FOMC’s Moment of Truth

August 9, 2011

U.S. politicians struck out, failing to address America’s long-term fiscal strains.  So did EU leaders and the ECB, leaving investors unconvinced that Italy and Spain can avert the insolvency problems of smaller EU economies and fearful that the EU as a whole will lack the resources to manage such a firestorm.  The last chance to stave off an intensifying global market meltdown lies with the Federal Open Market Committee, which already has a count of no balls and two strikes.

The Fed’s credibility is low with congress and the public.  It was tarnished for its role in the Great Recession.  Fed regulators failed to police the housing market properly and simply never saw the coming storm until the roof blew off.  The Fed’s balance sheet ballooned because of QE1 and QE2, which I believe averted a depression but may only have pushed the day of reckoning into the future. 

In an understatement, the Fed has not done a superb job predicting economic trends.  With hindsight, Fed economists like of the rest of us appear pretty clueless.  The statement of June 22 and the Bernanke press conference that day appear way to complacent.  The Committee released forecasts that projected economic growth of 3.3-3.7% in 2012 and 3.5-4.2% in 2013.  Nowhere was the R-word suggested as a risk.  Rather, “recovery was continuing at a moderate pace, though somewhat more slowly than the Committee had expected.”  Bernanke argued that mid-2011 was not August 2010 and that a case could not be made to extend quantitative easing.  Rather than looming deflation the year before, inflation was above target, and employment was expanding faster than in the summer of 2010.  The slower-than-expected pace of growth was partly blamed on temporary factors, but the Chairman conceded that since all of the slowdown could not be so attributed, some of it appeared to be structural and likely to endure. 

The messages on June 22 were 1) the Fed had done what it could, 2) the Congress must avert a default and 3) people need to be patient while the balance sheet adjustment process continues.  With joblessness at 9.1% — higher than the peak in all post-WW2 downturns through 2005 except one — and with employment at roughly its end-1999 level, the Fed accepted that such was as good as it gets.  Ominously, stocks fell during Bernanke’s June press conference.

In the seven subsequent weeks, the U.S. GDP path has been revised downward to show a much deeper peak-to-trough plunge in the recession and a shallower rebound that came close to stalling in the first half of this year.  The avoidance of a default left investors unimpressed and scared.  The politics stinks, and the final deal’s components sealed the deal that America is headed for recession and a rising, not falling, deficit because of the lack of growth.  In a dozen trading days from July 21 to August 8, the S&P 500 sank 16.7%, and gold climbed over 11% and to $1771 earlier today, 47% higher than a year ago.  Ironically, 10-year Treasury yields, which the hawks warned would shoot skyward a la Greece, are 58 basis points lower now than then.  The lowest level such reached on any FOMC announcement days during the Great Recession was 2.52% in mid-December 2008 versus 2.39% now.  Outside precious metals, commodities look like a price bubble that is imploding rapidly after having burst.

Markets are rallying in advance of the FOMC statement on the belief that some stimulus will be offered to the market gods, QE3 for starters.  The question remains whether there is anything that the Fed can do to avert a recession scenario.  In times of a liquidity trap, fiscal policy is the weapon of choice, but only drag is coming from that direction.  The investors nightmare is written on Japanese walls.  Over two decades after peaking, the Nikkei-225 is at 8944, down 77.3%.  An equivalent tumble would place the Dow at 3222.  Japanese real GDP has grown just 0.8% per annum on average over the past two decades.  If U.S. growth were to be similarly squeezed, unemployment could crest above 13%.  Stay tuned.

  EUR/$ $/JPY 10Y, % DJIA Oil, $
06/30/04 1.2173 109.44 4.63 10396 37.95
06/30/05 1.2090 110.89 3.96 10370 57.00
06/29/06 1.2527 116.07 5.20 11077 73.41
06/28/07 1.3452 123.17 5.10 13456 69.82
08/07/07 1.3749 118.55 4.73 13510 72.27
09/18/07 1.3888 115.75 4.51 13475 81.42
10/31/07 1.4458 115.28 4.42 13873 93.59
12/11/07 1.4682 111.49 4.11 13645 89.78
01/30/08 1.4792 107.31 3.70 12454 91.70
03/18/08 1.5786 98.73 3.41 12257 107.53
04/30/08 1.5562 104.58 3.83 12953 111.54
06/25/08 1.5568 108.37 4.18 11837 133.62
08/05/08 1.5445 108.42 3.97 11484 119.82
09/16/08 1.4144 105.16 3.36 10936 91.18
10/08/08 1.3625 99.87 3.50 9447 87.02
10/29/08 1.2933 97.15 3.81 9145 67.38
12/16/08 1.3790 90.14 2.52 8687 44.14
01/28/09 1.3253 90.01 2.61 8356 42.92
03/18/09 1.3115 98.13 2.94 7340 47.73
04/29/09 1.3331 97.06 3.02 8194 51.05
06/24/09 1.3984 95.43 3.59 8373 68.76
08/12/09 1.4221 96.17 3.71 9366 70.64
09/23/09 1.4779 91.50 3.50 9859 69.13
11/04/09 1.4884 90.75 3.51 9896 80.66
12/16/09 1.4542 89.78 3.56 10478 73.14
01/27/10 1.4045 89.49 3.61 10148 73.31
03/16/10 1.3756 90.64 3.67 10645 81.45
04/28/10 1.3157 94.10 3.75 11043 82.57
06/23/10 1.2284 90.12 3.13 10307 76.50
08/10/10 1.3107 85.85 2.81 10605 79.94
09/21/10 1.3132 85.21 2.66 10747 73.05
11/03/10 1.4059 81.35 2.53 11174 84.59
12/14/10 1.3423 83.37 3.38 11497 88.47
01/26/11 1.3658 82.55 3.41 12001 87.36
03/15/11 1.3969 81.04 3.29 11815 98.09
04/27/11 1.4665 82.63 3.36 12612 112.48
06/22/11 1.4392 80.12 2.97 12175 94.87
08/09/11 1.4219 77.29 2.39 10991 81.60

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

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