Leveling the Playing Field June 23, 2014

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Off to vacation this week, so this is going to be short and sweet. Rates had a relatively
benign week with Yellen sticking to the script a bit better this time around. If anything,
we came away feeling like the FOMC and Yellen during her Q&A struck a more dovish
tone than expected. In fact, we are really starting to wonder if the Fed is going to hike
rates in 2015

The Fed revised its GDP forecast down by a shocking 0.7% for this year, now at 2.2%.
There are three certainties in life: 1. Death, 2. Taxes, 3. The Fed being overly optimistic
in its forecasts. That means 2.2% GDP this year is probably still too high. Fast forward
to January 2015 with tapering concluded and a sub-2% GDP for the year, do you really
think the Fed is hiking rates within six months?

Yellen made it seem as if the Fed will remain accommodative until the economy is
chugging along at 3% growth and inflation is around the preferred 2.0% range. I
remember 2008 when the Fed aggressively slashed rates in order to avoid a full scale
meltdown. The measures the Fed took helped avert disaster. But keeping rates at 0%
while we have positive growth and all-time highs in equities is bothersome.

The reason the Fed is doing this is, of course, the labor market. An UR of 6.3% is a great
improvement over the 9.9% UR four years ago, but Yellen et al are clearly concerned
about the structural changes to the UR and the historically low participation rate. But if
interest rates have been at 0% for over 5 years and the Feds balance sheet has quintupled
in size, should we be looking for other methods to improve labor markets? ER doctors
use different tools than a general practitioner on a Wednesday, why not the same here?

Noisy Inflation
Meanwhile, everything that we buy seems to be costing more and more but inflation is
not on the Feds radar. I guess Fed members dont buy gas or milk or NBA teams. This
weeks PCE could very well exceed the Feds PCE forecast for 2016. On Tuesday the
BLS reported that the seasonally adjusted price index for meat, poultry, fish and eggs hit
an all-time high. The same day, the BLS also reported that the electricity price index also
hit an all-time high. The price at the pumps hasnt been this high at this time of the year
in over six years. Not coincidentally, energy stocks are also hitting all-time highs.

During her Q&A, Yellen conceded that inflation readings have been a bit on the high
side but attributes it to data being noisy. Do paychecks reflect noisy inflation?
Household income, when adjusted for inflation, is about 7% lower than it was in 2000.



As Dr Doom himself, Swiss investors Marc Faber, told CNBC on Friday, The more they
print, the more inequality there is, the weaker the economy will become. He went on to
say what the Fed has done is lift asset prices and the cost of living. In the meantime, the
cost of living increases are higher than the wage increases. The typical American
household income is going down in real terms.

Once again the Fed finds itself in a precarious position. Until now the low inflation
readings bought them time to remain accommodative. What do they do if inflation
reading keep ticking higher instead of moving back towards 2%?

On the one hand, the Fed-speak makes us think they wont hike until 2016. On the other
hand, inflation may force them to hike sooner than they would like.

The first signs of a rate hike will likely cause a shock to the markets. As we have
discussed ad nauseam over the years, the typical Fed tightening cycle is a slow and steady
climb higher in 0.25% increments every 6 weeks. I wonder if perhaps the Fed will
simply hike once and pause while allowing the resulting shock to do some of the dirty
work for it.

So what does the Fed do? Maybe they change the way inflation is calculated. And if that
sounds odd, just remember that the calculation has changed more than 20 times since the
1970s. If inflation was calculated the same way it was in 1980, it would be around 10%.


Im on vacation this week but the important people will still be in the office. Iraq,
durable goods orders, and a bunch of Fed-speakers will be the market movers. Have a
great week!













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