I've written several columns over the past few months explaining why the Federal Reserve can't and won't raise rates, and why the rationale they've offered for telegraphing doing so soon is faulty.
Last week I wrote about the resulting credibility issue with capital market participants that's developed as a result of that rationale and why the Fed will most probably have to soon begin walking back expectations for rate increases this year.
There are risks to the capital markets and economic potential inherent in reversing course on rate hikes, though. and I'll discuss those briefly. Once the logic for monetary policy decisions and projections is allowed to become as far apart from what capital market actors think they should be, there are risks in attempting to realign monetary policy with market expectations. That logic also has has been building for over a year now,
Market participants in all asset classes have expressed with financial decisions that their collective assessment of the near future economic environment for the US is less optimistic than the Fed's. That has happened during the past year, and increasingly so over the past quarter,
This is most obvious in the increase of long end U.S. Treasuries by the largest banks in the U.S. over the past year, which I discussed last week. But it has also been reflected as a major contributing factor in driving the dollar index higher, as I discussed earlier this month in the column, Prepare for the Fed to Change Course.
A rising dollar helps to suppress commodity prices, especially oil, and it helps to drive down treasury yields. Declining oil prices causes gasoline prices to decrease and is a catalyst for an increase in U.S. consumer confidence, which is now at its highest level in a decade.
Declining long end U.S. Treasury yields drives down residential mortgage rates, which are now at their lowest level since the record lows of the spring of 2013.
Rising consumer confidence and declining mortgage rates helps to marginally increase the demand for housing. This traditionally is the primary catalyst for the beginning of a cycle of consumption increases leading to production increases, job and wage gains, and the virtuous cycle of an expanding economy.
That brings me to the risks inherent in the Fed altering its telegraphed course on rate hikes. The Fed's action, narrative, and projections for rate hikes has helped to contribute to the decline in oil prices. That is going to cause economic activity in the oil sector, largely concentrated in Texas and North Dakota, to decline precipitously and be reflected as such in GDP this year . That is because booming economic activity in those areas had been a major positive contributor to aggregate national GDP during 2014.
The decline in oil prices and long end yields, however, has also set up the housing market for its best spring / summer buying season since subprime mortgages began to default in 2006.
As I discussed last November, every year since Lehman failed in 2008, something has happened in the capital markets that has prevented the U.S. from having a strong spring / summer housing market. That "thing" has been instability of mortgage rates in the spring following the end-of- year holiday season.
If the Fed is right now caught in a timing trap, if they begin now to walk back expectations of raising rates in June, the markets will logically conclude that the dollar is currently priced at a premium. The markets will then will sell it. The declining dollar will be reflected in rising long-end treasury yields and oil prices.
Rising long-end treasury yields will cause mortgage rates into the spring housing season and decrease housing affordability. It will also cause oil prices to rise, which will push gasoline prices up again and deflate the nascent positive shift in consumer confidence.
This process could cause home buyers to punt for another year on a home purchase.
We are getting signs of that process occurring now.
Treasury Inflation Protected Securities (TIPS) are increasingly being priced by the markets in anticipation of rapidly decreasing long-term expectations for inflation and now indicate that inflation will not rise to the level of the Fed's target of 2% for over the next decade.
This again is a signal being sent by the markets that the Fed can't raise rates this year. It is beginning to be exhibited in other markets as an expectation that the Fed won't raise rates this year. That is exhibited by today's plunge in the dollar and commensurate reflection of rising oil prices and long end treasury yields.
The Fed so far has not changed its telegraphed intention of raising rates, but the markets are increasingly exhibiting a belief that they will soon and that they must.