Leap of Faith
“Despite Powell’s kabuki act last week, we anticipate—and welcome—another series of interest rate hikes next year.”
During the formative first months of the Reagan era, as the nation was recovering from the double-digit inflation of the 1970s, the new administration appealed to then-Federal Reserve Chairman Paul Volcker to loosen his notoriously tight grip on interest rates. Volcker, today regarded among the most effective of post-war central bankers, refused to relent in what he insisted was an unfinished war on inflation.
Needless to say, events vindicated the chairman, and his obstinacy helped clear the way for Reagan’s own charmed presidency. So is history repeating itself for current Fed head Jerome Powell, dread enforcer of monetary normalization?
The parallels are inexact. Volcker spent a decade wrestling prices to the mat while Powell is coping with the legacy of a generation of fiscal extravagance. Now as then, however, we are fed a steady diet of market-top forecasts and recession speculation, labor-pricing power and diminishing earnings, much of which is blamed on rising interest rates. To paraphrase Harry Truman, if 3.5% growth, healthy earnings and a retail revival is a symptom of an exhausted economy, I’m a Hottentot—just don’t ask me what a Hottentot is.
Despite Powell’s kabuki act last week, in which he “spoke enough words for market participants to hear whatever they wanted” about Fed policy, as a Cantor Strategist aptly put it, we anticipate—and welcome—another series of interest rate hikes next year.
The case for a reprieve from gradual belt tightening—aside from gyrating share prices, which have a history of moving both north and south regardless of the credit environment—are docile inflation rates and wage growth measures. It is true that inflation has eroded since Volcker’s day, a byproduct of the global economy which, like it or not, has yoked the world’s supply chains, labor and financial might for the sake of the affordable goods and services we now expect as a birthright.
In fact, some indicators suggest a pause in inflation growth. Last month for example, the yield on the 10-year inflation breakevens, a measure of inflation expectations derived from inflation-protected government bonds, dropped to 1.98%, breaching the Federal Reserve’s important 2% target—though the 10-year real yield, which accounts for inflation, nudged higher.
In contrast, industrial sectors reveal clear signs of stress from rising costs. Last month, manufacture PMI series registered gains in salaries and raw material costs while the ISB’s non-manufacturing PMI price index reached a recent high. At the same time, the small business sector’s NFIB survey of price increases hovered at record highs.
The Fed has a hard job during the best of times, let alone during the most recent finale of the longest bull market ever. In our view, Powell is sagely trying to wring the froth from an economy with a record of surprising on the upside. It happened in 2014 and again in 2016 and it may yet elude the top-watchers next year in which case Powell, like Volcker before him, would be vindicated. In addition to preempting an overheating economy, staying the policy course would impose respect for market fundamentals after a generation of loose credit, allow higher returns for savers and more generous interest income for retirees, and boost purchasing power with the help of a stronger dollar.
We are aware this is not a consensus view. BlackRock, for example, argued last month that rising payrolls are not an economic stimulus but a drag on output and earnings and that Powell should take his cue from Wall Street. “Markets are screaming that rising wages are doing much of the heavy lifting in tempering cyclical overheating in growth and inflation,” BlackRock Managing Director Rick Rieder wrote, “such that incremental Fed tightening on top of narrowing profit margins is too onerous a burden for growth.”
If the dismal science teaches us anything, it’s that there is no “right” way to manage an economy because each cycle presents a unique set of circumstances and challenges. On this point, however, we disagree with our BlackRock counterparts. Wage growth is fuel for GDP, particularly for an economy that relies on consumption for two-thirds of its output, and wages are rising nicely, finally. The average hourly earnings survey for November, at 3.1% on a year-on-year basis, was the largest in a decade. Spending is also responding in kind. According to the Commerce Department, consumer spending in October jumped 0.6%, its largest increase in seven months and well above expectations, while inflation-adjusted spending rose 0.4%, also a seven-month high.
Still, adjusted for inflation wages are lingering at about 1.0%, one reason—along with changing demographics and rising borrowing costs—home and automobiles sales are uninspiring. On the other hand, banks are exploiting rising interest rates as an occasion to write loans to their commercial and industrial clients—possibly to a fault. The Fed last month identified in a financial stability report unstable debt owed by US businesses as one of the “top vulnerabilities facing the U.S. financial system”, in addition to leveraged loans and high-yield corporate debt.
Where will this end? “In the long run,” John Maynard Keynes famously pronounced, “we’re all dead.” Until then, we are just like the gnomes in the Fed’s boiler room, crunching data to calculate the leap between the existing economic cycle and the next one.