Yellen Strikes Out Trump

In December of 2015, one year ago, the Fed did something no other Fed board had done in nearly a decade, raise interest rates.  It was only a quarter of one percentage point, .25%, but a raise it was.  At the same time they announced potentially four additional increases during 2016.  Three of those increases would never materialize, the fourth and final one came today.  You will see later where I am going with this, but, strike one!

Both the targeted Fed funds rate and the discount rate were raised .25%:

“Effective December 15, 2016, the Federal Open Market Committee directs the Desk to undertake open market operations as necessary to maintain the federal funds rate in a target range of 1/2 to 3/4 percent…”

“In a related action, the Board of Governors of the Federal Reserve System voted unanimously to approve a 1/4 percentage point increase in the discount rate (the primary credit rate) to 1.25 percent, effective December 15, 2016.”

Decisions Regarding Monetary Policy Implementation, The Federal Reserve, December 14, 2016

Thus, in the last decade, the Fed raised rates exactly two times and a total of one half of one percentage point, in financial parlance, 50 basis points.  Somewhat more interesting, as this rate hike was fully expected, was its revised policy stance on further rate hikes and interest on required and excess reserves, IORR and IOER, respectively.  First, the interest on  reserves…

Without going in to the full history of the matter, a series of measures, “quantitative easing”, by the Fed produced record bank reserves.  Reserves, money held in banking institutions, serve as the raw material for bank credit expansion.  Prior to 2006, the Federal Reserve did not pay interest on these reserves.  The decision to change this policy rested on the desired ability of the Fed to introduce ample or even excess liquidity in to the banking system without the risk that banks would lend too freely, thus creating inflation.  This clever tactic, as far as the Fed is concerned, has been a smashing success.  The economy has risen from smoldering ashes following the 2008 financial crises, achieved a sub 5% unemployment rate and all the while, maintained a consumer inflation rate below 2%.  What is concerning is the implications of this “success”.

Prior to the hike in December, 2015, interest on reserves was .25%, after December, 2015, and through today’s meeting, .5%.  What this means is that banks had a decision to make; assuming they had demand for credit, loans, they would need to project a return greater than .25% and .5% respectively, pre- and post-December, 2015.  Projected returns greater than this bogey, make the loan, returns less than the bogey, don’t make it because they would be better off earning the .25-.5% directly from the Fed.  If you are thinking it should be pretty easy to earn such paltry returns, you would be wrong.  As of October 31, 2016, excess reserves, or additional capacity to lend stood at nearly $2 trillion.  Either bankers and their shareholders hate money, or they simply could not, or have not been able to, find worthy borrowers.  My guess, it has been the latter.  And, if you are of the opinion that the economy has been slow, sluggish, stagnant, just a few adjectives that have been used to describe the economy since 2008, you might expect the Fed to lower, or even remove the subsidy completely, and force the banks to make loans and earn their money the old fashioned way.  Well, your expectations would be wrong.

The Board of Governors of the Federal Reserve System voted unanimously to raise the interest rate paid on required and excess reserve balances to 0.75 percent, effective December 15, 2016.

Decisions Regarding Monetary Policy Implementation, The Federal Reserve, December 14, 2016

Yes, your reading and understanding is correct.  The very same banks that could not find willing and able borrowers at above .5%, now have a hurdle of .75% over which they must jump.  Please keep in mind, by the way, that this is a net return or rate of interest, not a gross rate of return or interest.  Even assuming the economy has improved over the last several months, and there appears to be little to no evidence that this is the case, it is unlikely it has improved enough to accommodate additional credit expansion at the higher rate.  Strike two!

So, rates are going higher, and credit may indeed be more difficult to come by.  What else?  Try full sterilization of the Trump tax and infrastructure spending “plan”; “we’re going to do great things, trust me on this!”  Well, the Trump transition team has been a little more detailed than that.  Something about lowering taxes and $1 trillion in infrastructure spending.  Sounds like something you would do with a 10% unemployment rate, not a 4.6% unemployment rate; no public debt, not $20 trillion in debt; a liberal program to assist unskilled workers entering the country, not a 30-foot high wall on the southern border and mass deportations; and an expanded program to attract needed high-skilled immigrants, not visa restrictions preventing then from taking vacant positions.   I find highly suspect the notion that US roads and bridges are crumbling and shortages exist in mass transit, but even if this was true, who is going to design and build the newly-proposed infrastructure?

For the last one hundred years that unemployment statistics have been kept, 4.6% is considered full employment.  This low rate simply accounts for a small percentage of the working population that is, for one reason or another, in between jobs.  Much has been made of the decline in workforce participation, but I do not believe anyone is questioning the accuracy of the numbers.  People are either retired, are in school, on welfare of some kind, or have satisfactory living arrangements despite being out of the workforce.  Retirees will need to be pulled from their rocking chairs, students from their classrooms and stay-at-home-moms from their pre-school aged children.  Ending the welfare and entitlement state might turn the trick, but I have not seen, read, nor heard any specific proposals outlining this.  Absent somewhat “draconian” measures and “totalitarian” directives, current workers must be bid away from their current employers.  That is the only way the somehow new and improved, I’m skeptical, infrastructure could be realized.  This, apparently, is what Janet Yellen, and the FOMC, are concerned about as well.

The labor market has improved enough that the United States will not need big U.S. government spending to reach full employment, Fed Chair Janet Yellen said Wednesday.

“I would judge that the degree of slack has diminished. I would say at this point that fiscal policy is not, obviously, needed to help us get up to full employment,” the central bank chief told reporters after the Fed hiked interest rates.

The U.S. unemployment rate fell to 4.6 percent in November. Yellen noted that her predecessor at the Fed, Ben Bernanke, called for fiscal stimulus when “unemployment was much higher than it is now.”

Yellen: We don’t need a spending binge to reach full employment, CNBC, December 14, 2016

Chair Yellen’s response to the massively inflationary Trump proposals?

The Fed also took a more aggressive view on future hikes. It now projects three increases in 2017, two or three in 2018 and three in 2019.

Yellen: We don’t need a spending binge to reach full employment, CNBC, December 14, 2016

Strike three!  We are staring down the barrel at 8 to 10 more rate hikes over the next few years and a central bank, the Fed, that is held accountable for inflation, not the President.  If I consider today to be his first at bat, President-elect Trump just struck out to Janet Yellen.

There is no question, as evidenced in the most recent spike in US equity markets, that Trump trepidation has turned to Trump exuberance and Trumponomics has been sweeping the country.  But, while it might be too late to get the champagne back in the bottle, Trump’s plans may never get off the ground.  Whether he can overcome the Fed, or not, he will also need to deal with Congress.  No easy task given only slight majorities in both the House and Senate and cold to lukewarm support from many fellow Republicans.  For Mr. Trump, David Stockman’s, The Triumph of Politics, Why the Reagan Revolution Failed, might be constructive reading at this point in time.  Can Trump succeed where Reagan failed?    He has certainly been dealt a mighty blow today, but the game has just begun.  He will have more chances at the plate, but I suspect fewer than many might realize.

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