The Fed is not 'walking the talk'

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The bond markets' indifferent response to last Friday's statement by the U.S. Federal Reserve (Fed) that interest rates may be raised this year seems about right. By moving up the yield on the benchmark ten-year Treasury note two basis points to 2.21 percent, it looked like bond traders heaved a big and tired Friday afternoon yawn before heading out for the long Memorial Day weekend.

The story, however, would have been entirely different had the Fed's message come with an increase of the federal funds rate – the only interest rate the Fed directly controls -- closer to its 0.25 percent target. But that is not what happened: the effective cost of overnight money was pushed down two basis points to 0.11 percent, roughly unchanged from a 0.08 percent level of a year ago.

The Fed's current management of its monetary base – the only aggregate it directly controls -- is also at odds with suggestions of an incipient policy tightening. In the course of March and April, the Fed's balance sheet expanded by $219 billion to an almost record-high $4.059 trillion – a 3.3 percent increase from the year earlier, and a whopping five-fold jump from pre-crisis levels.

And to make sure that these numbers are properly understood as a market-friendly policy posture, the Fed's statement last Friday also carried a reassuring message that future interest rate increases would proceed in a "cautious" and "gradual" manner.

Cheap credit hitting structural hurdles

Upon reflection, and refreshed over the long weekend, bond traders will probably take another look at all that. I think that would be useful, because the Fed's numbers and statements indicate a questionable conviction that the data-driven monetary policy and market behavior will remain benign and orderly.

A good place to start that review would be a closer look at employment and inflation, the two variables the Fed said last Friday that will determine its future interest rate decisions.

With regard to labor markets, the Fed acknowledges that progress is being made, but that "we are not there yet." That is true. Adding the 8.5 million people officially counted as unemployed and 8.7 million who are involuntarily working part time (because they cannot get full-time jobs) and those who are no longer looking for a job (because they tried and failed), the actual unemployment rate is about 11 percent rather than the reported 5.4 percent.

And it gets worse. The long-term unemployed (people without a job for 27 weeks or more) represent nearly one-third of official unemployment numbers. It also seems that getting a job is becoming more difficult: the number of people without a job for less than five weeks increased in the course of April by 241,000 to a total of 2.7 million – another one-third of the officially unemployed.

What is all that telling us?

I believe that these numbers are strongly suggesting that we are now hitting structural labor market problems – a mismatch of demand and supply -- which cannot be solved by zero interest rate policies. These problems require specific measures, such as better access to education, vocational training, labor relocation and retraining to provide the skills and qualifications which are in growing demand.

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A significant acceleration of U.S. labor costs is an indication that the supply of skills on demand is shrinking. For example, the employment cost index in the private industry in March was 2.8 percent above its year-earlier level -- a significant pickup from that index's annual gain of 1.7 percent in March of last year.

The core inflation is 1.8 percent

Similarly, the rate of increase of unit labor costs (labor compensation minus labor productivity) in the nonfarm business sector doubled over the last four quarters from the previous four-quarter interval.

I am not saying that some cyclical job creation cannot be supported by zero interest rates, but, from now on, any such employment gains will come at the expense of price stability.

That is what transpires from a closer look at the general inflation picture. A slight consumer price deflation (-0.2 percent) in April is a result of collapsing costs of energy (-19.4 percent), energy services (-1.2 percent) and the dollar's 16 percent trade-weighted appreciation over the last twelve months. A soaring dollar pushed import prices down 10.7 percent in the year to April in a sector representing 16.5 percent of the U.S. economy.

Meanwhile, the core inflation rate (CPI excluding food and energy) hit 1.8 percent. We are, therefore, very close to the Fed's target of 2 percent. We don't have to wait, as the Fed says, "to be reasonably confident that inflation will move back to 2 percent over the medium term." We are there already. And we have been there since the middle of last year.

A quick look at the CPI components in areas not exposed to international competition will also confirm that inflation is not as benign as the Fed seems to think. The latest inflation numbers for medical care commodities, medical services, shelter, general services (less energy) and food range from 2 percent to 4.1 percent.

In an economy where the actual growth rate of 2.7 percent over the last four quarters has far exceeded its potential (noninflationary) growth of 2 percent, the Fed should not be so lulled by transitory and reversible declines of energy prices. More attention should be paid to the steady core inflation of 1.8 percent since July 2014.

Investment thoughts

The actual inflation and the loosening inflation expectations may not allow the Fed to pursue a "cautious" and "gradual" adjustment of its zero interest rate policy maintained since 2008. I believe that the Fed has committed a typical error of maintaining an exceptional monetary stimulus for much longer than the economy needed it.

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The Fed has also missed a chance to normalize its interest rates before the beginning of the next year's presidential elections. The campaign is already heating up with a heightened media attention, caucuses and forthcoming primaries. Rocking the markets and consumers with actual and expected rate hikes is not a thing to do at the time when the U.S. economy remains the key election issue.

Ever since I began writing this column in 2012, the Fed's policy has led me to be consistently negative about bonds and very positive about U.S. equities. Since that time, the S&P 500 has offered an average annual return of 15 percent, while world bonds' average annual returns, over the same period, had been reported as a dismal minus 1.5 percent.

I have not changed my mind. The U.S. equity market will benefit from the growing economy and will provide a broad range of effective hedges if you are so inclined.