The frustration between market analysts and the U.S. Federal Reserve grew a little hotter yesterday with the release of the FOMC’s press statement at the end of its latest two-day meeting.
The 12-member Federal Open Market Committee decided to reduce its monthly purchases of bonds and mortgage-backed securities by another $10 billion – the sixth such reduction this year – shrinking its purchasing program to just $25 billion per month, well on its way to zero by October. It also decided to keep the benchmark interest rate on loans between the central bank and other banks unchanged at between 0 and 0.25%.
It’s not that these decisions surprised the markets. On the contrary, the equity markets moved very little on the news, with the S&P 500 broader market index moving less than a point for a 0.01% gain on the day. While the bond market did lose a little ground, with the benchmark 10-Year Treasury bill’s yield increasing by a modest 9 basis points from 2.47% to 2.56%, this move was simply an adjustment of the water level as the Fed elephant slowly climbs out of the bond swimming pool.
No, what concerns many was not what the Fed did, but what it didn’t do. Even one of the Fed’s own members is feeling a little frustrated with the central bank’s staunchness.
The Fed Stays the Course
What the Fed didn’t do was reduce the bond buying to zero right away; nor did it change the wording of its intentions toward interest rates.
In yesterday’s press release, the FOMC reiterated that it will likely “be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal”.
Despite such strong economic data from all fronts – manufacturing, GDP, job creation, inflation and other positive news besides – the Federal Reserve remains undeterred. Interest rates will remain low for a “considerable time” after the monthly bond buying program ends.
Even one of the FOMC’s own members dissented in the decision, namely Charles Plosser, who objected to his colleagues’ stubborn plan, as he believes “such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee’s goals”, the press statement revealed.
Plosser together with many market analysts are like worried passengers prodding the driver to take his foot off the accelerator and slow the economy down by increasing interest rates and getting us back to normal rates sooner. The fear is that the economy has picked up so much forward momentum, if the Fed doesn’t let up on the gas pedal soon, the entire recovery could derail.
Does the Federal Reserve know something the rest of us don’t? Before considering what the Fed might know, let’s first consider what the rest think they know.
Passengers Point To Progress
Since the journey toward recovery began in 2009, the recovery train has picked up considerable steam.
Tremendous progress has been made on nearly all fronts from job creation to manufacturing expansion. Over the past several quarters the GDP growth rate, wages and inflation also have started to pick up, as the following graphs show.
Source: TradingEonomics.com
Critics fear that if the transition toward interest rate normalization isn’t embarked upon soon, the entire economy will overheat, inflation will run out of control, and bubbles in rising equity prices will burst as the entire economic recovery jumps the tracks and derails.
How can rapid growth be a bad thing? Because of inflation. Low interest rates erode the value of money which can’t keep up with rising prices. Were runaway prices to turn into hyper-inflation, the Fed would be forced to inflate the value of the dollar quickly by jacking up interest rates in leaps and bounds.
This, in turn, would cause a shock to the financial system, as businesses would not be prepared to absorb such a rapid rise in the cost of money, and companies would collapse.
To avoid playing catch-up with runaway inflation, critics would rather see the Fed raise interest rates sooner and gently rather than later and abruptly.
But the Fed insists on waiting. Does it see some danger ahead?
The Driver Points to a Hill
The Federal Reserve isn’t blind. In its press release, the FOMC acknowledges progress has been made.
“Information received since the Federal Open Market Committee met in June indicates that growth in economic activity rebounded in the second quarter,” the release starts off. “Labor market conditions improved, with the unemployment rate declining further.”
So what’s the problem? “A range of labor market indicators suggests that there remains significant underutilization of labor resources,” the statement answers. There are still way too many workers not being utilized, or out of work.
Source: TradingEonomics.com
Even though the unemployment rate has declined steadily from 10% to 6% since the recovery began five years ago, the labor force participation rate (the percentage of the working population that is actually working) has been declining as well.
But how can there be fewer unemployed and, at the same time, fewer people working? By separating the unemployed into two groups, that’s how.
There are really two groups of unemployed people, those who have been looking for work within the last four weeks, and those who have given up. All a falling unemployment rate means is that there were fewer people looking for work during the last four weeks. It does not mean they have all started working. Many of those who are dropping out have simply given up or gone back to school; hence the falling participation rate.
A growing population also contributes to a lower participation rate if these new citizens can’t find work either.
Let us not forget there are still over 2 million unemployed workers who are not counted among the 6% unemployed because they have gone more than four weeks without looking for work. If we counted these unemployed who are “marginally attached to the workforce”, the actual unemployment rate would be near 8%.
As the FOMC makes clear, “Consistent with its statutory mandate, the Committee seeks to foster maximum employment” [which is considered to be an unemployment rate of 5%] “and price stability” [which is considered to be 2% inflation over the longer-term]. It has a long way to go to achieving those objectives.
If the economy is to make it up that hill, the Fed must keep its foot on the pedal and keep stimulating the economy with cheap money.
The Critics’ Misinterpretation
Where the FOMC’s critics get it wrong is in looking at certain numbers as automatic triggers to Fed action. They see inflation at 2% and unemployment at 6% as indications that Fed has reached its targets. They also see strong GDP figures of +4% annual growth in Q2 (higher than the 3% expected), an upward revision to Q1 growth (from negative 2.9% to negative 2.1%), and recent manufacturing increases as indications the economy is firing on all cylinders.
But economists are urging us not to be taken by the apparent momentum of the economy, as the underlying factors are still weak. In an interview with Nightly Business Report yesterday, Alan Blinder, professor of economics at Princeton University and a former Vice-Chair of the Federal Reserve, sees recent data as “unsustainable”.
“If you look into the details, you’ll see that a sizable portion of the 4% [GDP growth in Q2]… was inventory accumulation,” Blinder clarified, “and firms don’t just keep on piling in and piling in inventory.”
So what is sustainable? “The rest of the year looks 3 to 3.5; that is sustainable for a while,” Blinder estimated future GDP growth. But then added it is “not sustainable in the long run”.
When asked what would make him agree with dissenting FOMC member Plosser and other Fed critics who believe the Fed should move more quickly in raising interest rates, Blinder answered, “If the inflation rate keeps going up and crosses 2%, and if the economy keeps on growing at 4% per annum. I don’t think either of those is going to happen.”
Investing With the Fed, Not Against It
By the wording in its press release, it seems the FOMC likewise does not believe either of those is going to happen. “Fiscal policy is restraining economic growth,” and “longer-term inflation expectations have remained stable,” the Committee noted.
The Fed isn’t looking at just the most recent data sets, but is also looking at projected future labor market growth and inflation expectations. In fact, “even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run,” the FOMC statement makes clear.
There are no magic trigger-numbers that will move the Fed. The FOMC will adjust rates higher when it believes the economy as a whole can handle them, but not before.
Tomorrow’s monthly non-farm payrolls report will likely trigger more Fed criticism, especially if the number is strong. Investors must ignore the chatter by side-car drivers and critics who keep telling us what they would do if they were in the driver’s seat. The FOMC is driving this train, and it will be keeping rates down for quite a while longer.
Stay long equities, don’t be afraid of short-term bonds, and above all, don’t fight the Fed.
Joseph Cafariello
