Long-term rates came down a hair this week from the prior three-week spike, but there is no sign of another flirtation with the February lows. The third-straight monthly slide in retail sales and oil to $45 a barrel might have taken the edge off of Fed-fear, but did not. Lowest-fee mortgages are 4.00%-ish, the 10-year T-note well above 2.00%. Everyone assumes the Fed next Wednesday will remove “patience” from its post-meeting language, opening the door to its first rate hike since 2006. Many in markets think it’s coming in June, fewer think September. But it’s coming. What is the Fed’s purpose now? The Fed’s purpose is to protect us from extremes in the business cycle. Capitalist economies tend to self-reinforcing spirals up or down with violently bad endings. When the Fed sits down to talk about action, the entire internal conversation is based on the mathematics of the business cycle — equations, charts, and models. All of necessity backward looking, vulnerable to truly changed conditions. Each cycle from 1945 to 2000 was carbon-copy — each expansion, tightening, recession, easing, and recovery. A perfect world for models. But, beginning in 2001, a jobless recovery, a burst stock bubble, a false recovery based on undiscovered (incredibly) credit and housing bubbles, six years at 0% cost of money, and today’s uneven and iffy recovery — nothing in the last 15 years resembled back-look models. Add to that uncertainty: the Fed and markets assume that changes in monetary policy take most of two years to take full effect. The Fed’s mathism and models are honestly the best it can do, but also provide a mask beneficial to the Fed. Better that complexity conceals from civilians the reality: its decisions are a collective dampened thumb stuck into the breeze. The mathism and thumbs are directed at two questions: first, what is the capacity of the economy to grow without inflation, expressed as the Non-Accelerating Inflation Rate of Unemployment? NAIRU, pronounced like the jacket. If too many are unemployed, our spiral sinks into deflation and the Fed can and must spew invented cash; too few unemployed, and the Fed must tighten long before wages grow too fast. The second question: Where do we set the Fed funds rate? Lowering or raising on what slope? Found in every numbing Fed paper today, this notation: r*. Beaten to death in a speech by the new Prez of the Cleveland Fed, Loretta Mester, r* is the “equilibrium Fed funds rate,” the result of this equation: The unintended(?) black comedy in Mester’s speech: “The big issue is that the equilibrium real rate, r*, is unobserved. Incidentally, so are the level of potential output and the natural rate of unemployment.” Translation: we’re guessing at the values of the variables. In a heating economy we’re going to jack Fed funds somewhere above inflation… but r* looks scientific and precise. Really cool equation. Back to the business cycle Back to the business cycle. Two things drive the spiral: unemployment, as above assuming it translates into wage gains, and second the credit cycle, in a hot economy when new loans, the rising value of collateral, and wages all chase each other. Today we have very little wage growth. John Williams, sensible Prez of the San Francisco Fed in a speech last week says he knows the unemployment capacity limit is 5.25%: tighten now, and gradually higher rates in two years will offset the wage effects of full employment. But, this time looks very different: global competition, IT effects, predatory exports (China, Germany), and a hyper-dollar all push down on wages. Our job growth is in low-wage sectors not subject to competition or IT. Waiting tables. There is no up-winding in the credit cycle. Mortgage rates returned to 70-year lows without any up-tick in purchase applications. Very good and tough new bank regulation, run-proofing the system and intercepting bad ideas (subprime car loans, “leveraged loans”…) have already tightened credit. The bond and mortgage markets fear a Fed “normalization” marching upward mindlessly to levels appropriate before 2000, 3.5%-4%. I hope next Wednesday the Fed tamps down that view of normal, and how long it should take to get there. ——————————————————– 10-year T-note in the last year. Stumbling around now at 2.10%, held down only by the lowest overseas rates ever measured (some say comparable to rates in 14th Century Europe after depopulation by the Black Death). German 10s pay 0.23%, and in a currency rapidly depreciating versus the dollar. The euro this week free-fell from $1.10 to $1.05. The Fed’s last 15 years have borne no resemblance to its prior 85, and I would not place big bets on its tidy return to normal in the next 15. “Real Potential GDP” by the Congressional Budget Office looks so precise. NOT. The following gorgeous chart is courtesy of www.calculatedriskblog.com. The biggest single question in the labor market: what is its size? That’s the denominator in arriving at an unemployment rate. The workforce relative to population appears to have entered a sustained and deepening decline 30 years ago, blamed on everything from poor skills to retiring Baby Boomers to excessive federal benefits. I don’t find any of the explanations satisfying — are we as a people and economy so different? If the workforce is in fact bigger than we think, a reserve cohort which will come back into visible work, then the real unemployment rate is higher than the official one, and the economy is much less likely to enter “wage-pulled” inflation.
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