Fed's Economic Projections - Myth Vs Reality
Each quarter the Fed releases their assessment of the economy and their forward looking projections for three years into the future. (See Fed Downgrades Economic Outlook for the December analysis)
While Bernanke puts on a great “dog and pony” show for the media – there are only two primary issues where the financial markets are concerned. The first issue is the Fed’s commitment to continue the current liquidity programs into the future. Secondly, the continuation of artificially suppressing interest rates by keeping the overnight lending rate, Fed Funds Rate, near zero. In the latest FOMC meeting both of these goals were met:
“To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month...Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.”
While that sounds great on the surface this has hardly been the case historically. As shown below, rates tend to rise during these liquidity programs as funds rotate out of bonds to chase equities. Mortgage rates have also risen which will begin to put pressure on refinancing and purchases of homes. With the bulk of the housing market currently driven by speculative demand, primarily from private equity and hedge funds, the rapid rise in prices is outpacing rental rates which historically has not ended well. (This is an early sign of a new housing bubble)
“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
As I wrote recently in “The Fed Has Already Imposed a ‘Cyprus Tax’ On U.S. Savers” the impact of the Fed’s zero interest rate policy is not achieving the Fed’s stated goals.
“The problem is that the actions of by the Fed are having the opposite of the intended effect. If you refer back to the chart above you will see that economic growth, savings, and incomes have all declined as the Fed has continually driven rates lower. Lower interest rates have not the boon of economic prosperity as advertised. What history does show is that higher levels of personal savings are necessary to support productive investment which leads to economic growth rates.”
Secondly, while the unemployment “rate” is declining, it is a very poor measure from which to benchmark the health of the economy. The drop in unemployment is primarily due to temporary hires, labor hoarding and falling labor participation rates. As shown below – real full-time employment as a percentage of the working population shows that employment has only marginally increased since the financial crisis. The drop in jobless claims does not necessarily represent an increasing employment picture but rather labor hoarding by companies after deep levels of employment reductions over the past 4 years.
David Merkel recently summed this up best stating:
I really think the FOMC lives in a fantasy world. The economy is not improving materially, and inflation is rising. Note that the CPI is close their 2.5% line in the sand. TIPS-implied inflation 1X1 (one year ahead for one year) is 2.32%, and 5X5 is around 2.86% annualized.
Current proposed policy is an exercise in wishful thinking. Monetary policy does not work in reducing unemployment, and I think we should end the charade.
In my opinion, I don't think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy finances itself. When this policy doesn't work, what will they do?
GDP growth is not improving much if at all, and the unemployment rate improvement comes more from discouraged workers.
With these points I agree. However, let’s look now at the changes in the Fed’s forecasts for GDP, Employment and Inflation.
When it comes to the economy the Fed has consistently overstated economic strength. Take a look at the chart and table. In January of 2011 the Fed was predicting GDP growth for 2012 at 3.95%. Actual real GDP (inflation adjusted) was 2.2% or a negative 44% difference. The estimate at that time for 2013 was almost 4% versus current estimates of 2.5% currently.
We have been stating repeatedly over the last 2 years that we are in for a low growth economy due to the debt deleveraging, deficits and continued fiscal and monetary policies that are retardants for economic prosperity. The simple fact is that when an economy requires more than $5 of debt to provide $1 of economic growth - the engine of prosperity is broken.
As of the latest Fed meeting the forecast for 2013 and 2014 economic growth has been revised down as the realization of a slow-growth economy has been recognized. However, the current annualized trend of GDP suggests growth rates in the next two years that will be lower than the Fed's current average estimates of 3.2% and 3.15%. As we have stated over the past year - a recession in 2013 remains a strong likelihood given the current annualized trend of economic growth since 2000 combined with impacts from the sequester, higher taxes and further potential spending cuts from the upcoming budget debates. A recession in 2013, followed by a rebound in 2014, would leave economic growth running at annual rate close to 1%-1.5% versus the current estimate of 3.15%. In other words, like with all other Fed forecasts, these numbers will likely be revised down.
What is very important is the long run outlook of 2.6% economic growth. That rate of growth is not strong enough to achieve the "escape velocity" required to substantially improve the level of incomes and employment that were enjoyed in previous decades.
The Fed's new goal of targeting a specific unemployment level to monetary policy could potentially put the Fed into a box. Currently, the Fed sees 2014 unemployment falling to 6.6% and ultimately returning to a 5.5% "full employment" rate in the long run. The issue with this “full employment” prediction really becomes what the definition of reality is.
Today, average Americans have begun to question the credibility of the BLS employment reports. Even Congress has made an inquiry into the data collection and analysis methods used to determine employment reports. Since the end of the last recession employment has improved modestly. However, that improvement, as shown in full-time employment to population ratio chart above, has primarily due to increases in temporary and lower wage paying positions. More importantly, where the Fed is concerned, the drop in the unemployment rate has been due to a shrinkage of the labor pool rather than an increase in employment.
The problem that the Fed will eventually face, with respect to their monetary policy decisions, is that effectively the economy could be running at "full rates" of employment but with a very large pool of individuals excluded from the labor force. The chart below shows three levels of unemployment.
The U-3 level of unemployment is what the BLS reports as the "official" unemployment rate. The U-6 rate includes all those in the U-3 report plus those working part-time for economic reasons. The "real unemployment" rate simply adds those that have been unemployed longer than 52-weeks to the U-6 rate. This was originally considered the U-7 rate during the Clinton Administration before it was eliminated to improve the unemployment statistics for political reasons. However, with millions of individuals on “extended unemployment benefits” for 99-weeks, the exclusion of those individuals after 52-weeks doesn’t provide a real picture of domestic unemployment.
Importantly, while the Fed could very well achieve its goal of fostering a "full employment" rate of 6.5% - it certainly does not mean that 93.5% of working age Americans will be gainfully employed. It could well be a victory in name only.
When it comes to inflation, and the Fed's outlook, the debate comes down to what type of inflation you are actually talking about. The table and chart below show the actual versus projected levels of inflation.
The Fed significantly underestimated official rates of inflation in 2011. However, in 2012 their projections and reality became much more aligned. For the average American the inflation story is entirely different. Reported inflation has little meaning to the consumer as the real cost of living has risen sharply in recent years. Whether it has been the cost of health insurance, school tuition, food, gas or energy - these everyday costs have continued to rise substantially faster than their incomes. This is why personal savings rates continue to fall as incomes remain stagnant or weaken. It is the rising "cost of living" that is weighing on the American psyche.
The latest retails sales numbers showed that roughly 50% of the increase in sales in February was due solely to gasoline and food sales. The question for the Fed becomes how long can current policy suppress inflation at or below 2% which is the long run prediction of the Fed? More importantly, where the consumer is really concerned, will it even matter?
The Diminishing Effects Of QE
With the Fed embarking on its fourth Large Scale Asset Purchase program (Quantitative Easing or Q.E.), and deploying specific performance targets, the question of effectiveness looms large. Bernanke has been quite vocal in his testimonies over the last year that monetary stimulus is not a panacea. In his most recently statement he specifically stated that “fiscal policy has become somewhat more restrictive.”
With the Fed now fully engaged, and few if any policy tools left, the effectiveness of continued artificial stimulation is clearly waning. Lower mortgages rates, interest rates and excess liquidity served well in priming the pumps of the real estate and financial markets when valuations were extremely depressed. However, four years and four programs later, stock valuations are no longer low, earnings are no longer depressed and the majority of real estate related activity has likely been completed.
It is for this reason that the returns from each subsequent program have diminished. The reality is that Fed may have finally found the limits of their effectiveness as earnings growth slows, economic data weakens and real unemployment remains high.
Reminiscent of the choices of Goldilocks - it is likely the Fed's estimates for economic growth in 2013 are too hot, employment is too cold and inflation estimates may be just about right. The real unspoken concern is the continued threat of deflation and the next recession.
One thing is for certain; the Fed faces an uphill battle from here.