Last week, hedge-fund manager Stan Druckenmiller said that the Federal Reserve's current policy "seems not only unnecessary, but fraught with unappreciated risk." My takeaway from his warning, informed in part by what's happened in the U.K. this year, is that investors should ignore the prognostications of policy makers at this confusing juncture in the economy and focus on the dull but more informative economic signals on growth and inflation.
Using history as his guide, Druckenmiller pointed to what happened in 2003, when the fed funds rate of 1 percent was increased more than fivefold in the space of two years even though policy makers had pledged to keep borrowing costs down for "a considerable period." Here's a chart showing what the Fed was telling investors, compared with what it actually did to borrowing costs:
So what happened to transform those words into sweet little lies? Inflation happened.
At the end of 2003, U.S. inflation was running at an annual pace of 1.9 percent, though its average during that year was 2.3 percent. The average jumped to 2.6 percent in 2004, with a peak of 3.3 percent in the middle of the year. Consumer price increases accelerated to 4.7 percent by September 2005, and averaged 3.4 percent during the year:
So the staircase of rate increases that began in mid-2004 and drove the funds rate to 5.25 percent from 1 percent in the space of two years was motivated by a change in the economic backdrop. Now, with the fed funds rate stuck at 0.25 percent since the end of 2008, Druckenmiller is concerned that the Fed is storing up trouble for the future:
Five years into an economic and balance sheet recovery, extraordinary monetary measures are likely running into sharply diminishing returns. The odds are high that the Fed's monetary experiment will be more disruptive down the road than the Fed anticipates.
The recent experience of the Bank of England is instructive. Governor Mark Carney has been under fire for seeming to change course, preparing the ground last month for higher interest rates later this year, after suggesting last year that borrowing costs would probably remain unchanged until at least late 2016. An economy that is delivering faster growth than any other Group of Seven nation, though, has justifiably changed Carney's view on the timing of the first move higher.
Druckenmiller is the guy who persuaded George Soros to bet against the British pound in 1992 in a trade that delivered a $1 billion profit, and now runs his own wealth through Duquesne Family Office LLC. He reckons that while a Fed rate increase in the first quarter of next year would slow growth, the longer-term benefits of moving early may prove desirable:
It will be better in five or 10 years than it would have been. If the policy continues for the next year or two the risks will go up while those people taking a victory lap will scream louder and louder.
The median forecast of economists surveyed by Bloomberg News is for U.S. inflation to average 2 percent this year and 2.2 percent next year. Should the pace of price increases pick up, however, the Fed will be obliged to repeat the history of a decade ago and start raising rates -- and that would be a good thing.
Corrects year of Soros's attack on the pound in eighth paragraph.
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