This morning, Fed Chairman Ben Bernanke sat before lawmakers giving testimony in regards to current and future monetary policy. The chairman's tone was reminiscent of a very polite host making an announcement to his frolicking and inebriated guests that the party would indeed be drawing to a close in due course. The equity markets responded, at one point dropping about 100 Dow points in the period of a few minutes.
Bernanke repeatedly stated that the Fed cannot affect long-term structural issues, such as employment and growth, and is only effective in the short cyclical run to aid a recovery. He mentioned that the Fed's view is that structural long-term unemployment is now between 5% and 6%, but he stated that those figures could be off as the numbers are very subjective. This reflects a deterioration from a few years back when structural full employment was considered to be around 3-4%. Bernanke said this morning, that he believes there are still a couple of unemployment points that remain in the cyclical realm, as he attempted to reinforce the Fed's current policy targeting a 6.5% unemployment rate.
The chairman also stated that they are monitoring the markets for the potential of froth and the potential effects of a roll over in asset prices. "Reaching for yield" by savers, due to low interest rates was also mentioned in cautionary tones.
Numerous lawmakers expressed concerns that high asset prices in areas such as equities and farmland could pose risks to a fragile economy. It was also repeatedly stated by lawmakers, that many of their constituents are deeply concerned about Fed policy and that they (the constituents) are not seeing positive effects from low interest rates and excessive liquidity in regards to issues such as unemployment.
Bernanke continued to bring home the point that the Fed cannot affect long-term structural economic issues and that those issues must be addressed by the fiscal authorities.
Bernanke also mentioned deflationary pressures and the current rate of inflation being only 1% (half the Fed's target), as significant headwinds to a long term recovery and a justification for the Fed's continued easy monetary policy.
Long-term structural economic issues include:
The labor force participation rate is at the lowest point since 1979. This is largely a product of the current demographic shift taking place, as the baby boomer generation retires at about 10,000 per day, which is not expected to peak until 2020.
Lower incomes and wages continue to be a long-term structural headwind.
According to The Wall Street Journal, real median household incomes have been dropping over the last few years.
Increased dependence on government assistance programs including; food stamps, social security, Medicare and Medicaid remain huge challenges to fiscal authorities. Many of these problems have been exacerbated by the propping up of asset and commodity prices by the Fed which has made the necessities unaffordable to a growing segment of the population, as real wages and income are on the decline.
The core of Bernanke's message:
The Fed can not affect long-term structural economic issues -- it can only mitigate short-term cyclical problems.
Given this, the question should be asked; What is cyclical to the Fed?
The natural fluctuation of the economy between periods of expansion (growth) and contraction (recession). Factors such as gross domestic product (GDP), interest rates, levels of employment and consumer spending can help to determine the current stage of the economic cycle. --Investopedia
While the definitions of an economic cycle are broad, it is clear that Bernanke acknowledges that the long-term structural economics are changing and apparently not for the better in terms of growth and unemployment. As he mentioned, these concerns must be addressed by the legislative and fiscal authorities. This is because the Fed cannot great value. The Fed can only create the illusion of value (liquidity). Liquidity can help in a time of crisis, for a short time, to a prevent issues such as bank runs. However, if too much liquidity is added for too long it will create bubbles by inflating asset and commodity prices which will have extremely dangerous effects when they burst on an already structurally weak economy.
Those concerned with excessive liquidity in the financial system in reference to a structurally weak economy and the potential for asset bubbles, should consider the chart of the Adjusted Monetary Base which gives a reference point regarding the amount of the liquidity being injected into the system.
In regards to "froth" and "reaching for yield" consider the chart of the Wilshire 5000, which is widely considered to be the broadest index of U.S. stocks.
My conclusion is that as the Fed withdraws, there will likely be significant volatility as well as a major correction in U.S. equity prices, as markets do tend to trade around their fundamentals in the long run. Given the low rate of inflation and deflationary pressures, I would look for the U.S. dollar to continue to appreciate in value for the next several years.
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Disclaimer: Nothing in this article is to be taken as professional financial advice, nor is it a solicitation to buy or sell any type of securities. All financial decisions are your own, seek professional advice before taking action.
Disclosure: I am short SPY, IWM. 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. Long, VXX, UVXY, TVIX