The Fed Is Driving America Toward Recession

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With evidence mounting that America is hurtling toward another recession, the Federal Reserve moved last week to tighten monetary conditions. Their action is the economic equivalent of America using a jumbo jet filled with passengers for a kamikaze attack on an ISIS decoy.

In this case, the jumbo jet is the U.S. economy, and the decoy is inflation. Fed Chair Janet Yellen and the FOMC* appear to the last true believers in the Phillips Curve, which is the now-amply-discredited notion that rising employment and wages cause inflation.

The Fed claims that it is "data driven," but the only data that it seems to be looking at is the "headline" (U-3) unemployment rate. This was reported at 5.0% for November, but this is equivalent to 9.8%, if you adjust for the precipitous decline in labor force participation that has occurred under President Obama. Still, the FOMC must have heard somewhere that a 5.0% U-3 number represents "full employment," and they apparently concluded that it was time to "raise interest rates," to "prevent the economy from overheating."

For the record, having more people working and earning more money causes "prosperity," not "inflation." It is a decline in the real value of the dollar that causes (actually, is) inflation. A tight labor market can no more reduce the value of the dollar than it can decrease the length of the foot.

What made the Fed's action into the equivalent of a jumbo jet kamikaze mission was that money was much too tight already, and that recession warning signs have been popping up all over the place.

First, let's note some of the economic red flags waving in front of us:

· On the same day as the FOMC's action, the Fed reported that November's "Index of Industrial Production" was down by 0.6% from October, and down by 1.2% from November 2014. This sort of decline is normally seen only during recessions.

· Junk bond prices have cratered, hitting 4-year lows.

· On December 11, the Census Bureau reported that the "Total Business: Inventories to Sales Ratio" rose to 1.38 for October 2015. This is up significantly from the 1.30 number seen in June 2014, and it is the highest ratio observed since the end of the last recession, in June 2009. (More on this later.)

The biggest economic red flag of them all is that commodity prices, which have been falling for the past 15 months, continued their plunge in the wake of the Fed's announcement.

On June 30, 2014, the CRB Index** closed at 308.22. This was very close to its 312.06 average for 2005, which was the last year that America saw decent real GDP (RGDP) growth (3.34%).

The day before the Fed's announcement (December 15), the CRB Index closed at 174.23, down by 43.47% from June 30, 2014. Over the next 3 trading days, the CRB Index fell by another 1.19%, to 172.16. Comparing against month end numbers, this is the lowest CRB Index value that we have seen since June 1973.

The reciprocal of a broadly based commodity price index is the best functional measure of the real value of the dollar. I use the CRB Index, because it has been reconstructed on a monthly basis back to January 1749. This makes it possible to use the CRB Index to analyze all of the U.S. business cycles since December 1854 (which is when NBER*** dating begins).

By its nature, the Fed has absolute control over the real value of the dollar. This is because: 1) it controls the amount of "final" dollar money in the world (the U.S. monetary base); and, 2) it has the power to adjust the total amount of dollar liquidity in the world so as to hit any target for the real value of the dollar that it cares to set.

Unfortunately, since its founding in 1913, the Fed just hasn't been able to marshal the intelligence and the wisdom to do its basic job, which is to provide the economy and the markets with a stable dollar. The result has been a 100-year string of economic disasters and disappointments.

The economic mishaps over which the Fed has presided have been costly, and there is good reason to fear that we are about to experience another one, in the form of a recession.

By the way, the CRB Index is not the only element of market feedback regarding the real value of the dollar that our allegedly data-driven Fed has been ignoring. From June 30, 2014 to December 18, 2015, expected five-year inflation fell from 2.00% to 1.22%.

Now, to be fair, the Fed's policy change "worked," but only in the same sense that crashing a jetliner into a plywood cutout of an ISIS Humvee would "work."

The Fed Funds rate did go up, although not by the full amount of the 25 bp increase in the rate at which the Fed pays "interest on (bank) reserves (IOR). On Thursday, December 17, the IOR rate rose from 25 bp to 50 bp, while the Effective Fed Funds rate went up by only 22 bp, to 37 bp.

If the Fed's goal was to boost interest rates across the board, they failed. Bloomberg reported on Friday that 5-year Treasuries were yielding 1.68%, down by 1 bp from Tuesday.

While the equity markets cheered the Fed's announcement (the Dow Jones Industrial Average was up by 1.28% on the day), they haven't much liked the operational reality of the new policy. During over the two trading days that the Fed's new policy has actually been in effect, the Dow lost more than 620 points, or 3.50%.

Let's now look at the mechanism by which the Fed's actions and non-actions are slowing the economy.

In terms of the CRB Index, the U.S. dollar was worth 79.03% more on December 18, 2015 than it was on June 30, 2014. If the dollar's drastic gain in real value is not reversed, it is very likely that the nation will fall into another recession (if we aren't in one already).

OK, but why would a rise in the real value of the dollar cause a recession? After all, if the dollar goes up in value, real incomes will rise by the same percentage as the real prices of the goods and services that we buy, right? So, people would just keep spending as if nothing had happened, right?

Unfortunately, it doesn't work that way.

The fact that someone has 79.03% more income will not make him or her willing to pay 79.03% more for a Happy Meal. Similarly, a company that suddenly has 79.03% more real revenue will not be content to pay 79.03% more in real terms for an hour of labor.

There is always plenty of money around to buy everything that the economy can produce. However, the reason that anyone buys anything is that they judge that the item in question is worth more than the money required to purchase it. If the dollar becomes more valuable, on the margin, people will choose to buy less.

In response to a more valuable dollar, American consumers will reduce their overall spending, shift their purchasing patterns (generally in the direction of "necessities"), and buy more imports, which have suddenly become less expensive. Lower sales will lead to mounting inventories.

Rising inventories will cause U.S. producers to cut output, even while they increase foreign outsourcing in response to higher real labor costs. Voilà: falling RGDP and employment-i.e., a recession.

If you normalize the "Total Business: Inventories to Sales Ratio" (I/S ratio) and the real value of the dollar in terms of the CRB Index, and then plot them against each other from November 2001 (the trough of the 2001 recession) to October 2015, you will see an interesting correlation. When the CRB value of the dollar falls, the I/S ratio goes down, and when the dollar rises, the I/S ratio rises. This is exactly what our model of what causes recessions would predict.

The CRB value of the dollar has been rising since June 2014, and the I/S ratio has been going up since July 2014. Given the enormous (71.02%) increase in the CRB value of the dollar since then, there is good reason to fear that the I/S ratio could move into recession territory. At 1.38 for October 2015, the I/S ratio is already higher than it was at the start of the Great Recession (1.28 in December 2007), and about halfway to its all-time high of 1.48 (which it reached in January 2009).

Bottom line: the CRB value of the dollar is already far into the recession danger zone.

The NBER has identified 33 completed business cycles since 1854. On average, from the start of a recession to the low point reached by the CRB Index during the downturn, the CRB Index fell by 15.01%. This is equivalent to a 17.66% rise in the real value of the dollar. During expansions, the CRB Index has gone up by an average of 36.43%, which is equivalent to the dollar losing 26.70% of the real value that it had at the trough of the previous recession.

In contemplating the 79.03% rise in the CRB value of the dollar since June 2014 (18 months), it is sobering to note that it only took an increase in the dollar's CRB value of 108.81% over a span of 43 months to take America from the prosperous peak of the Roaring 20s (August 1929) to the pit of the Great Depression (March 1933).

Similarly, the short, but violent recession of 1920 - 1921 was caused by a 113.81% rise in the CRB value of the dollar over a 19-month period (January 1920 - July 1921).

Someone has to stop the Federal Reserve from taking 322 million Americans along with them on their monetary kamikaze missions. The results produced by the Fed's 100% discretionary, make-it-up-as-we-go-along monetary policy (which started in 2001) have been disastrous. Republican presidential candidates should be making reining in the Fed a top campaign issue for 2016.

*The Federal Open Market Committee, which is the body that determines the Federal Reserve's monetary policy.
**The CRB Index is a commodity price index comprising: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gasoline, and Wheat.
***The National Bureau of Economic Research, which is the group that declares when economic recessions begin and end.


Louis Woodhill (, an engineer and software entrepreneur, and a RealClearMarkets contributor.  


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