Fed tightening is coming! Fed tightening is coming! That is the message Wall Street heard when Chairman Ben Bernanke provided clearer guidelines on future monetary policy this week. Like Paul Revere’s message to the Colonials on April 19, 1775, this announcement was hardly a surprise as many have argued for more restrictive policy for some time – however, the confirmation that something has changed sparked a financial call to action. Bottom line, the era of maximum quantitative easing is ending and both the economy and the markets will now need to adjust to that reality. Bernanke indicated that IF the economy preformed as the Fed expected – growing real GDP at a 3.0% to 3.5% annual rate in 2014 – QE should end by mid-2014 when the unemployment rate is expected to be 7.0%. Actual tightening would begin sometime after mid-2015 when the unemployment rate is expected to be 6.5%. To end by the middle of next year, most analysts expect a reduction of QE, by one third, to be announced after the September FOMC meeting. Financial markets move on expectations and then correct on reality. Bottom line, it does not matter whether the Fed starts to remove accommodation in September or December, financial markets are resetting for a world with higher interest rates and, as a result, greater uncertainty. Thus, risk premiums are widening, hitting asset classes like mortgages, corporates, high yields and emerging markets much harder than treasuries.
The FOMC’s new stance drew a dovish dissent and a rare public rebuke of the policy from St. Louis Federal Reserve President James Bullard, who pointed to low inflation and called the announcement “inappropriately timed.” Bernanke, at the press conference after the announcement, argued that low inflation was transitory. The focus of monetary policy now appears to be entirely on jobs, jobs, jobs. We find this troubling in that we believe the Fed’s singular power is to change the size of the economic pie and that business competition, subject to fiscal policy and regulation, determines the outcome of growth versus inflation. The economy has been growing at around a 4% nominal rate for the past three years while the Fed was increasingly accommodative. The FOMC’s forecast is for 5% nominal growth in 2014 and beyond, as they become les accommodative and eventually tighten.
The Fed is adamant that it is the level of their balance sheet that determines monetary policy. Wall Street is certain it is the flow of asset purchases. That disagreement is not academic. The debate means as accommodation is removed, stimulus from monetary policy may be ineffective as investors’ fear of the reduced flow will raise interest rates and volatility, thus limiting growth.
The combination of Bernanke’s more hawkish than expected presentation and Bullard’s vocal dissent only increase the feeling that the Fed is jawboning the markets, but to what purpose? Were stock prices and home values rising too quickly? That was what QE was supposed to do. Are they now high enough that the markets are on their own? The latest round of QE was started when the economy was softer than expected in mid-2012 and there was the specter of a massive fiscal tightening coming on January 1. 2013. We have now survived the moderated fiscal cliff and are dealing with sequestration – and growth has not collapsed into recession. Having survived a significant fiscal tightening, with a federal deficit on track to shrink to 2.5% of GDP in 2015, the Fed will now remove monetary stimulus IF the economy manages 3% plus growth. This is the side of Keynesian policy that has been poorly implemented in post-war cycles – the tightening of monetary and fiscal policy as the economy healed to dampen the peak of the cycle. Hopefully, this strategy generates a longer flatter cycle, with a milder next recession. However, like every new model – whether a car, computer software or government policy – caution is wise before assuming everything will work as planned.
Several factors make us skeptical that the Fed will achieve its targets for 2014. First, on nominal growth, the US has not experienced back to back quarters in excess of 5% nominal growth since early 2007 at the peak of a cycle marked by very easy monetary and fiscal policy. However, as long as they are making their targets on growth and jobs, we expect they will continue to ignore concerns about low inflation. More importantly, we expect to see more limited improvement in the unemployment rate as the easy gains have already been accomplished. Over the past year the decline in unemployment has been most pronounced in those areas with the highest rates.
California, Nevada and Florida – among the hardest hit by the real estate correction – were the three states with the greatest improvement. Even if real estate remains strong, which we doubt with higher interest rates, there will be no repeat of the end of foreclosures. Meanwhile, the states with the lowest unemployment rates in the energy belt of the west north central and west south central regions saw only a 0.3% decline in unemployment rates. These two regions were the only ones to have labor force growth greater than population growth – a phenomenon that will limit future gains in the national unemployment rate. Indeed the Fed has made clear that if the decline in the jobless rate is not accompanied by a rising participation rate they will delay the start of tightening.
The size and sustainability of the sharp rise in interest rates caused by the Fed’s announcement will be evaluated over the next several weeks to determine how badly it might damage the housing recovery. Thirty year rates have jumped from 3.5% just a few weeks ago to 4.25% today, and are widely expected to move up to 4.5% in short order. True, even at that rate they are low by historical standards and only slightly above where they were when this round of QE started. However, much of the recent rise in home prices was a direct result of lower mortgage rates making it easier to qualify for a loan. QE inflated equities markets also made it easier for some to make down payments and for investors in all cash deals. Over the past year, the number of existing home sales in the under $250,000 range – which accounts for roughly two-thirds of sales – are up only 10%, while sales above $250,000 have exploded by over 30% with the biggest gains at the highest prices. We see the same phenomenon in new home sales, with square footage increasing for single family construction even as the mix shifts to more multi-family starts. In May, home prices were back up to essentially the same level as in May 2008. During that time, nominal income growth has been extremely limited, up just 1.5% for the median household. However, mortgage rates plunged from 6%, reducing monthly payments by 25% as of May at then prevailing 3.5% rates. Bottom line, home buying is still far less attractive today, as the conviction that homes will always rise in price has been debunked. If home appreciation stalls due to the roughly 10% jump in monthly payments at current rates, banks are certain to rein in their recent easing of lending standards and the past years housing strength will ebb.
For us, the biggest question still remains what happens in the emerging markets that had been the engine of growth for this global expansion. The threatened reduction in QE has devastated EM currencies and bond markets, and added to domestic tension, particularly in Brazil. We have argued that whether they like it or not, the Federal Reserve is the central banker for the world economy, because the dollar is the world’s reserve currency. This became evident in 2011, when the start of QE2 set off a wave of inflation – especially in food – in EM markets leading to the Arab Spring. Now, the end of QE is spiking interest rates as a global credit crunch takes hold, and the deflationary pressure on commodities prices is of greatest concern in goods exporting EM nations.
The situation is exacerbated by the problems in China, which is facing a self-imposed credit crunch as the new leaders seek to rein in their ballooning debt. Economic readings out of China have been disappointing all year as the economy has failed to respond to the newest round of debt financed infrastructure projects started in mid-2012. That stimulus came after China was surprised by the slowdown in exports to Europe. Now, they face a potentially much larger slowdown in exports to the EM – which accounts for roughly half of all Chinese exports. The PBOC reacted quickly after Bernanke’s comments, apparently injecting funds to push down elevated SHIBOR rates. Their sensitivity reflects the hard lesson learned after inflation spiked in 2011 – while the Fed may have a strong impact of foreign markets, they give that impact no consideration in their discussions. Chairman Bernanke has been extremely clear in the past that foreign governments are responsible for their own monetary and currency policies – especially China.
We are concerned that conducting US monetary policy based on job growth in the effective suburbs of the global economy will lead to a slump in world growth. This has two feedback loops to the US: first, 40% of the profits earned by US firms represented in the S&P are from overseas. True, these are mostly in Europe, but many of those firms are internationally integrated. Second, roughly 60% of the capital goods produced in the US are destined for foreign shores. Again, in most cases this is because US multinationals are buying US produced goods and deploying them as they expand internationally. Meanwhile, 60% of the capital goods purchased by US buyers are from abroad. Production of capital goods is a market in which specialization is very advanced.
In fact, the greatest hope for a faster US recovery – to meet the Fed’s 3% plus target – was likely to come from a strengthening of capital goods production as US private firms tap into their fortress balance sheets for expansion. A combined rise in US long term interest rates and slower growth in the emerging markets, where they have been putting capital to use, undermines that possibility. Optimists argue that a reduction in state and local drag will allow the private sectors’ robust growth to shine through. However, part of the private sectors’ success has been because 20% of the economy – government – was not bidding for resources, and in fact was freeing them up for private sector use. If government has finished it retrenchment, as seems likely, their competition for labor, materials, and savings will increase. Bottom line, the restraint of less accommodative monetary policy – like the restraint from tighter fiscal policy this year – will make it tougher for the economy to recover. We see a continued muddle through, with modest improvement in employment that meets but does not exceed the Fed’s target of 7% by mid-2014 and 6.5% by mid-2015. Our concern is not about the US, where the next recession is likely to be mild because it’s hard to break a leg falling from a first story window. It is whether the emerging markets are entering a period like 1997 where a credit crunch acts like an ebbing tide and reveals who has been swimming naked.
The McVean Weekly Economic Newsletter will not appear next week as we will be in China —
looking for nudists.