The Fed Is Still Living in Denial

March 16, 2016, 10:17 PM UTC

The Federal Reserve’s mood about the economy may still be too overheated.

On Wednesday, the Federal Reserve decided to keep rates where they were for another month, and indicated that it was only likely to raise rates twice in the next year and four times in 2017. The change brings the Fed’s own rate expectations closer in line to what the market was predicting before this week’s FOMC meeting.

In her press conference Wednesday afternoon, chair Janet Yellen sounded quite upbeat. “Risks to the downside appear to be diminished,” Yellen said, noting that people were more optimistic about finding work, and that the ranks of the long-term unemployed are falling. “The course of the economy is improving, which likely means that the path of rates is to rise over time,” says Yellen.

Nonetheless, the Fed has a history of tricking it self into believing the economy is stronger than it really is—something that has happened a lot during this recovery. And there is reason to believe it is doing so again. If that’s the case, the Fed could be living in denial about its ability to raise interest rates.

Case in point, while the Fed had said it would delay when it raise rates, its path of increase is pretty much the same as it expected before. In December, the Fed said it thought the short-term rate it sets would reach 3.3% by 2018. Now they think rates will only make it to 3%. It doesn’t look like the Fed has adjusted its outlook very much at all.

The problem is it’s hard to see why the Fed is so confident, not only that the economy will continue to improve, and to do so enough to whether more rate increases, especially when the first rate increase went pretty terribly.

Despite the falling unemployment rate, there has been little sign of wage increases, something Yellen acknowledged in the press conference. Although she said anecdotally there seems to be signs of a pick up in wages. Yellen also sidestepped a question about why consumers haven’t increased spending more given the steep drop in gas prices.

Does this signal that consumers are still worried about the economy? Yellen said it was really hard to say why consumers were doing what they were doing. And that the micro data she looks at seemed to suggest that lower gas prices have given a boost to consumer spending, which I guess means spending would be even worse off without the drop in gas prices—not great for the economy.

Also, it’s been 81 months since the end of the last recession, meaning the current economic expansion is due for a downturn. Perhaps, that’s why default rates on a wide rate of debt from auto loans to high-yield corporate debt is rising faster than it has in years.

Add the risks ahead, which are sure to raise volatility in the market and the economy, including the possibility of England’s “Brexit” from the euro, as well as a contentious election here and it’s hard to see how the Fed will be able to meet its interest rate goals.

“Even that dovish forecast is difficult to believe given the risks,” says Joseph Brusuelas, the chief economist for accounting firm RSM.

The biggest problem though is overseas, which Yellen acknowledged in the press conference continues to be weaker than Fed economists expected. That’s hurting sales of big companies. Increasing interest rates will only make that worse, because the dollar is likely to strengthen, causing sales of U.S. multinationals to fall further.

Fed and interest rate hawks will counter that exports only make up a small portion of the overall economy, which is generally still driven by U.S. consumers — and that the Fed would be better off raising rates now so it has room to lower rates later.

But here’s the thing: The international economy means a lot to the largest stocks in the country, and the stocks that make up the S&P 500; more than it used to. That’s perhaps why earnings for the companies in the S&P 500 are now expected to fall 8.3% in the first quarter, which would be the fourth quarter of negative growth for the biggest and most important companies to the stock market.

Whether it’s accurate, the stock market has a lot of influence on how Americans the perceive the strength of the economy. That’s even more so after the financial crisis, when everyone saw how weakness in the markets could bring down the economy. The market, which still near an all time high, and rebounding recently, has still been pretty rocky lately. The Dow Jones Industrial Average just crossed 17,000 again, something it did in December and in August and in November 2014. So the market has been treading water for a while. Even with the rebound, and rising 11 points today to 2,027, the S&P 500 is still down 3.6% for the year.

If the Fed were to tell the market that it plans to put rates on hold for longer, that would give a boost to the market, getting us through the rough patch we are in now and putting off the need to worry what to do when we need to lower rates in the future.

That’s key because even more than jobs or wages or inflation, perception has the power to drive the economy. As the economy continues to improve, exit polls from the primaries say that the economy remains most voters’ top concern. As long as that remains the case, the Fed’s determination to raise rates is going to remain out of whack with reality.


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