Stop me if you've heard this one before: A Fed official walks into a bar and says the economy is improving and rate hikes are appropriate. The patrons order another round to celebrate. Then disappointing data comes out, the high fives stop, and the Fed official ducks out the back...only to come back the next day saying the same thing. Anyone who pays even the smallest attention to the financial media has experienced versions of this joke dozens of times. Yet every time the gag gets underway, we raise our glasses and expect the punch line to be different. But it never is. Last week was just the latest re-telling.

For nearly a month the Fed's bullish statements stoked optimism on the economy and raised expectations, based particularly on the most recent FOMC minutes, for a summer rate hike. But these hopes were dashed by the May non-farm payroll report, which reported the creation of only 38,000 jobs in May, the worst monthly performance in six years, based on data from the Bureau of Labor Statistics (BLS). The number missed Wall Street's estimate by a staggering 120,000 jobs. If not for the 37,000 downward revision reported for April (160,000 jobs down to 123,000), May could have shown a contraction. This would have constituted a major black eye to the Obama Administration's favorite talking point that its policies have led to 75 months of continuous job gains. (6/3/16, Democratic Policy & Communications Center).

To make the report even stranger, the plunge in hiring was accompanied by a drop in the unemployment rate to just 4.7%. Of course the fall in the unemployment rate was a function of another major drop in the labor force participation rate to just 62.6%, matching the June 2015 rate, which was the lowest level since the late 1970s (BLS). So the unemployment rate did not fall because the unemployed found jobs, but because they stopped looking. The market reaction was swift and sharp, as it always has been when a fresh shot of cold water has been thrown in the face of market boosters. The dollar fell hard and gold rose sharply.

But we can rest assured that despite any embarrassment that the Fed may be experiencing for having so gloriously misdiagnosed the current economic health, it will be right back at it in a few days, telling us about all the positive economic signs that are emerging and how it is ready and willing to start raising interest rates at the earliest opportune moment. Boston Fed president Eric Rosengren waited exactly 48 hours to start that campaign as he sounded bullish notes in a Monday speech in Finland. (6/6/16, Greg Robb, MarketWatch)

Given how many times this scenario has unfolded, leading to the point where even reliable Fed apologists like CNBC's Steve Liesman have begun questioning the Fed's credibility, one wonders what the Fed hopes to achieve by continuously walking into the bar with a new smile. But this performance is the only policy tool it has left. The Fed appears to believe that perception makes reality, so it will never stop trying to create the rosiest perception possible. It may view its own credibility as expendable.

There is also the possibility, however unlikely, that the Fed officials are not just trying to create growth through open-mouth operations, but that they actually believe that their policies are working, or are about to work. This would be as dogged a commitment to policy as medieval doctors had for bloodletting, which they thought was a useful therapy for a variety of ailments. Doctors at that time had all kinds of seemingly plausible reasons why the technique was effective. If the patient did improve after draining blood, it was taken as a sign of validation. But they would continue to apply the leeches even if the patient did not improve. Failure was simply a sign that that more blood needed to be drained. Similarly, central bankers consider ultra-low, and even negative, interest rates as an ambiguous stimulant that will create growth when applied in large enough doses.

But what if modern central bankers, much like medieval doctors, are operating on a wrong set of assumptions? We know now that draining blood creates conditions that actually decrease a patient's ability to fight infection and recover. Perhaps, one day, bankers will come to a similarly delayed conclusion about how zero and negative interest rates have prevented a real recovery that would otherwise have naturally taken place.

That's because artificially low interest rates send false signals to the economy, prevent savings and investment, and encourage reckless borrowing and needless spending. They prevent the type of business and capital investment that is needed to create real and lasting economic growth. But don't expect bankers, or their cheerleaders on Wall Street, the financial media, government, or academia, to ever make this admission. They do not believe in the power of free markets. They believe in government. Such a leap is simply beyond their powers of comprehension.

But there is another cycle here that is much more influential on the current market dynamic and should be much easier to spot. When the Fed talks up the economy and promises rate increases, the dollar usually rallies. When the dollar rallies, U.S. multi-national corporate profits take a hit, and the market falls. When the market falls, economic confidence falls and puts pressure on the Fed to maintain easy policy. This is a loop that the Fed does not have the stomach to break.

Because the Fed waited more than seven years to lift rates from zero, the cyclical "recovery" is already nearing its historical limit, if it's not already over. This could put the Fed into a position of raising rates into a weakening economy. Normally it does so when the economy is accelerating. Some identify this delay as the Fed's only policy error. But had it moved earlier, the recession would have simply arrived that much sooner. The Fed's actual policy error was thinking it could build a "recovery" on the twin supports of zero percent interest rates and QE, and then remove those props without toppling the "recovery."

But despite all this, there are those who still believe that the Fed will deliver two more rate hikes this year. Given the anemic growth over the past two quarters, the recent plunges in both the manufacturing and service sectors, average monthly non-farm payroll gains of only 116,000 over the past three months (most low-wage, and part-time) and the stakes contained in the election that is just six months away, such a conclusion is hard to reach. Instead, I expect we will get the same bar gag we have been getting for the past year. Many of those who now concede that a June hike is off the table still believe July to be a possibility. I believe the Fed will go along with that hype until it can no longer get away with it...then it will start bluffing about September, or perhaps December.

The Fed has to keep talking about rate hikes so it can pretend that its policies actually worked. But the truth is that the Fed policies have not only failed, they have made the problems they were trying to solve worse, and raising interest rates will prove it. So the Fed resorts to talking about rate hikes, to maintain the pretense that its policies worked, without actually raising them and proving the reverse. This can only continue as long as the markets let the Fed get away with it or until the numbers get so bad that the Fed has to admit that we have returned to recession. That is the point where the Fed's real problems begin.

Read the original article at Euro Pacific Capital

Best Selling author Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital. His podcasts are available on The Peter Schiff Channel on Youtube.

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