Fed's Economic Projections - Myth Vs. Reality (Jun 2013)
Each quarter the Fed releases their assessment of the economy and their forward looking projections for three years into the future. (See Fed Projections Myth Vs. Reality for the March analysis)
While Bernanke puts on a great "dog and pony" show for the media – there are only two primary issues with which the financial markets are most concerned. The first issue is the Fed's commitment to continue the current liquidity programs into the future. Secondly, is the continuation of artificially suppressing interest rates by keeping the overnight lending rate, the 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. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. 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 discussed recently in "What Inflation Says About Bonds & The Fed" I showed that interest rates tend to rise during QE programs rather than fall (chart below) as allocations rotate out of bonds to chase equities. Mortgage rates have also risen which puts pressure on refinancing and purchases of homes particularly with the substantial price increases as of late. It is important to remember that people buy "payments" and not houses. 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.
In regards to the continuation of ultra-accommodative interest rate policies the FOMC stated:
"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 two stated goals of full employment and price stability.
"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."
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.
The FOMC lives in a fantasy world. The economy is not improving materially and deflationary pressures are rising as the bulk of the globe is in recession or worse. The problem is that the current proposed policy is an exercise in wishful thinking. While the Fed blamed fiscal policy out of Washington; the reality is that monetary policy does not work in reducing real unemployment. However, what monetary policy does do is promote asset bubbles that are dangerous; particularly when they are concentrated in riskiest of assets from stocks to junk bonds.
However, if you want to see the efficiency of the Federal Reserve in action it is important to view their own forecasts for accuracy. I have been tracking the Fed's forecasts for you so that you can see the changes as they occur 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 2.3% 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 to 2.9% and 3.05% respectively as the realization of a slow-growth economy is recognized. However, the current annualized trend of GDP suggests growth rates in the next two years are likely to be lower that that.
With 48 months of economic expansion behind us this current expansion is longer than the historical average. Economic data continues to show increasing signs of weakness and the global economy is a drag on domestic exports. With higher taxes, government spending cuts and the debt ceiling debate looming the fiscal drag on the economy could be larger than expected.
What is very important is the long run outlook of 2.5% 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 6.55% 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. Of course, this also explains that continued rise in the number of individuals claiming disability and participating in the nutritional assistance programs. 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 just 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. Unfortunately, in 2013 the deviation between expectations and reality has once again surfaced as deflationary pressures have risen and current inflation, as well as forecasts, have dropped markedly. The Fed's greatest economic fear is deflation and the current drop in annual rates of inflation will keep pressure on the Fed to continue to accommodative policy active for longer than most expect.
However, 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, and consumer credit has risen, as incomes remain stagnant or weaken. It is the rising "cost of living" that is weighing on the American psyche and ultimately on economic growth.
The Diminishing Effects Of QE
With the Fed committed to continuing its 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 is restraining economic growth."
With the Fed now fully engaged, and few if any policy tools left, the economic 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 later, stock valuations are no longer low, earnings are no longer depressed and the majority of real estate related activity has likely been completed. More importantly, the recent surge in leverage and asset prices smacks of an asset bubble in the making.
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 should be the continued threat of deflation and the next recession.
One thing is for certain; the Fed faces an uphill battle from here.