July 13, 2011

Round one of the July Humphrey-Hawkins testimony revealed little that wasn’t already obvious from known information, such as lackluster economic data trends and past Fed communications like the latest FOMC minutes and the Chairman’s press conference last month.  The FOMC bias continues to err on the side of insufficient growth in jobs and GDP.  Growth in the first half of 2011 was weaker than monetary officials anticipated, and although gradually improving conditions are predicted in the second half and 2012-13, officials are not convinced such will happen to the extent assumed and are prepared to stimulate additionally if the economy deviates substantially on the south side of their forecast.  A sequence of steps to be followed in an eventual exit strategy that will reduce the central bank balance sheet and normalize interest rates was reiterated pretty much as outlined previously.

Talk of an exit strategy is getting ahead of the present reality.  In this trust-but-verify interlude, the extremely accommodative stance in the wake of QE2 is not going to be tightened for quite some time longer, and further ease hasn’t been ruled out before the exit strategy is activated.  Bernanke estimates that the impact of the second quantitative easing from November 2010 through last month will be akin to a reduction in the federal funds rate that is very uncertain in size but centered on three-quarters of a percentage point. 

The market knows, too, that FOMC thinking is not monolithic at the moment, but Chairman Bernanke sides with the more dovish wing that worries more deeply about the damage of premature tightening than the consequences of starting to snug later than one optimally should.  Critics of the Fed, and some of the FOMC’s own people, think that ultra-low interest rates are actually impeding short-term as well as long-term growth.  That’s an interpretation that Mr. Bernanke does not share.  Such a deviation would presumably promote a soft dollar, other factors being the same.

Stocks tried to rally on Bernanke’s testimony, but the day’s rise was small relative recent loses.  Higher inflation now than a year ago means the economy would have to deteriorate more this time than it did then then in order to elicit QE3.  Either policy remains steady, as it was from March to August of last year, or the economy virtually stalls, the Fed eases, and America will be experiencing ever more closely what Japan has been going through for twenty years.  More restrictive fiscal policy is coming by design or after horrendous market circumstances, so U.S. demand management as a whole is heading into more restrictive waters.  July 2011 is not August 2010 from a Fed policy standpoint. 

The rationale for a new rally in equities lies in the Fed’s baseline growth projections coming true of faster activity starting now and accelerating to 3.3-3.7% next year and 3.5-4.2% in 2013.  If the United States can accomplish that in spite of incrementally tighter macroeconomic policy, it will have made a meaningful start toward discrediting fears of America’s Japanification, but seeing is believing.  For now with 10-year Treasury yields extremely low at 2.88% just twenty days short of the debt hike ceiling witching hour, investors do not seem to be buying into the Fed’s optimism.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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