News, Trends, & Analysis

Don’t Fight the Fed

By Walter Kemmsies, Chief Economist, and Dan Solomon, Eonomist for Moffat & Nichol

At the heart of the economy’s weakness, and by default, the container trade volume weakness, is the Federal Reserve’s policy actions.

The over-extended housing market and vulnerable financial sector, linked by low-quality real estate loans and excessive exposure to risky mortgages, were brought back in line as the Fed raised its Federal Funds policy interest rate from 1% in 2004 to 5.25% in 2006. By mid 2007, the economy began slowing considerably, and since then the Fed has reversed its stance by cutting the policy interest rate from 5.25% in August 2007 to 2% by March 2008.

Although the Fed is concerned with inflation, it has indicated that it is more interested in avoiding a recession and aiding a recovery in the housing market.

Sustained economic growth will resume ­— in time

With the Fed pursuing policies such as low interest rates and providing ample liquidity to banks, it’s only a matter of time before the economy’s growth rate picks up. Just as it took some time for policy interest rate increases to prick the housing-finance bubble and slow the economy, it is taking some time for policy rate reductions to support economic growth.

The unusual increase in oil prices this year is delaying trend growth recovery — impacting auto sales and other consumer spending sensitive to gasoline prices. However, business expenditures on capital goods and inventory-building have begun to pick up, and the decline in house prices is beginning to ease. This bodes well for container volume growth.

Response to policy

The chart to the right shows the Federal Funds Policy Interest Rate since 1983 and the growth rate in U.S. international container volumes measured in TEUs; shaded areas indicate periods of economic recession. Historically, there has been an inverse and lagged relationship between the Fed Funds rate and TEU volume growth. To demonstrate, container trade volume growth is plotted on the left-hand axis and the Fed Funds rate is plotted inverted against the right-hand axis.

During the period shown on the chart, the Fed Funds rate peaked in 1984, 1989, 1995, 2000 and 2006, with troughs in TEU growth in each of the subsequent years. This reflects the fact that changes in the Fed Funds rate have a lagged impact on the economy and therefore on container volume trade growth.

Notice that since the 1980s, there have been two peaks in the Fed Funds rate in between recessions. Coming out of a recession the Fed usually continues to lower the Fed Funds rate to stoke demand for goods and services. However, companies at that point are still reducing their payrolls and do not engage in capacity expansion, which means that demand grows faster than supply. This creates upward pressure on prices and inflation begins to accelerate, which in turn prompts the Fed to begin raising the policy interest rate to slow demand growth.

Rising interest rates tend to expose over-extended segments of the financial sector. In the 1980s, Latin American countries defaulted on their loans; in the 1990s, Asian countries and Russia had a debt crisis, preceded by the Mexican peso crisis of December 1994. In 2007 and 2008, low-quality mortgage loans and mortgage derivatives were at the center of the bank debacle. To a large extent, the financial sector’s woes are typical mid-cycle events. As the crisis unfolds and before the economy slips into recession, the Fed starts lowering interest rates again.

Similar to what happened during 1984-85 and 1994-95, rising interest rates and slower consumer spending growth in 2007 and in the first half of 2008 sparked fears of a recession. During this period, The Philadelphia Federal Reserve’s Livingston Survey of economic forecasts showed the consensus view deteriorating, reflected by rising estimates of the odds of a recession. Rising oil prices and inflation led many to believe that the Fed would begin tightening again despite economic weakness. However, the Fed made it clear that stabilizing the housing market and avoiding a recession were a priority ­— lowering the Fed Funds rate to 2% in March and making liquidity available.
Given that declining house prices and rising mortgage delinquencies could result in general deflation similar to the 1930s experience, it is clear that stabilizing the house market and the economy had to be the first priority.

Container volumes to rise

Economic weakness resulting from poor housing and auto trends not only has a direct negative impact on consumer expenditures on imported goods but also lowers container growth, because the cargo related to these industries account for a large share of the total volume. It is unlikely that weakness in the dollar was to blame for that, because most of America’s imports come from Asian countries that maintain a relatively fixed exchange rate to support their exports to the United States. However, the weak dollar has made U.S. goods cheaper in other countries.

The dollar’s weakness is mostly attributable to low U.S. interest rates compared to other countries. As the U.S. economy strengthens, this will be reflected in rising interest rates, and the value of the dollar will increase as well. In sum, as the U.S. economy improves thanks to Federal Reserve policy, container volumes will increase, mostly driven by import volumes. Those who are doubtful are reminded of the old analysts’ saw: “Don’t fight the Fed.”