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, along with the decline in oil to $45 a barrel, might have taken the edge off of Fed fear, but did not. Lowest-fee mortgages are 4 percent-ish, the 10-year T-note well above 2 percent.
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.
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 backward looking and vulnerable to changing conditions. Each cycle from 1945 to 2000 was a carbon copy: 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 credit and housing bubbles, six years at 0 percent 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 fact that the Fed and markets assume that changes in monetary policy need almost two years to take full effect.
The Fed’s mathism and models are honestly the best it can do. But the models also provide a mask that’s beneficial to the Fed. Their complexity conceals from civilians a reality they might find alarming: The Fed’s 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 nonaccelerating 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 federal 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 president 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 [the federal funds rate] somewhere above inflation.”
But r* looks scientific and precise. Really cool equation!
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 president of the San Francisco Fed, in a speech last week says he knows the unemployment capacity limit is 5.25 percent: 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 hyperdollar all push down on wages. Our job growth is in low-wage sectors not subject to competition or IT. Waiting tables.
There is no upwinding in the credit cycle. Mortgage rates returned to 70-year lows without any uptick 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 percent. I hope next Wednesday the Fed tamps down that view of normal, and how long it should take to get there.
Lou Barnes is a mortgage broker based in Boulder, Colorado. He can be reached at lbarnes@pmglending.com.
