A wild card in Fed’s rate hike timing

Federal Reserve building, Washington.
Getty Images
Federal Reserve building, Washington.

The U.S. economy is leaking.

Europe's self-flagellants are happy about that. Suffering from excessive fiscal retrenchment and corrosive sanctions, they see a path to salvation in exports to America. Asia's trade surplus runners also hope that their 5.4 percent increase in exports to the U.S. during the first five months of this year will continue – and that they will get bigger as American domestic demand picks up speed and leaks out to the rest of the world.

What's the leak?

In the first half of this year, America's trade deficit subtracted 1.14 percentage points from its economic growth. And that is the time when the U.S. economy just managed to eke out a 1 percent increase in its gross domestic product (GDP).

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The American financial community – and, apparently, some governors of the U.S. Federal Reserve (Fed) advocating an early interest rate increase – are blissfully oblivious to the trade deficit speed bumps. They are obsessing instead with non-issues.

What are these?

Inflationary capacity pressures, of which there are no signs in American wages, unit labor costs or on factory floors. In spite of that, market operators see tightening credit conditions and the Fed's alleged confusion about the technical aspects of liquidity withdrawals.

Equity market downward correction?

It all seems like a trading case is being built to take equity prices down.

That may well happen, but if it does I believe that would be a good buying opportunity.

The reason is simple. A sustained decline of equity prices can only happen if the Fed is determined to cool down an overheated economy driven by excessive capacity pressures in labor and product markets.

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We are nowhere near that point. The Fed is now contemplating a gradual "normalization" of its policies after a long period of rescuing its badly damaged financial system and managing the recovery from the Great Recession – under conditions of a pronounced fiscal tightening since 2010.

Nothing at the moment suggests that the Fed should rush that "normalization" process. And it is reassuring to see no signs that the Fed is about to do that.

As mentioned earlier, a 1 percent GDP growth in the first half of this year, and the continuing weakness in U.S. trade accounts, are no cause for inflation alarm.

Labor market conditions are still too weak. The actual unemployment in July was exactly double the officially reported 6.2 percent rate (adding 7.5 million of part-time workers who can't find a full-time job and 2.2 million people who have given up looking for a job). The long-term unemployed (people without a job for 27 weeks or more) account for one-third of the total, and their number was virtually the same as the one observed in June.

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How can we get inflation from that?

Here is what the labor markets are saying. Real wages in the year to June rose only 0.2 percent, and unit labor costs over the twelve months to the first quarter (the last observation available) increased by only 0.8 percent.

Are we going to import inflation? From where? From the deflationary Europe? At any rate, the dollar's trade-weighted appreciation over the last twelve months (1.4 percent), and its widely anticipated further strengthening will prevent any major import-induced inflationary pressures.

The Fed's very easy policy stance

Amid growing anxieties about the Fed's intention to discontinue asset purchases next October, you may find reassuring that its monetary base expanded by a hefty $52 billion during the first three weeks of July. That is well above the average monthly increase of $38.5 billion in the first six months of this year. And the Fed's balance sheet continues to grow at an annual rate of 22 percent.

Banks' excess reserves (aka loanable funds) held at the Fed at an interest rate of 0.25 percent hit a new high of $2.63 trillion at the last reserve reporting period on July 23, 2014. So far this year, these reserves have been rising at an average monthly rate of $31 billion; they are also a whopping 30 percent above their year-earlier level.

Is it any wonder that the Fed's key policy rate – the effective federal funds rate – was 0.06 percent at the close of trading last Friday? That marks a year during which that rate was kept in a 0.05-0.10 percent range – less than half the Fed's official target of 0.25 percent.

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These are hardly the makings of a situation where the Fed is seen rushing to raise interest rates in an economy growing well below its non-inflationary potential and struggling with an actual unemployment rate of 12.4 percent.

I am sure the strong headwinds from trade with Europe, China and Japan (that is 42 percent of world GDP) also loom large in Fed's policy decisions.

Japan's valiant efforts to keep the economy growing may be compromised by falling real incomes, weakening private consumption and declining business investments. China's economy seems set to stay on the path of its officially targeted 7.5 percent growth rate, but its increasingly difficult trade and investment environment may already be causing serious problems for U.S. companies.

The EU, destination of one-fifth of U.S. exports, is running the risk of aborting its fledgling economic recovery with overly restrictive fiscal policies and broad-ranging sanctions in its trade with the Russian Federation.

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The Socialist governments in France and Italy are trying to shake things up a bit. Undermined by rising unemployment, these two countries (representing almost 40 percent of the euro area) are plotting – with the help of some German Social Democrats – a head-on assault on stifling austerity policies. That could be very exciting. Stay tuned for next week's report.

Germany's government is also under attack from some of its businesses because they are being hard-hit by their sanctions-eroded sales and investments in Russia.

Incidentally, the ISM report on U.S. manufacturing activity published on August 1, 2014 also talks about sanctions and problems caused by worsening global political instabilities.

For example, the U.S. chemical industry fears that "geopolitics still presents a considerable risk as well as the European market," and various manufacturers in healthcare industries report that "Russia's demand for medical devices from the U.S. has dropped by 40 percent."

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Investment thoughts

Being fully-valued, U.S. equity markets may experience occasional downdrafts, but the Fed is not about to sink Wall Street by a needless rush to begin raising interest rates. Even when the Fed decides to initiate that process with global ramifications, it will proceed carefully and gradually. Also, please note that the higher interest rates will only begin to "bite" aggregate demand in earnest when the federal funds rate hits 4 percent or higher.

Timing? I don't know. And neither does the Fed. We all have to do what the Fed does: Watch the data on economic activity, labor markets, costs and prices.

And here is for the very long view: Gold bugs (whom I frequent occasionally) have no fear and no doubt. Gold prices (+7.2 percent from the year ago) are anticipating accelerating inflation, rising interest rates and the next cyclical downturn – or much worse.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.

Follow the author on Twitter @msiglobal9