversing and closing the week up around 1%.  One of three reasons cited for this unprecedented volatility was the rate hike expected in September.  The other two reasons were China concerns and better than expected Q2 GDP numbers.

In a series of interviews in the Wall Street Journal, Fed officials shared their thoughts on whether the time was right for a rate increase.

Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, thinks it would be "premature" to raise rates today, given the low rate of inflation.  He seems to be leaning towards even more QE, not less. 

On the other hand, James Bullard, president of the Federal Reserve Bank of St. Louis and Loretta Mester, president of the Federal Reserve Bank of Cleveland seem more comfortable with the Fed raising rates because they believe the U.S economy is on "solid ground."

Why such diametrically opposite views based on the same datasets?

To be clear, we aren’t economists and don’t play one on TV.  We are bottoms-up fundamental value investors.  So this discussion will be simple, some may say too simple, but sufficient for our purposes.

 

QE: What was the intended outcome? Inflation and U.S. economic recovery

QE (QE2 actually), was initiated in late 2010. 

The rationale was simple:  Keep rates low, so consumers will have an incentive to spend their money rather than save, spurring demand for other assets, driving up the prices of goods, thus creating an inflationary effect.  The rise in asset prices (such as home prices) would create a “wealth effect.” This, in turn, would translate into more spending creating a virtuous cycle that would jump-start the economy in a moderately inflationary (rising prices) environment.

Some skeptics argued that QE (or unprecedented money printing) would debase the U.S. dollar and drive up gold prices, as gold would regain its role as a reserve currency.

 

QE: What really happened?  Deflationary risk, sputtering economy

  • Since November 2010, the S&P500 index has appreciated almost 70%, before dividends.  An asset price increase that one could argue was an expected consequence of QE. 
  • On the other hand, U.S treasury yields are very low (the 10-year at around 2%) and the US dollar is up almost 25%.  A stronger dollar post-QE seems unexpected.
  • Gold is down 20% since 2010 and down 40% from its 2011 highs. Also unexpected.
  • Inflation is stubbornly low with core inflation running at 1.5%.  Unexpected.
  • Prices of commodities, such as oil and copper, are at generational lows. Unexpected.

So why do we find ourselves in what seems to be a dis-inflationary (some would say deflationary) environment?

David Einhorn in his excellent “Zero Bound Odyssey” presentation at the Grant’s Investment Conference, earlier this year, makes a strong case for placing the blame squarely on QE. 

Here’s the cliff’s notes version of the argument:  Instead of spending all that easy money created by QE and in an effort to chase yield, investors (and banks) lent out that money.  Commodity producers took advantage of that cheap debt and produced more, creating an oversupply of commodities (such as oil). 

So instead of increased demand for goods which would have driven up asset prices (QE’s original intent), we ended up with an oversupply of goods driving down asset prices (an unintended consequence of QE) i.e., deflation instead of inflation.

 

Fast Forward to the present and the Fed's dilemma. 

Does the Fed hold off raising rates until the inflation rate climbs a bit higher?  OR is QE directly responsible for the low inflation rates and the Fed should raise rates sooner rather than later to stop what could be a self-inflicted deflationary cycle?

 

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