With the Federal Reserve talking about “tightening” monetary policy by hiking the “Fed Funds” rate – the reality is the Fed Funds rate has little to do with the actual credit market.

The Fed rate is not actively traded and variable rate financial products are not linked to it.

However, the London Interbank Offered Rate (LIBOR) is the rate used as the benchmark for many adjustable rate mortgages, business loans and financial instruments traded on global financial markets.

In other words, increases in LIBOR tightens the flow of liquidity in many of the debt markets that directly affect the average consumer and small business by increasing costs.

This is particularly burdensome when annual rates disposable income growth is on the decline.

Danielle DiMartino-Booth pointed out this problem in her latest post:

“Disposable personal income growth, adjusted for inflation, grew by 2.2 percent over last year, a full percentage point below March’s 3.2-percent pace. That downshift helps explain two things. For starters, the saving rate fell in June to 5.3 percent, the lowest since last October. Meanwhile, revolving credit growth, aka credit card spending, galloped ahead at a 9.7-percent annual rate.”

In other words, consumers are turning to credit consumption to support their current standard of living rather than the expansion of consumption. This is why economic growth continues to wane.

This brings me to my point. If it is LIBOR that affects the consumer, and ultimately economic growth given the 70%ish contribution of consumption to it, then we should be looking at the rates that directly impact the consumer. Whether it is auto loans, mortgages, variable rate debt, credit cards, etc., those interest rate costs are directly impacted by changes in LIBOR.

With interest rates rising sharply on the short end of the yield curve the impact to consumption will likely occur sooner than currently anticipated.

There is a very high correlation between negative spreads and future economic growth. In every instance where there has been a negative spread on rates, the economy has either slowed markedly or was in a recession.

As my Dad used to warn me just before I broke something that was previously working:

“Do you really think it is a good idea to mess with that?”

With the Fed hopeful strong economic data is on the way, the recent bounce in the data is likely not much more than that. The data suggests, on any fronts, the Fed will once again be disappointed as LIBOR “front ran” them to sharply tightening liquidity leading to further consumer constraint.

The potential for a Fed policy mistake at this juncture is extremely high and climbing.

Lance Roberts is a chief portfolio strategist and economist for Clarity Financial. To read more of his commentary, CLICK HERE NOW.