Fed Meeting - Reconciling A Weak Economy
The Fed meeting yesterday ended as expected with the Federal Reserve taking no action in terms of implementing further policy actions to boost the financial markets overtly, ie. Quantitative Easing. The only real "shocker" coming out of the meeting, if you want to call it that, was that the Fed states that they expect to "hold rates at exceptionally low levels until late 2014." This is an extension of about 1 year from the previous meeting.
However, that was enough to boost the stock market as the fear of a rise in interest rates, at least from the Fed, has been put on hold for now. The important take away from this is that, despite the recent reports to the contrary, the economy is much weaker than expected. If the economy was truly on the verge of a recovery there would be no need to extend exceptionally low rates for such a period of time.
Fed Chairman Ben Bernanke, has little to show after nearly three years of economic weakness and trillions of dollars of financial support as shown in the January meeting statement: "Information received since the Federal Open Market Committee met in December suggests that the economy has been expanding moderately, notwithstanding some slowing in global growth. While indicators point to some further improvement in overall labor market conditions, the unemployment rate remains elevated. Household spending has continued to advance, but growth in business fixed investment has slowed, and the housing sector remains depressed. Inflation has been subdued in recent months, and longer-term inflation expectations have remained stable."
One of the issues that the Fed ran into, as I suspected, is that the uptick in 3rd quarter GDP which was driven primarily by utility spending from an abnormally hot summer. The continuation of performance in the 4th quarter was driven mostly by a $60 Billion tax cut from lower gasoline prices and a restart of the economy from bled down inventories post the Japan earthquake. The Fed is well aware of this which is why they reduced estimates for economic growth for a second time in as many meetings. The table and chart show the mean of the forecast range by the Fed for GDP and unemployment as compared to the original estimate prior to the November 2011 meeting.
Here is the interesting point. The economy is projected to get weaker in the coming year while employment is expected to get better. That is quite a conundrum. However, we have seen the unemployment rate improve in recent months far more than the level of job creation would otherwise provide.
As we covered in our Real Employment Situation Report in December a large reason for the decline in the unemployment rate was the continued movement of individuals out of the counted labor pool. Currently, as shown in the chart below, there are more than 85 million individuals that are no longer counted. Therefore, if this current trend is projected out the unemployment rate will continue to improve while the economy continues to "struggle through" its weak growth trajectory.
Markets Front Running Events That May Not Happen
First of all, as opposed to the take by the mainstream media, the Fed did not "pledge" anything in regards to interest rates. The statement from the Fed clearly stated that "...the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrantexceptionally low levels for the federal funds rate at least through late 2014." That is not a pledge. That is an outlook. Furthermore, this is not a great conviction about the economy. Low rates of utilization, anticipation of economic conditions and a deflationary environment (keeps inflation low) for the next three years is not a strong economic outlook. No wonder the Fed is slashing its growth projections
Secondly, the markets are jumping on the extension of Q.E. 2.5, "Operation Twist", which has been effective at pressing the longer end of the yield curve down. In the statement the Fed also hinted. again, at further options: "The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability" However, the reality is that the Fed is trapped in a box as Q.E. has caused inflation pressures to rise during the last two cycles and "Operation Twist" has not had a tremendous effect on promoting economic growth.
The reality is that further extensions of programs may have issues. There is tremendous political pressure building about the continued expansion of the Fed's balance sheet, currently over $3 Trillion and rising, and the risk that it poses. Secondly, QE programs kick up inflation pressures which impact economic growth. Finally, each round of Q.E. has had diminishing effects on the economy and the market. This is why we have seen Bernanke punt to the White House in the previous two meetings to supply solutions to promote economic growth. Unfortunately, those pleas have fallen onto deaf ears.
In the final assessment there are still significant downside risks to the economic outlook. The concerns about the European fiscal and banking issues have been momentarily quelled by the Fed's action to open dollar swaps with the international markets and the expansion of the ECB's own balance sheet to over €3 Trillion just since November. However, the risks of a resurgence of the European crisis is very real and will renew strains in global financial markets which are likely to have adverse effects on domestic confidence and growth.
The key complication for the Fed, as shown by their continued debate on future actions, is how to meet their dual mandate of creating "full" employment without stoking inflationary pressures. While the Fed set a long term inflation target of 2% - CPI is already running well ahead of that target currently. Furthermore, unemployment remains stubbornly high, despite trillions of dollars of injections, and their ability to "create" full employment seems elusive. So, while the Fed's statement yesterday was generally benign and supportive for the markets in the near term...it what Ben is not saying that has us worried.