The Fed made a historically important decision this week, and it wasn't to raise interest rates. For the first time in 35 years, the Fed moved from a data dependent method of determining the level of the fed funds rate to a theory dependent method. The expectations are that the Fed will move interest rates a few more times in 2016. The question is: which way? 

 

The Fed's expectation is for the economy to improve, for inflation to rise, and for employment to stay around 5%. What if they're wrong? After all, their forecasting record is mediocre at best. The facts are that both the growth rate and the inflation rate are lower today than they were at the Fed's last meeting. So why did they raise? Yellen was asked that question at her news conference and really didn't answer it. The closest she came was that they had great confidence in their forecast. So, the Fed has moved from decisions based on market data and evidence, to decisions based on confidence, belief, and hope.

 

This is the real problem with a fiat standard. It is only as good as the people that control it. What worries me is we have a Fed unwilling to change their opinion based on facts and evidence. I changed my mind this year as the evidence changed, and many others have done the same. The growth rate and rate of inflation have fallen substantially, undershooting the Fed's forecast. If anything, there is a case to be made for a more accommodative Fed, not a tightening of monetary policy.

 

In the face of this present economic decline, the Fed has raised the payments on new homes, adjustable mortgages, home equity loans, cars, and credit card balances among other things. At the same time they raised the interest rate on excess reserves, which is an incentive for banks NOT to lend money to borrowers, but keep the money risk free in the bank and now get a fifty basis point return up from 25 basis points. Savers however, will not see any real increase in interest paid to them.

 

Among independent economists polled, the expectation for a recession in 2016 has just gone up to 23%, the highest in years.

Global weakness is the number one threat to the economy according the poll. Even those that don't believe we will go into recession according to this poll shows expectations fell during the year for GDP to fall from an expected 3% at the beginning of the year to 2.3 today. The Fed is hoping for GDP in 2016 to rise toward 3% and inflation rise to about 1.5% on its way to 2%.

 

 

ERCI, one of the best forecasting firms in the business sees things differently:

 

The economy is best described as one with a long-term decline in trend growth, exacerbated by ongoing cyclical slowdown.ECRI uses the Three Ps, how pronounced, pervasive, persistent is a change in the data, to determine whether recent moves in data are noise or not.

 

-Yoy payroll jobs growth at a 17-month low


-Yoy GDP growth at 1½-year low


-Yoy industrial production growth near 6-yr low

 

This matches what ECRI has been saying for a long time. Now that this reality is officially on the table, the cyclical slowdown recognized by Main Street, but not Wall Street, especially for 2016, makes a huge difference to the sustainability of the Fed’s rate hike cycle.

 

If the Fed is wrong in their assessment for 2016, they will be forced to reduce interest rates and even possibly go to negative rates just as many other central banks have done around the world -- with dubious results I might add. The sad fact is the Fed can do little to improve economic prospects. Real change can only come with the assistance of a fiscal change in policy.

 

 

It is the federal government, not the Fed that can increase the money supply overnight by reducing taxes thereby increasing the amount of money chasing goods in the economy. This would increase prices, and increase the velocity of money which has been flat on its back for years and it would stimulate growth. Further it should address the increasing fees and insurance premiums in the health industry which is one-sixth of this nation’s economy, and reduce the thousands of pages of regulations that have been thrown over the economy like a wet blanket.

 

The price of gold takes the temperature of a nation’s economy and the value of its money. For five years gold has been falling, and has been an excellent barometer of where we're going. Growth is running at about 1.5% presently and inflation a quarter of a percent year over year. Gold at $1050, at 6 year lows, is telling us along with most other economies that the trend is still to the downside.

 

The bright spots in the economy are low energy prices, high car sales, and technological innovation. But dark clouds are forming in debt markets, and the prospects of corporate bankruptcies in depression ravished sectors like energy, metals, agriculture, and manufacturing persist.

 

 

Watch gold for the direction of the future. A new leg down in gold suggests a new leg down for the economy and inflation. The deflationary recessionary forces are mounting and must be watched closely. Janet Yellen said in her news conference that the Fed has considered the possibility that their theory may be wrong about increasing growth and inflation; and that if a surprise should happen to the downside they have plenty of tools to deal with it.

 

That again is theory. Without the federal government taking actions like those listed above, it will be difficult for the Fed to affect change. I have no doubt they will try, but I don't have the same confidence that they have that they will succeed.

 

Paul Nathan

paulnathan.biz