Fed’s Optimistic Outlook Unlikely to Happen

June 20, 2013

Biological metaphors help to understand what’s happening in U.S. and global financial markets.

Financial markets are like an over-active auto-immune system.  Weakened economies get monetary medicine to nurse them back to health.  As the process evolves, the medicine is withdrawn gradually, not all at once.  Ideally, policymakers want the increments of policy change to be almost undetectable in case they have underestimated the risks to the patient. 

But financial markets don’t think incrementally, and individual investors are correct to act now on the suggested possibility of a tighter Fed stance in the future because that’s how other investors will respond to the news.  Whether the Fed’s forecast proves correct or not is irrelevant.  What matters is being part of the first response.  The resulting collective early financial market shift exceeds what is safe for the economy, which then becomes vulnerable to the equivalent of an allergic drug reaction. 

From an extremely accommodative position, U.S. monetary conditions are tightening in leaps and bounds.  The dollar strengthens in the risk-averse environment, making exports and import-competing goods less competitive.  Ten-year Treasury yields at 2.43% are 35 basis points higher than on June 6, 80 bps above their level on May 1 and 74 bps higher than the 4Q12 average.  Real interest rates have risen even more sharply because inflation is lower.  Consumer prices fell 2.0% at an annualized rate in the three months to May compared to an annualized dip of just 0.2% in the final quarter of 2012.  The core personal consumption deflator has moved less sharply, just a half percentage point, but in the same downward direction.  Higher longer-term interest rates will boost mortgage rates, increasing the costs of home ownership.  Fed officials suggest that any adverse damage upon the predisposition of households to spend from higher interest rates will be offset by the wealth effects of house price inflation and the rise in equity wealth.  In a what-have-you-done-for-me-lately environment, support from a positive wealth effect could melt away pretty quickly. 

For four other reasons, It seems overly hopeful to think that economies can handle the shift away from extreme monetary support.

  • First, fiscal policy also has a tightening bias, and this has less to do with the deficit’s current relative size, which has actually declined quite sharply, and more to do with a political agenda to downsize the size of government.  The Fed assumes diminishing fiscal drag.  Many of us do not.
  • Second, the U.S. economy’s speed limit had sharply declined well before the subprime credit crisis began in the summer of 2007.  Real GDP average 2.4% per annum in the seven years between 3Q00 and 3Q07, a third less than its average annual expansion during the second half of the 20th century.  Even if a complete recovery to the old normal occurred, there would be slower GDP growth and a high rate of under- and unemployment.
  • The third factor addresses the why of point number two.   The slower trend growth a grounded in secular trends such as the technology revolution, the globalization of labor, capital, and goods markets, globalized monetary policy, and the neglect of basic infrastructure and long-term unemployed workers.
  • Rightly or wrongly, Bernanke is perceived as a lame duck, and this image will impede his ability to control market expectations through communication means.

What then does all this mean?  Most likely, the economic trends that are a pre-condition for tapering and eventually raising interest rates will be elusive.  That doesn’t mean that quantitative easing won’t be reduced before the end of this year or that the jobless rate falls to the 7.0% threshold by mid-2014.  The danger is that removal of Fed support will lead to unsatisfactory continuing progress in the economy, compelling the Fed to retrace its steps.  After QE1 ended, a time came when QE2 became necessary.  The discontinuation of QE2 had a similar result.  The Fed would argue that the open-ended, data-guided nature of QE3 makes this experiment fundamentally different, but such a difference does not remove the danger when policy support disappears.

The dollar could benefit in the near term from the risk-off mind set of yesterday and today.  Based on experience since 2010, the U.S. currency is liable to be less volatile than bonds, equities, or gold.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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