Bill Greiner breaks down the economic market for Mariner Wealth Advisors and their clients.
Aug. 6, 2018 Commentary

Rounding Third and Heading Home: Will the Federal Reserve Spoil the Party?

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Our economic theme for 2018 has been Rounding Third and Heading Home. This theme conjures up visions of excitement and finality. We have been suggesting within our theme that overall economic growth, inflation and interest rate increases should accelerate. And, indeed, this has been happening for much of this year.

The phase which our economy has been passing through this year has been similar in many aspects to past economic boom phases. In past cycles, the boom phase is followed by recession. But while the boom phase is in force, overall economic growth tends to rise more rapidly than was the case during the expansion phase. Additionally, the higher overall growth rate tends to be accompanied by rising inflationary pressures and rising interest rates.

Historically, during the boom phase, the Federal Reserve tends to raise interest rates in an attempt to cool overall economic growth and temper inflationary pressures. Remember, the Fed has a dual mandate – economic growth (full employment) and price stability. Rising growth and inflation tend to go hand-in-hand, particularly when the economy has entered a period where excess productive capacity is being stretched. When this occurs, pricing tends to rise, bringing on inflationary pressures. So, the Fed  tends to foster monetary policies which can spur overall economic growth (reduced interest rates, as an example). If this activity is too aggressive, inflation trends can rise.

Or, the Fed can fight rising inflation by attempting to cool final demand growth by restricting money supply (raising interest rates, as an example). Consequently, the Federal Reserve is constantly walking a tightrope. If the Fed fosters monetary policies which go too far one way or the other, growth may be too slow, or inflation may be too high.

Where We Stand 

Recently, the government reported that U.S overall gross domestic product (GDP) growth eclipsed the 4 percent level. Over the last 12 months, GDP growth has risen close to the 3 percent level some in Washington have been seeking. This is great news. Over the same 12-month period, inflation (as measured by the consumer price index, or CPI) has risen to 2.9 percent from 1.6 percent over the previous 12-month period. So, the age-old tradeoff of higher growth bringing on higher inflation has occurred.

Don’t get us wrong. The Fed has been targeting a tolerance 2 percent inflation rate. Depending on how it is measured, inflation is not really out of hand. But inflation has risen over the last 12 months, this fact is undisputable.

Will inflation continue to rise? We’re not sure, but the seeds of higher, sustained inflation have seemingly been planted. Growth in employee compensation rates has recently risen nicely. Total compensation is up by 4.5 percent over the last 12 months as compared to a 2.5 percent growth rate a year earlier. Historically, inflation gains have been more “sticky” when accompanied by rising labor costs. Additionally, the New York Federal Reserve’s “Underlying Inflation Gauge” model suggests we should expect further upside inflationary pressure to occur over the next 12-18 months.

Where We Are Going 

In an attempt to normalize monetary policies, the Fed has raised rates eight times over the last 24+ months. We believe the Fed will raise short-term interest rates two more times this year and three times next year. This will bring short-term, overnight interest rates to the 3 - 3.25 percent range. What does this, along with other Federal Reserve and government fiscal policies hold in store for the overall economy and bond market? Additionally, how high should we expect interest rates to rise for the remainder of the boom cycle?

Treasury Bond Market 

As mentioned, the Fed has been raising rates for the last 30 months. The Fed funds rate is now approaching 2 percent. Additionally, most investors are not focused on the Fed’s balance sheet trimming activity. The combination of these two issues together, along with a surge in government deficit spending, has the capability of impacting economic activity.

  • If we look back to 1990, we see that the “real” Fed funds rate has been between 5 percent and -2 percent (“real” interest rates are how high interest rates are in relation to prevailing inflation).  The simple numerical average has been around 1.5 percent. If the Fed is interested in returning monetary policy to some degree of normalcy, investors should eventually expect to see Fed funds trading at the 3 – 4 percent range.
  • In addition to raising interest rates, the Fed has outlined their plan on shrinking the size of their balance sheet, again in the name of normalization.
    • By the end of 2019, this process will eliminate the need for the Fed to renew maturities in their portfolio totaling about $1 trillion, on a cumulative basis.
    • This effort reduces monetary liquidity in the financial system by $1 trillion.
  • The Congressional Budget Office (CBO), a non-partisan government budget organization, is estimating that government deficit spending will total $11.8 trillion on a cumulative basis over the next 10 years. This spending will need to be financed with the government issuing additional debt.
    • Government debt outstanding (as a percent of GDP) is expected to rise to the highest level seen since the end of World War II.
    • Government debt-to-GDP ratio is expected to rise to two times the average seen over the last five decades. 
  • Adding the Fed’s desire to reduce the size of their balance sheet, along with the Treasury’s need to float massive, new debt offerings, creates rising risk of a building economic credit crunch.

In our estimation, the above-mentioned risks have the combined ability to increase price volatility in the financial system, followed by a slowdown in overall GDP growth and corporate earnings growth. This risk may not materialize for some time. 

In the meantime, we think the economy will demonstrate positive GDP growth, slowly rising inflationary pressure and slowly rising interest rates. 

 

This commentary is limited to the dissemination of general information pertaining to general economic market conditions. The information contained herein is not intended to be personal legal, investment or tax advice or a solicitation to buy or sell any security or engage in a particular investment strategy. Nothing herein should be relied upon as such. The views expressed are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. There is no guarantee that any claims made will come to pass. The opinions and forecasts are based on information and sources of information deemed to be reliable, but Mariner Wealth Advisors does not warrant the accuracy of the information that this opinion and forecast is based upon.

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