The Fed Would Be Irresponsible to Cut Rates and Here's Why

As I write this the CME FedWatch Tool has an 80% chance of the U.S. Federal Reserve cutting the interest rate bounds down 25bps to a 200-225 range from its current range of 225-250. There is another 20% chance that they cut even more by 50bps. Taking my calculator, it is telling me we have a 0% change of leaving rates as-is. A zero percent change we don't cut rates with the economy booming? I feel like Mugatu, am I the only one who doesn't think the Fed has any leg to stand on when proposing a rate cut?

What is the Fed Trying to Do?

The Fed is very vocal about it's dual mandate, low unemployment and low inflation. Currently unemployment sits at a low of 3.7%, the lowest since we first landed on the moon back in 1969. Inflation also has been historically low. Non-core CPI (what the Fed says they follow) has been hovering between 2.3-2.4 all year, which is fine. The Fed says two thing about inflation; they expect it to move inversely with unemployment and they have a target of 2%. My reading of this makes me question my sanity, slightly above their target and but not increasing, an ideal situation, yet they still want to cut rates?! Again watch the crazy pills clip here. 

I'm trying to put myself in the Fed's shoes to figure out what is they are thinking. This week NY Fed President inferred a rate cut was to "take preventative measures." That remark was taken to mean a 50bps cut was more likely than 25bps so much they had to issue a statement walking it back. Even at 25bps the Fed is gambling we are heading into a recession with a poor track record. In the last recession the Fed began easing in September 2017. That was a few months before the subprime mortgage crisis went super-nova but would anyone argue this cut did anything to soften the landing?

What should the self described "data dependent Fed" be looking at?

Is the data showing us going into a recession? Beyond unemployment and inflation the numbers have been coming in great. Retail sales released on July 16 showed June 3.4% over last year and had positive revisions to previous, slower months. Another vouch for a strong US consumer, Consumer Credit expanded 4% in May. So why are consumers taking out loans if there is a recession around the corner? Also, the banks that have reported earnings have shown strong mortgage numbers. About they only number to reinforce their "preventative measures" argument, Q2 GDP is coming out this week expected at 1.8% after Q1 of 3.1% but would any number cause the Fed to halt their cuts?

What are the dangers?

A 25bps cut would mean a 10% reduction in the upper bound. The last easing period we were twice as high before cutting. We cannot cut based on preventative measures in an economy that could be argued to be booming. If the economy takes a turn for the worst the Fed will have no room for additional cuts. How do you stimulate an economy by telling it the new "deal" on interest rates is only 2 percentage points different than before? Is that going to drive new mortgages or commercial loans? The only thing the Fed would have left would be another asset purchasing program, the legality of which is up for debate.

Look around to who is asking for a cut, it's Wall Street. Wall Street would love to have cheaper money again to fuel the stock market. We see this as the CME FedWatch is dependent on market data and they fully expect to get their cut. The problem is that cheap money into the stock market is only going to fuel bubbles. Making stock market pain even worse in the next pullback. 



Given the good economic data, the Fed cutting would be unprecedented and irresponsible. As every business cycle comes to an end, so to will this one and we will have nothing left as far as monetary easing to fight the next recession. I would urge the Fed not to cut rates. Our next move should be higher rates in this economy, not lower.

Greece and the Eurozone

Right now, and probably for the last year or so the biggest black eye for Europe and even the world economy has been Greece. I think, along with many others, that Greece will eventually leave the Euro monetary union. That is no longer the question being asked, how they leave is the hard part. As to how Greece leaves the Eurozone I look to Brazil and it's Real Plan from 1994 for inspiration. Brazil's Real Plan is the most successful currency conversion plan to date. It also was implemented in times of hyperinflation in Brazil, a problem that Greece does not have yet because it is tied to a strong currency in the Euro.

 If Greece is to leave the Euro a multi step plan has to be enacted that is similar to the Plano Real that Brazil introduced to much success in 1994. The first step is to introduce the drachma into the market as an imaginary currency at first. The price of goods will be published each day by the central bank in drachmas and Euros side by side so the public can get used to the new currency. This is important in maintaining a low expectation of inflation of the drachma within public perception. Inflation is going to be high if the central bank of Greece starts printing drachmas to pay for its debt.

The second step is different from Brazil. This step involves stopping withdrawals from banks and asset from fleeing the country to safer economies. In short Greece needs to close its doors for business for a few months. Yes trade can be going on still but foreign investors can not be allowed to cash out investments and call up loans made in the country. This is too prevent Greece from being Euro-ized, a form of dollarization but with Euros instead, even though the country officially uses the Euro now. Prices and wages need to be fixed so as expectation of the inflating drachma can not be allowed to happen before the drachma is even set in place. Brazil also froze wages and prices but did not have to close the doors on its economy because it already had no other substitute to turn to. Greeks could easily ignore what their government is doing and keep doing business in Euros.

Now the Greek government needs to step in. They need to finally come together and balance their budget. They need to make sure their trade is a surplus and expenses are kept in check. The central bank meanwhile needs to set interest rates high to attract foreign investment along with other foreign investment attracting programs such as debt-for-asset swaps.

The next step is for all electronic transactions to take place in Greek Drachmas only. All savings accounts and investments will all be transferred electronically to drachmas. The ratio they set the exchange rate between drachmas  and Euros doesn't matter and is really just nominal but it must remain constant. The second phase of this step is to outlaw Euro domestic transactions and have the citizens trade in their Euros for drachmas.

Now the hard part. Greece needs to make sure inflation remains under control. For at least the first few months the central banking authority in Greece needs to keep exchange rates constant to the Euro. After a few months the central bank can allow its currency to float a little bit but they should not make it completely free-float so as to not have runaway inflation. The central bank will need help from the ECB maintaining a large deposit of Euros to manipulate its currency for the short term.

This whole process should take less than a year to not drag it out. Brazil implemented its Real Plan in a rather genius way, during the 1994 World Cup, when the entire country was fixated on football instead of the economy. Greece needs to pick an event that their entire country will be caught up in, like the 2012 Olympics or holiday, to take attention and expected inflation off of the economy. Changing to the drachma will bring back Greek competitiveness in the world economy and will allow Greeks to have the freedom to control their own currency and keep their style of life that a Eurozone country cannot support.

Minnesota Manufacturing Inventories Index

Coming later this week I will compile the first release of the Minnesota Manufacturing Inventories Index (MMII). This will be an aggregate inventory of United States manufactures current holdings. Hopefully this statistic will provide some insight as to how the US manufactures are doing and also the economy as a whole. The statistic release will go back to pre-2008 financial crisis level so the reader can see how inventories fluctuate in the business cycle. Some manufactures I already plan on having included in the statistic are Ford, US Steel, and Boeing. Additional firms will be included to get a general consensus for the economy. Look for the MMII this Friday.