Most Central Bank watchers know that our Federal Reserve has a dual mandate
of stable prices in the context of maximum employment. But its use of the words "stable
and maximum" is somewhat misleading. For instance, one would assume that "stable" inflation
would lead the Fed to pursue no change in prices and "maximum" employment would
be a rate targeted at 0 percent unemployment; but this is not the case.
For some antithetical economic reason central bankers have unanimously redefined
stable prices as adopting a 2 percent inflation target. The Fed has also morphed
the term maximum employment rate to mean a 5-6 percent unemployment rate, clinging
to the misguided belief that full employment is the progenitor of inflation,
despite no supporting economic or historical evidence.
For instance, the 12.2 percent (YOY) rise in the CPI in November 1974 led
to the cyclical high of unemployment in May of 1975, which also coincided with
the 1973-75 recession. Likewise, in 1979, the YOY high in CPI of 14.6 percent
was followed by another cyclical high in unemployment of 10.8 percent in late
1982.
The Misery Index hit a high of 20.76 during 1980. And one now has to wonder
what the true Misery Index (the unemployment rate plus the inflation rate)
would be if both inflation and unemployment were calculated properly.
What the Fed doesn't understand is that full employment can exist in perfect
harmony with stable prices. That's because having more people producing goods
and services can never by itself lead to an environment of rising aggregate
prices. And, most important, an increasing rate of inflation increases the
rate of unemployment.
This condition plagued the United States during the majority of the 1970's
and early 1980's and was "affectionately" referred to as stagflation: rising
inflation that is coupled with a high unemployment rate and low to negative
economic growth.
But Janet Yellen isn't going to have to dust off her eight track of KC and
the Sunshine Band to evoke the 1970's; she is creating 70's style stagflation
with her monetary policies.
For the past few weeks the Fed has been circling the wagons trying to convince
markets it can raise the Fed funds rate slow enough to boost GDP growth higher
than the 0.5 percent rate in the first quarter; while also raising it quickly
enough to prevent inflation from getting out of control.
But, the evidence clearly shows that since July of 2015 GDP growth has been
languishing; falling from 3.9% to 0.8%, while CPI has been rising during a
relatively similar time span; from 0.2% to 1.1%.
In fact, the most recent month over month increase in the CPI of 0.4 percent
was the highest since February 2013.
Meanwhile, the unemployment rate, which conveniently excludes discouraged
workers, appears benign at just 5 percent. But we are starting to see chinks
in the armor of employment.
Most recently, the 4-week moving average for unemployment claims was 275,750,
an increase of 7,500 from the previous week's unrevised average of 268,250.
And according to the BLS, the economy added just 160,000 new jobs in April.
Wall Street had expected a 203,000 gain. This left many to wonder if hiring
has begun to taper off along with a broader economic slowdown.
According to Market Watch, the pace of hiring was the lowest since September
2015 and job creation has slowed to an average of 200,000 net new jobs created
for the past three months. This slowdown in the pace of hiring is coming off
a five-year high of 282,000 a month in the fourth quarter of last year.
As stated before the Fed is seeking robust growth in the context of low inflation.
But what is becoming manifest is the exact opposite. The Fed is missing its
targets on both fronts--inflation is rising while at the same time growth is
slowing.
What will Janet Yellen do if faced with a recession that comes along with
inflation? Both the Fed and Wall Street are totally unprepared for this risk.
The government's effort to engender viable growth through debt and inflation
is virtually guaranteed to fail. It has tried to repair an asset bubble and
debt saturated economy by increasing both conditions. But, the real medicine
the economy needs is to allow the free market to set interest rates much higher,
which would deleverage the economy and allow the normalization of asset prices
to income ratios.
This is why a collapse worse than 2008 is inevitable.
After 90 months of ZIRP and the creation of unprecedented asset bubbles--especially
in the fixed income area--a neutral level on the Fed Funds Rate does not exist.
Bubbles never pop with impunity no matter how much the FOMC would like investors
to believe that this time is different.
The Fed will either be slowly raising interest rates into an economic meltdown
or will remain behind the inflation curve until inflation runs intractable.
Therefore, the most salient question for investors to answer is: Will the economy
suffer through a 70's-style stagflation before the markets and economy fall
into a steep and unprecedented contraction, or will it simply implode into
the inevitable deflationary collapse straight away. My guess is that it will
be the latter and next week's commentary will explain why.
