Finally, the Fed openly came out in favor of nominal GDP targeting. I applaud its decision, but I wonder if it did enough.
While unemployment figures have improved, it is still too high. The Fed has a dual mandate: to maintain a stable price environment and to stimulate the economy. While the former has been a roaring success, the jury remains out on the latter. What is the main driver behind persistent unemployment?
Well, it's simple. The employers are not recruiting. Instead, they are sitting on piles of cash. Take Apple (OTC:APPL), for example, which apparently has stockpiled more than $120 billion in cash. As reported by Forbes:
As of Sept. 29, 2012, the company had $121.3 billion in cash, cash equivalents and marketable securities, an increase of $39.7 billion or 49% from Sept. 24, 2011.
Other companies are not far behind. The total stockpile of corporate cash is $1.7 trillion, according to International Business Times:
American companies held a whopping $1.74 trillion in cash and other liquid assets at the end of the third quarter, the Federal Reserve said last week. That is $44 billion more than three months earlier and more than erases the prior quarter's slight decline.
What can the Fed do to encourage these companies to start to invest the cash, which in turn will raise production and create job growth? The answer that has been circling in an eclectic group of monetary theorists is nominal GDP targeting.
This is how it works. The Fed first says that it will do whatever it takes to get unemployment down to a predetermined target. That it will achieve by setting a target for nominal GDP growth. In so doing, it will pump oodles of cash into the economy until the target unemployment rate is reached. In the process, it will be fine with inflation rising above the usual target threshold, up to a certain point.
That's what the Fed did on Wednesday. It set an unemployment target of 6.5%, and an inflation threshold of 2.5%.
Why does this approach work? Imagine you are a corporate manager. You do not have any clear idea of how serious the Fed is in lowering unemployment. Higher unemployment means lower demand, so as long as you do not have certainty of the seriousness of the Fed in lowering unemployment, you will anticipate lower demand -- and hence not invest. You will be more prone to do that if inflation remains low, as the value of your cash stockpile is in no risk of evaporating.
Now, however, the Fed has put you in a tight spot.
1. On one hand, there is a real inflation risk as the Fed is clear that it will be OK with an up to 2.5% inflation rate. So, the value of your cash stockpile may drop. This increases the attractiveness of making current investments.
2. At the same time, since you now know that the Fed is hellbent on lowering unemployment, you have a better sense of future demand.
3. This one-two punch puts quite a bit of pressure on the corporate manager to invest the cash rather than holding it in Treasuries, in particular if the Fed is also going to buy loads of Treasuries and keep yields down, making your real rate of return negative.
(To see how real interest rates are now negative, please refer to my previous article "Should Investors Worry About Inflation Or Rising Rates? Probably Not.")
This is what is known as nominal GDP targeting. In policy circles, this is otherwise known as Evans Rule. As per Businessweek:
This is essentially what Charles Evans, President of the Federal Reserve Bank of Chicago, has been arguing for over the last year. Dubbed the Evans Rule, the argument holds that monetary policy shouldn't be tightened until the economy heals pasts a certain predetermined threshold. In a speech delivered in September 2011, Evans made the point that the Fed should be just as aggressive about fighting high unemployment as it is about high inflation. Said Evans:
'Imagine that inflation was running at 5 percent against our inflation objective of 2 percent. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn't any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.'
This policy has some legs. It has supports from a wide range of economists, left and right. It has the support of The Wall Street Journal and The Economist, not exactly known for left-leaning ideas. It also has the support of Paul Krugman, the doyen of left-leaning economists in the opinion circles. Finally, the investment banks are for it as well -- e.g., Goldman. As reported by Slate:
The idea has long been floating around in monetary theory circles, and during the course of the Great Recession was pushed by a smallish band of dissident right-wing economists, most notably Scott Sumner and David Beckworth. More recently it got a huge boost from the Goldman Sachs macroeconomic forecasting team, which led to some additional cheerleading from Christina Romer, Paul Krugman, and other heavyweight progressives. In the economics blogosphere, it's become quite popular with proponents from Brad DeLong to Ramesh Ponnuru and fans at The Economist and Wall Street Journal as well as now here at Slate.
So, in all, this is a welcome move. It doesn't really change anything, as the Fed actions will remain unchanged. It will keep injecting liquidity at the same rate as it did before. But the means of communication and the explicit targets stated have changed, and that should send a clear message to the corporate managers. To me, this should lead to economic growth.
But did the Fed do enough? Not enough, I would say. Both the threshold targets are not aggressive enough. For one, the U.S. NAIRU has historically been 5%, and setting a target as 6.5% is not aggressive enough.
So what is the NAIRU? According to Wikipedia:
In monetarist economics, particularly the work of Milton Friedman, NAIRU is an acronym for non-accelerating inflation rate of unemployment, and refers to a level of unemployment below which inflation rises. It is widely used in mainstream economics.
In effect, this means NAIRU is the rate of unemployment at which the rate of inflation stays constant. Above this rate of unemployment, the rate of inflation should fall. Below this rate, inflation should rise. Historically this rate has been 5% for the U.S., so setting a target of 6.5% still leaves the economy in a disinflationary state, which is not enough to boost corporate investments in my view.
So what could the Fed have done? To me, it could have set an inflation target of 4%, and not 2.5%. This 4% rate, incidentally, is what Paul Volcker targeted in the 1980s, and hence is quite respectable in my view. At the same time, the Fed should have stated that the unemployment target is the historical NAIRU of 5%. That would have really given the corporates the boost that they needed to start investing again.
Be that as it may, I still believe that this is a welcome change in the way the Fed communicates. By openly embracing nominal GDP targeting, it is leaving the door open to future revisions of the inflation and unemployment targets. Overall, this should help the economy, and with it the stock market.
With that, it's time to make some market bets. I am bullish over the next 12-18 months on the U.S. economy, assuming the Fed holds this stance. The natural investment to me is the S&P 500. I use the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) as well as the 3x leveraged ETF on the same, the ProShares UltraPro S&P 500 ETF (NYSEARCA:UPRO). I also think that this move by the Fed will end up increasing inflation, and when there is inflation there is a rush to spend by the consumer (as every dollar buys less tomorrow). Hence, I am bullish on the iShares Dow Jones US Consumer Goods ETF (NYSEARCA:IYK), and the 2x leveraged version of it, the ProShares Ultra Consumer Goods ETF (NYSEARCA:UGE).
Finally, one note about gold. I had earlier written articles stating why I was not bullish on gold (see "Gold Should Move Sideways In 2013"). I am now not so sure about that. If inflation is headed up, then there may be a case for a bull market in gold after all in 2013. For that, I like the SPDR Gold Trust ETF (NYSEARCA:GLD), and the 3x leveraged gold miners play, the Direxion Daily Gold Miners Bull 3x Shares ETF (NYSEARCA:NUGT).
Disclosure: I am long UPRO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choice. I am merely stating what I personally plan to do for my own portfolio.