The Fed increased the official rate in the US from 0.75 to 1 percent. The central bank appears keen to keep its promise of December last year. At the time, the Federal Open Market Committee (FOMC) implied that the official rate would be raised three times in the course of 2017. Is this unexpected rate hike in March a reason for sceptics as yours truly to expect two additional rate hikes? In my view, we should still call such expectations seriously into question.
First about that rate hike earlier this week. I am increasingly convinced that this step should be seen as something the Fed could not possibly avoid, rather than as a rate increase that the Fed could have postponed further.
While the Fed was fighting against the dangers of deflation until recently, in the meantime the loss in purchasing power in the US reached 2.7 percent. Even if we, as the Fed often does, look at so-called core inflation (that is, inflation less food and energy), we can observe that prices are rising with more than 2 percent a year. That is something the Fed has been trying to achieve for years.
The US economy grew in the last few months of last year with about 2 percent. That is considerably less than the growth we were used to in the period before the current crisis. However, comparing recent growth against those pre-crisis growth levels is wrong. It is, as it were, akin to comparing apples and oranges. The economic growth before the current crisis was in large part due to extending credit and spending and that motor is running at a slower pace than it was at the time. The growth estimates of the Fed, the growth that the US economy is able to produce in the long run, is a better benchmark. The central bank expects the US economy to grow in the medium and long term by about 3 percent a year. From this perspective, economic growth equaling 2 percent a year, as was the case in the last few months, is not bad at all.
In short, the recent developments in both inflation and economic growth forced the Fed, as it were, to raise the official interest rate, especially since the market is not expecting a significant drop in inflation in the next few months, yet it is counting on high or even increasing economic growth due to the plans of president Trump, such as massive tax reductions and investments in infrastructure.
If the Fed, against that backdrop of solid economic growth and increasing inflation, would have left the official rate where it was, then the central bank would have been playing with fire. Investors might have begun anticipating a significant further increase in inflation. Since, in that case, long-term interest rates would have increased rapidly and considerably and consequently economic growth would have been frustrated, doing nothing was out of the question for the Fed.
The Fed was also unable to explain why it suddenly forecasts fewer rate hikes for the remainder of this year and next year, 2018. If the bank would have done so, investors would immediately have asked themselves the question why the Fed would anticipate fewer rate hikes. Was the central bank more worried about the US economy than it admitted? Hinting at more rate hikes than previously announced was also impossible for Janet Yellen’s crew. In that case, long-term interest rates would rise further and could endanger the economic recovery. When a few days before the FOMC-meeting, the Bureau of Labor Statistics published yet again an excellent jobs report, the Fed had almost no other choice than raising interest rates.
Although this year only recently kicked off, I continue to factor in one more rate hike this year, and not two as the market expects. I have a few reasons to disagree with the market.
First: if the earlier comments on inflation and economic growth hold true, then I think it is quite strange that the Fed is aiming to raise interest rates just three times this year. The official rate would be at 1.5 percent at year-end, which is by any standards too low for the above described economy. The central bank should raise rates faster.
With that, we arrive at my second reason behind my expectation that the Fed will raise the official rate only once this year: the state of the US economy is far worse than what the Fed wants us to believe.
It is true that consumer and producer confidence have strengthened substantially in the past few months. But such headline numbers disguise important details. Consumer confidence went, for instance, especially through the roof ever since Donald Trump won the presidential elections. But this is mainly the case among his supporters. Studies show that consumer confidence outside that group has become increasingly under pressure.
With these recently added new monthly jobs, we observe the same effect. Many new jobs were created in construction, for instance. The construction sector is traditionally dominated by Republican supporters. The fact that “their” party won the elections, improved their confidence, something which led them to hire a lot of new employees. They also hired new employees in the assumption that the construction sector will greatly benefit from president Trump’s plans, such as constructing all kinds of new infrastructure and improving existing infrastructure.
But when we look at the purchasing power of US citizens, we see dark clouds on the horizon. Yes, wages recently increased a bit faster than normal, but, as mentioned before, so is inflation. Taken together, that means that the purchasing power of workers in the US has, in the best case, not increased and in, many cases, even slightly declined because of higher inflation.
Economic growth in the last quarter of 2016 equaled 1.9 percent, but that was the second estimate. The first estimate was 3.5 percent growth. In other words, as US statisticians got their hands on more hard data – for instance, the number of new orders instead of so-called soft data, such as confidence indicators – they had to revise their initial growth figure significantly down. The day before the FOMC would begin its meetings of last week, the regional Federal Reserve in Atlanta announced that it expected that growth for the first quarter of this year would come in much lower than expected earlier. An important indicator for economic growth, the Atlanta Fed’s GDPNow indicator, tumbled in a few weeks time from 2.5 percent growth to merely 0.9 percent growth for the first quarter of this year.
It’s the Purchasing Power, Stupid!
What mostly drove economic growth in the fourth quarter of last year, was domestic consumption by US households. But as I said earlier: because of the in the meantime substantially higher inflation, their purchasing power has suffered a setback (wage growth, after all, has not picked up pace in the past few months). This makes the expectations of a continuing consumer spending bonanza in the US highly doubtful.
If in the coming months, partially due to the increased and increasing inflation, domestic consumption increases less rapid than in the past quarters and companies receive fewer orders and create less jobs, then it would not surprise me if long-term interest rates would come under downward pressure in the US. This, in turn, might convince the Fed to leave the official rate unchanged in meeting after meeting. Let us include the political uncertainty as well, even within the Republican party itself, which might lead to delays and cuts in the announced tax reductions. As a result, both economic growth and confidence would suffer. Add to that the constant threat of president Trump’s protectionist policies, which he proposed on multiple occasions, and it should be clear that the current state of the US economy does not quite justify any new rate hikes.
No wonder that the immediate reaction of precious metals prices on the Fed’s rate hike was a sharp increase. We could regard this as a sign that the precious metals market is not fully convinced of the fact that Ms. Yellen will resort to the monetary break another two times this year. Besides this, we have another fact of utmost importance for precious metals markets. But more on that next time.