Stuck in the Monetary Mud

The Federal Reserve’s years-long campaign to sheepishly back away from its own policy forecasts continued in earnest last week when it officially reduced the four expected 2016 quarter point hikes, suggested back in December, to just two. Given the deteriorating economic outlook, I believe there can be little doubt that the Fed will soon complete the capitulation process and remove all expectations for additional hikes this year. Even before that happens, savvy observers should have already concluded that the Federal Reserve is stuck in the monetary mud just as firmly now as it has been since the dawn of the financial crisis back in 2008.

Rather than actively voicing its retreat in either its March policy statement or in Chairwoman Janet Yellen’s press conference, the market-moving policy shift was buried in the minutia of the Fed’s “dot plot” information array, in which each voting committee member signals their assumptions of where interest rates will be at various points in the future. Those tea leaves needed to be read to reach the conclusion that policy just got significantly  more dovish. But despite the Fed’s soft peddling, the policy shift made an immediate impact on markets, with the dollar getting hit by a variety of rival currencies and gold (and more significantly gold miners) climbing to multi-month highs.

The slowing sales, in turn, are leading to a dangerous increase in business inventories as unsold goods accumulate on shelves. The inventory-to-sales ratio now stands at 1.4, the highest it has been since May 2009 when the nation was in the midst of the Great Recession. In fact, it has never been this high at times when the economy was not in recession. Similarly, data revisions released last week also indicate that we may ultimately post the full year 2015 current account deficit of $481 billion, the biggest number since the recession year of 2008. If interest rates go up, that deficit could grow significantly worse. The industrial production numbers are also on a downward spiral. Recent data show declines for four straight months, the first time since 1952 that this has occurred without the U.S. being in recession. But if we are already in recession, which I expect we are, then, at least, that statement will no longer be true.

All this adds up to a nearly inescapable trap for the Fed. The economy is weakening while inflation is strengthening. In the meantime, asset prices, which have become the bedrock of any remaining economic confidence, are extremely vulnerable to an interest rate increase.

As a result, we should expect continued jawboning and inaction from the Fed. All it can do is pray that the economy heats up so it can finally do what it has long promised. But if we keep scraping along the bottom like we have, or go further into the danger zone, look for the Fed to take away those remaining two promised hikes just as easily as it did the first two. The last thing the Fed can bear is for a recession that may be bubbling just under the surface to boil over into full view in the months heading into the election. If that occurs, we all may be seeing a great many press conferences from Mar-a-Lago. That is a development that I’m sure Janet Yellen wants to avoid at all costs.

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