2019 Second Quarter Commentary

THE FEDERAL RESERVE BOARD (Fed)

Since World War II, the goal of the Federal Reserve Board (Fed) has been to stabilize prices and maximize the level of employment.

To achieve these objectives, the Fed has believed it necessary to predict future inflation rates and to steer interest rates up or down to maintain stable prices.  Frequent errors in judgement and failure to predict important financial crises in advance have called into question the validity of a Fed policy that depends on accurately predicting the future. 

For example: The Fed Funds interest rate was increased for the ninth time in December 2018:

  1. The Fed’s economic model to stabilize prices currently contemplates future inflation of 2% and a so-called “normalized” Fed Funds interest rate of around 3.5% vs. the 2% – 2.25%  rate existing prior to the December 2018 increase.
  2. With the US economy growing at 3% in 2018, unemployment at an historic low and corporate earnings rising over 20% from 2017, the Fed announced a continuation of its plan to boost interest rates two more times in 2019, while also reducing liquidity in the bond market by $50 billion per month.
  3. While this preemptive action to head off a possible spike of inflation may have seemed rational based on trailing economic indicators, it turned out to have been the “straw that broke the camel’s back” for an advancing stock market.  The stock market indices plunged over 20% in the following days.

This sequence of events suggested, once again, that raising interest rates based on fear of future inflation can be a flawed strategy because the future cannot be predicted.  Such increases have often ended cyclical recoveries and the contemporaneous stock market advances as happened in December 2018.

Dr. Wojlinower’s analysis addresses why the Fed’s attempt to manage the economy by controlling inflation, based on historical data, is obsolete in today’s global economy and has contributed to the Fed’s failure to correctly predict and steer inflation.  In the quotation below, he suggested that the Fed should pay more attention to the risk of financial instability as the lender of last resort, “which was originally, and probably should remain, its principal focus.”

“. . . why have the Fed and many other leading central banks been chronically over-estimating inflation?  Two major sources of inflation in the post-World War II period were rising wage rates and oil prices.  Technological innovations have curbed them both.  Globalization, spurred by advances in communication, travel, and transport, (especially containerization), has exposed Western labor to world-wide competition, sapping the political and economic power of industrial labor unions.  As for oil prices, the burgeoning of shale and off-shore petroleum resources outside the Middle East has been holding them in check.  Moreover, sharp decline in the cost of solar and wind energy, coupled with the improvement in storage batteries and the advent of affordable electric cars, are likely to displace fossil fuels.  This would fundamentally alter the costs and the uses of energy, with far reaching repercussions around the globe.  Textbook and economic models that treat inflation as a mainly monetary disorder are obsolescent.”

INFLATION AND THE INTEREST RATE

  2011 2012 2013 2014 2015 2016 2017 2018 2019
A* 3.0% 1.7% 1.5% 0.8% 0.7% 2.1% 2.1% 1.9% 1.8%
B* 0.0% 0.0% 0.0% 0.0% 0.25% 0.75% 1.5% 2.5% 2.5%

A – Inflation

B – Fed Funds Interest Rate

ECONOMY

The 2018 federal tax reduction, reduced regulations and increase in government spending helped the US to enjoy the fastest economic growth since 2005.  With unemployment at an historic low, personal income grew 4.5% and labor productivity increased 1.8% during 2018.

Data for the first quarter of 2019 has not shown much year over year growth primarily due to the Fed’s tight money policy throughout 2018.  There is a lag in the economy’s response to Fed interest rate changes.  While the Leading Economic Indicators were flat in January and February, the second half growth rate should improve as the effects of the shift to an easy money policy kick in and seasonal factors improve the economic atmosphere.  GDP growth is estimated at 2.0% to 2.5% in 2019.  The outlook for corporate profits is favorable and the University of Michigan’s consumer confidence index remains healthy at 97.8. 

Steady economic growth with subdued inflation, no price bubbles or economic dislocations and generally rising corporate earnings, create a climate that is highly favorable for equity investors.

STOCK MARKET

The Fed deserves credit for the prompt reversal of its plan to increase Fed Funds rates in 2019, which was the catalyst for the record recovery during the first quarter.  The S&P 500 Stock Index gained 13.5% through March.  At this time, no one can know for sure whether the December stock market drop signaled the end or just a pause in the cyclical bull market rise over the past nine years. However, we believe Fed Funds interest rates increase in December 2018 only temporarily slowed the economic recovery.  The strong first quarter stock market rally indicates that investors are looking beyond global headwinds, China trade negotiations and domestic political issues.  Moreover, the Fed’s reversal to easier monetary policies in 2019 has been followed by most other central banks, including the Peoples Bank of China    Thus, with forward price/earnings ratios around 17X and average dividend yields around 2.5% vs. about 2.5% yield on the 10-year Treasury; the tag line “TINA” remains an appropriate moniker – THERE IS NO ALTERNATIVE to common stocks for most investors.

This quarterly commentary is published by Westbourne Investments Inc. Please see our Legal Disclaimer

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