The Fed Is on a Collision Course

U.S. Federal Reserve Eccles Building, 1937


Is the Trump economic boom a mirage? The data say yes, but the Fed models say no. The Fed has a long track record of sticking to its model-based approach and missing major turns in the U.S. economy.

Current Fed policy will push the U.S. economy to the brink of recession later this year. When that happens, the Fed will have to reverse course and ease monetary policy. This will send the dollar crashing while gold and the euro soar.

At first, the claim that the Trump economic boom is nothing special seems contrary to the happy-talk headlines coming from CNBC, Fox Business, Bloomberg and other mainstream business media outlets.

Those economic cheerleaders recite the stimulative effects of the Trump tax cuts and point to the Atlanta Fed forecast that second-quarter GDP will be 3.9% (as of the July 11 update).

The Atlanta Fed estimate of 3.9% is in line with forecasts from National Economic Council head Larry Kudlow, Art Laffer (proponent of the eponymous Laffer curve), Steve Moore and others that say Trump’s programs will produce persistent trend growth of 3–4% or higher.

Such growth would break decisively with the weak growth of the Obama years. It would also make the U.S. debt burden, currently at 105% of GDP, more sustainable if GDP were to grow faster than the national debt.

There’s one problem with the happy talk about 3–4% growth. We’ve seen this movie before.

In 2009, almost every economic forecaster and commentator was talking about “green shoots.” In 2010, then-Secretary of the Treasury Tim Geithner forecast the “recovery summer.” In 2017, the global monetary elites were praising the arrival (at last) of “synchronized global growth.”

None of this wishful thinking panned out. The green shoots turned brown, the recovery summer never came and the synchronized global growth was over almost as soon as it began.

…In the third quarter of 2013, growth was 4.5%, even higher than the Atlanta Fed forecast for the most recent quarter. But by the first quarter of 2014, just six months later, growth was actually negative, -2.1%, comparable to some of the worst quarters in recent recessions. Growth was 5.0% in the third quarter of 2014, but then fell off a cliff and was barely positive, 0.2%, in the first quarter of 2015.

You get the point. Strong quarters have been followed by much weaker quarters within six months on six separate occasions in the past nine years. There’s no reason to believe the second quarter of 2018 will be any different.

The longer-term view of the entire recovery is more revealing. The recovery is currently 107 months old, the second-longest since the end of the Second World War. The average recovery since 1980 (a period of longer-than-average expansions) is 83 months.

So this expansion has been extraordinarily long — 30% longer than average — indicating that a recession should be expected sooner rather than later.

…In short, growth under Trump looks a lot like growth under Obama, with no reason to expect that to change anytime soon. In fact, the head winds caused by the strong dollar, the trade wars and out-of-control deficit spending may slow the economy and bring future growth down below the average of the Obama years.

…Why is the Fed tightening if the economy is fundamentally weak and the probability of a recession is so high?

There are two reasons. The first is that the Fed is using badly flawed models including the Phillips curve and a stochastic equilibrium macro model called FRB/US (or “Ferbus”). These models do not correspond to reality, but the Fed follows them anyway, which is why the Fed has never accurately forecasted a recession in its history.

The second reason is that the Fed knows a recession will happen sooner rather than later and is desperate to acquire some dry powder (in the form of higher rates and a reduced balance sheet) so it can deploy rate cuts and QE when the time comes. The problem, of course, is that by pursuing these policies, the Fed will cause the recession it is preparing to cure.

The single most important factor in my analysis is that when the Fed realizes its mistake of tightening into economic weakness, it will have to turn on a dime and shift to an easing policy. Easing will come first through forward guidance and pauses in the rate hike tempo, then possibly actual rate cuts back to zero and finally reversing their balance sheet reductions by expanding the balance sheet through QE4 if needed.

When that happens, the dollar will crash and alternative currencies such as gold, silver and the euro will soar.

Jay Powell seems determined to continue rate hikes on an aggressive path and possibly to accelerate the hikes. But he might be in for a severe case of whiplash when he has to make a hard pivot to easing. But by then, the damage will have been done.

Full article: The Fed Is on a Collision Course (Daily Reckoning)

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