Like the second quarter of 2012, the second quarter of 2013 is looking like a big economic disappointment after a very optimistic start to the year. The Philadelphia Fed's Manufacturing Index suggests slowing growth and the Fed's Industrial Production and Capacity Utilization Data suggests that this slowdown fits the pattern of an annual cycle. Independent analysis by Macroeconomic Advisers suggests that some of the slowdown in growth in the second quarter of 2013 is due to a slowdown in government spending revising first quarter economic data downward. So, how will the Fed respond?
Last year at this time the Fed's ongoing stimulus measures were limited to Operation Twist; weak economic growth last spring prompted the FOMC to extend Twist beyond its June expiration. Indications are that the Fed will follow suit this year as well. In the past week, regional Fed Presidents Bullard, Lacker and Kocherlakota have all suggested that the risk of disinflation is too high and might justify additional quantitative easing or at least a continuation of the asset purchases. This runs somewhat counter to the lukewarm growth picture painted by the April Beige Book data, but casts doubt on any suggestion that QE3 will begin tapering off in the next couple months and lends credence to my assertion that QE3 will likely continue at its current pace until September or even year-end.
Oddly, unlike their regional bank counterparts, Fed Board members have been remarkably quiet about weakening economic growth. Instead, both Jeremy Stein and Janet Yellen have given speeches over the last few days that focus on the Fed's role in financial regulation. While Stein's speech was a somewhat generic survey of macro-prudential financial regulation, Yellen's speech honed in on the value of flexible monetary policy rules only to then pivot to a discussion of how these rules impact financial regulation. Yellen specifically said:
I think most central bankers view monetary policy as a blunt tool for addressing financial stability concerns and many probably share my own strong preference to rely on micro- and macroprudential supervision and regulation as the main line of defense.
This speech seemed to suggest that the Fed and other central banks are at or near their limits when it comes to providing financial stability, even if that instability is cyclical.
The apparent impotence of central bankers has not been lost on the media; CNBC even ran an article titled "Central Bankers Say They Are Flying Blind." While this is undoubtedly an exaggeration, the persistent reliance on flexible and ever-changing "rules" by central banks around the world has yielded mixed results, at best. One of the earliest inflation targeters, the Bank of England has recently faced a series of 6-3 votes against initiating another round of asset purchases with outgoing Governor Mervyn King on the losing side. The argument against further stimulus seems to consistently be that inflation is near target levels, but Britain has lapsed into recession three times in the last five years.
In the EU, the world of flexible "rules" has highlighted the fact that a strict fiscal union is necessary for the Euro to survive in-tact, but proposals for such strict rules have officials from Europe's dominant economy, Germany, backing away from a fiscal union in an effort to shield German banks from stricter capital standards. Even one of the poster-children of central bank rulemaking, the Reserve Bank of Australia, has not steered Australia clear of economic crisis simply by adhering to monetary policy rules. In fact, the "rule" that has seemingly bolstered Australia's economy is the one that ties Australia to the global economic growth engine that is China.
The bottom line for investors is that flexible monetary policy "rules" have done little to diminish economic uncertainty and may be contributing to the annual cycles we are seeing in the U.S. economy. At this point, the question is whether continued economic stimulus in the form of asset purchases through the first and second quarter can get us out of a cycle in which strong first quarter economic data gives way to a weak second quarter, that bleeds into the third quarter, only for markets to recover by year-end. If recent pronouncements by Fed officials are any indication, investors should expect the Fed to maintain stimulus for the foreseeable future in order to break this cycle. If the Fed is successful, it would likely be wise for investors to use the cyclical second quarter market softening as an entry point into equities. However, should the Fed fail to break this cycle, investors need not hurry to reenter this market.