It is said that a picture is worth a thousand words. In the case of the Federal Reserve's monetary policy, though, some pictures are worth $3 trillion and perhaps much more.
How do we know? The Fed has said as much in its policy directives, which remain long on promises of policy support because the economic data continue to show the Fed is falling short of meeting its dual mandate of maximum employment and price stability.
Three items in particular last week exposed that shortcoming:
- The PCE Price Index for March, which showed inflation rising just 1.0% year-over-year
- The latest policy directive from the FOMC, which reiterated the Fed's intent to purchase $40 bln of agency MBS and $45 bln of longer-term Treasury securities per month in an effort to support a stronger economic recovery; and
- The 7.5% unemployment rate for April
Several weeks ago in a piece we labeled, Fed Up, we decried the over-analysis that is commonplace on Fed days. In that piece, we provided the reminder that the Bernanke Fed has been clear that incoming data will drive monetary policy decisions.
In brief, we felt some pundits got too worked up by the minutes for the March FOMC meeting and the prospect of the Fed tapering its asset purchases soon. The data following the March FOMC meeting frankly didn't support that assumption. Our view of things, supported by the charts below, remains unchanged.
Dual Mandate, Dual Disappointment
Maximum employment and price stability - those are the phrases that have kept Ben Bernanke up at night. They are idealistic mandates that aren't achieved, or sustained, easily even in normal times. What we are all witnessing today is that they are even harder to achieve in "new normal" times.
How do we know? We can count the ways:
- QE2; and
The US economy continues to struggle to achieve escape velocity a little more than four years since the start of quantitative easing and $3 trillion later. Tight lending conditions, political sclerosis, and fiscal repression are just some of the reasons why.
To be fair, the economy has improved. The rebound in the housing market and the surge in auto sales are some hopeful reminders that things are better than they were when the Fed announced an aggressive expansion of QE1 in March 2009.
Nonetheless, the overall improvement in the labor market has been slow at best and helped by a drop in the labor force participation rate. In terms of inflation, we are seeing disinflation; and it is evident that two-year inflation expectations remain in check. The Fed's efforts to meet its dual mandate, then, can still be seen as a picture of dual disappointment.
Please Buy Stocks
The Fed continues to do what it can, and what it believes is necessary, to help the economy achieve escape velocity, but its efforts haven't been made any easier by the reluctance of banks to assume more risk, the political partisanship in Washington, and a pervasive sense of uncertainty as it relates to the demand outlook.
Those influences of course are all intertwined in a debilitating way that has mitigated the effectiveness of the Fed's monetary policy. Things would have been a lot worse, and may have been a lot worse today, if the Fed didn't take the extraordinary measures it took to arrest the effects of the financial crisis.
That is all open for debate, but the point everyone is saddled with today is that the real economy isn't responding to the Fed's policy as many individuals, beginning with the 11.7 million people currently unemployed, had hoped it would.
The stock market though has been operating under an alternate reality that would lead one to think the best of economic times are upon us. Strong earnings growth has been an important factor driving the bull market, yet there has been no mistaking that the Fed's accommodative policy, and an unspoken plea from the Fed chairman to buy stocks, has been the most influential driver.
Fed policy, and central bank support around the globe, has been the safety net for all pullbacks over the last four years. Accordingly, it is understandable that nerves get a little frayed at the idea the Fed is talking about tapering its asset purchases.
That conversation at the Fed has not turned into action, and the reason is quite simple: the data have not provided a convincing cue. If anything, we'd say the data of late have boosted the probability that the Fed's next move would be to increase its asset purchases, not reduce them.
To that last point, we think the Fed risks inviting a confidence crisis if it pulls back on its asset purchases simply on the basis alone that the costs outweigh the benefits. To do so without data suggesting it is meeting its dual mandate would be tantamount to admitting its policy approach has been a failure.
We think that tacit concession would be particularly unsettling for the equity market, which has placed its full faith in the Fed providing unbridled monetary support in the face of weak data points pertaining to its dual mandate.
What It All Means
The FOMC policy directive released on May 1 was both bold and banal. In other words, it was a typical statement that need not be over-analyzed. The Bernanke-led Fed has been dovish, is dovish, and will remain dovish for some time. That is ultimately a supportive stance for the equity market, assuming of course there isn't a loss of faith in the Fed and/or there isn't an exogenous shock outside the Fed's control.
Despite the Fed purchasing roughly $3 trillion of agency debt, agency MBS, and Treasuries over the last four years, the US economy is still struggling to achieve escape velocity that will help it meet its full growth potential. The directive, however, indicates that the Fed remains bowed and determined to stay the course with accommodative policy in order to meet its dual mandate of maximum employment and price stability.
There weren't a lot of overt changes in the statement, but there didn't need to be. Three things are clear in the data that pertain specifically to the dual mandate the Fed hasn't met and the easy policy approach it has endorsed:
- The unemployment rate of 7.5% remains well above the baseline rate of 6.5% for possibly raising the federal funds rate and the Fed's longer-run goal of 5.2% to 6.0%
- The inflation rate has fallen, and continues to fall, below the Fed's longer-run goal of 2.0%; and
- Inflation expectations are in check.