Janet Yellen’s testimony to Congress last Wednesday confirmed the Fed’s ninth flip-flop since the current tightening cycle began in May 2013.
Yellen offered “forward guidance” that the Fed will not hike rates in September. A decision to pause the current tightening cycle constitutes a form of easing relative to expectations.
I’ve told my readers for months this was coming.
Now my analysis will shift to estimating how long the ease will last and when the next rate hike will occur.
Let’s unpack this a bit. Why do we say the tightening cycle began in May 2013 rather than December 2015, the date the “liftoff” in rates occurred?
Because May 2013 was when former Fed Chair Ben Bernanke gave the infamous “taper talk” suggesting the Fed would soon begin to reduce, or “taper,” money printing via asset purchases.
Whenever the Fed makes an announcement that changes expectations about policy, markets price in the new expectations. This repricing constitutes easing or tightening, depending on the direction of the change in expectations.
After May 2013, the Fed provided “ease” by not starting the taper in September 2013, as was widely expected. This was partly due to the emerging markets meltdown that occurred at the time of the taper talk itself. By December 2013, the coast was clear and the Fed switched back to “tightening” by starting the taper.
You get the idea. The Fed went from tightening (taper talk) to ease (delay in taper) to tightening (start of taper) in just seven months from May to December 2013. That’s two flip-flops right there, and the Fed did this without changing rates, but just by changing their words and the timing of balance sheet moves.
And so it went for the next four years. There’s no need to recite every flip-flop, but here are some of the more famous plays from the highlight reel:
- March 2015: The Fed tightens by removing the word “patient” from their forward guidance about no rate hikes
- September 2015: The Fed eases by delaying a planned rate hike in response to a stock market correction
- December 2015: The Fed tightens by raising rates for the first time in nine years
- March 2016: The Fed eases by delaying a planned rate hike after another stock market correction
- December 2016: The Fed tightens by raising rates for the second time in this tightening cycle
- July 2017: The Fed eases by indicating it will pause on future rate hikes for a while.
What’s behind the flip-flops?
In past business cycles, the Fed would tighten until the economy cooled or went into a recession because the Fed tightened too much. Then the Fed would ease until the economy came out of its funk and started to grow and create jobs.
The point is that the easing and tightening cycles were continual and were based on the business cycle. There were no flip-flops.
What’s different this time is that the Fed is dancing on a knife edge between preventing the next recession and being the cause of one. The Fed is not raising rates as part of a normal business cycle associated with an overly strong economy.
The trick is to raise rates in a weak economy without causing the recession you are preparing to cure. That’s what accounts for the easing by pauses and forward guidance.The Fed is raising rates in a desperate attempt to get them high enough (to around 3.25%) so they can cut them in the next recession without hitting the “zero lower bound.”
The Fed tightens as much as it can but then backs off when signs of slow growth, disinflation or disorderly markets appear. Then the Fed flips to ease until the danger passes and then goes back to tightening. Flip-flop, flip-flop.
Meanwhile, the markets have figured this out and are calling the Fed’s bluff. No sooner had Yellen given her remarks on Wednesday than the stock market rallied to new all-time highs. The stock market could see that the Fed will remain in easing mode for some time to come.
The classic description of Fed policy is they take away the punch bowl just when the party gets going. In this case, the Fed decided to leave the punch bowl just where it was, so the stock market decided to party on.
This may be a good party for the stock market, but it’s not a free lunch. We now have bubbles in Chinese credit, U.S. stocks and emerging-market bonds all at the same time.
These bubbles are set to burst either because the fundamentally weak economy cannot support valuations or because the Fed returns to tightening and causes the bubble to burst, just as it did in 1929.
The timing of this crash may be uncertain, but the likelihood is not. It’s time to take profits in stocks and increase your allocations to cash and gold at an attractive entry point.
The next time the Fed moves to tightening, they may actually call the markets’ bluff, with disastrous consequences.
Below, I show you why the Fed is already hitting the pause button, and why there will only be one additional rate hike this year. When will it come? Read on.
for The Daily Reckoning