Fed commentary: The minutes and market perception, imperfect together!

Yesterday, the so-called "minutes" of the March 18-19, 2014 FOMC meeting were released. This is a scrubbed and antiseptic review of some of the things that went on and that the members want known. The markets viewed the Committee's comments as indicating it would remain aggressive and equity investors shouldn't worry about an early hike in rates. I think people are missing key messages.

If there was one sentence in the "minutes" that caught investors attention it was this: "... even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run." Sounds great, until you start analyzing what that really means. It does not say that the rate hikes will not begin earlier than expected; it says that it will take time to get back to a normal funds rate. There is a big difference.

Let me explain using my forecast. I expect that by the end of this year: the unemployment rate will drop below 6%, not far from full employment, which is roughly 5.5%; job gains will be in the 250,000 per month range; openings and quits will be high; most other indicators will be pointing to a tightening in the labor market; inflation will have edged up to or above 2%, the Fed's target; and wage gains will be accelerating. Jobless claims are already near historically low levels when adjusted for the labor force and most other indicators are moving in the direction I am forecasting.

Under that scenario, by early 2015, economic conditions will have reached the point where the Fed's goals are in sight. That is when rate hikes would start. The operative word there is start. A normal fed funds rate is about 4% to 4.5%. That means the Fed has to raise the rate 400 basis points or more before it gets to "normal in the longer run", which is how the FOMC puts it.

If rates start increasing in March 2015, it could take 18-24 months before a normal funds rate is reached. Even if my optimistic scenario unfolds, the funds rate would not get back to normal until the end of 2016, nearly three years from now! That seems to fit the description of "for some time, ... keeping the target federal funds rate below levels the Committee views as normal in the longer run."

The point is that even if rates start going up early next year, we are at least 30-36 months away from where the Fed would actually have taken its foot off the gas. Only when the Fed gets above normal would the funds rate start acting as a brake. Until then, it is only easing off the accelerator.

But investors haven't thought that point through and unfortunately, the Fed members have done a poor job in explaining the difference between reducing the level of accommodation and actually tightening. Mr. Bernanke tried to get the point through that cutting back on asset purchases was different from tightening but he most people didn't want to think about the subtleties of monetary policy. Nevertheless, Chair Yellen and the other members need to work harder at getting that point across.

Today, the jobless claims number hit the lowest level since May 2007. Did the report cause the market sell-off? I doubt it but given that the markets rallied initially after the minutes were released, it probably played a part. But the idea that an early increase in the funds rate is bad for investors only makes sense if the markets have been hyped to levels that are unsupported by fundamentals by the Fed's asset purchase and low rate policy. If that is the case, then we have a bubble of some unknown size that has to burst as all bubbles eventually do.

So, is there a bubble in the equity markets? I have no idea but when investors are afraid of stronger growth, then something is amiss. Instead of worrying about when the Fed will start hiking rates, investors should start figuring out what stronger growth and rising wage and inflation mean for earnings. That would give me confidence we are looking at fundamentals not artificial factors when it comes to equity prices, regardless of what that might mean for the direction of the markets.

Joel L. Naroff is the co-author, with veteran journalist Ron Scherer, of "Big Picture Economics: How to Navigate the New Global Economy". Release date is April 21, 2014.