- The Fed's forecast for economic activity has dropped.
- Slow economic growth will mean slower increases in corporate profits.
- The level of stock prices will depend upon how long the Fed's credit inflation can support new or existing levels.
Yes, the Open Market Committee of the Federal Reserve System voted to continue to taper purchases of securities by another $10 billion…so that the total monthly purchases for the near term will be $55 billion. The Fed is holding on to its schedule of continuing to reduce monthly purchases.
The most interesting thing to me in all the information released yesterday pertaining to the Fed's monetary policy decisions and to the discussions around the state of the economy is the new prediction for economic growth.
Fed officials now believe that economic growth for the year 2014 will be 3.0 percent, down from their forecast of 3.2 percent in December 2013.
Binyamin Applebaum reported, in the New York Times, that Ms. Yellen, Chairwoman of the Board of Governors of the Federal Reserve, "Noting that growth had repeatedly disappointed expectations in recent years…said that some Fed officials had concluded 'that the potential growth rate of the economy may be lower at least for a time.' She cited the lingering effects of the recession, including unpaid debts and difficulties in obtaining loans."
Applebaum goes on to report "It was the first time the Fed officially predicted that the economy might not recover completely."
By this last statement, I take Applebaum to mean that the economy, this time around, will not attain growth rates that were achieved in the fifty years or so before the occurrence of the Great Recession.
Figures for the potential growth rate of the economy over the past fifty years have averaged around 3.2 percent and economic recoveries have often shown year-over-year rates of growth in excess of 4.0 percent.
So, the Federal Reserve seems to be accepting the fact that the economy will not, in this economic recovery which is in its fifth year, attain the rates of growth that were achieved in both in previous recoveries and in over the longer-term secular movement.
And, in saying this, I believe that the Federal Reserve is admitting publicly that monetary policy can only do so much…and, for the time being, the Fed has done about all it can to spur on the economy.
This is quite a statement for the Federal Reserve to make.
Furthermore, the Federal Reserve seems to be comfortable with the price situation. "The Fed's preferred inflation gauge, an index of personal consumption expenditures, rose 1.1 percent in the 12 months ending in January…." The Fed has expressed the view that its target rate of increase for this measure is 2.0 percent and officials seem to have little or no fear that the economy will drop into a further period of dis-inflation.
I am very comfortable with this forecast as I am on record forecasting that the economy will grow at an annual rate of 3.0 percent in 2014. This is up from a 1.9 percent annual rate of growth in 2013 and a 2.8 percent annual rate of growth in 2012.
In my estimation there are significant structural problems in both the composition of the capital that exists in the United States and in terms of labor force skills and participation. Ms. Yellen goes part of the way by saying that the economy will not have a potential growth rate as high as in the latter half of the 20th century, but I believe that the problems go beyond "the lingering effects of the recession, including unpaid debts and difficulties in obtaining loans."
As a consequence, my view of the economic picture for the next few years is for continual tepid growth substantially below the levels reached before the year 2000. And this will have important outcomes for the economy as a whole and for the various subsectors of the economy.
For one, continued tepid economic growth does not bode well for profits. In order for the US corporate sector to have more robust profits, the economy must show more life. I don't believe that this will happen. As economic growth remains modest and structural problems in the economy continue to exist, corporate profits will also remain on the modest side. Business profits just cannot grow if the real economy is not growing any faster.
And, as I mentioned above, we are in the fifth year of the current recovery. In most economic recoveries, exceptional economic growth, if it is to take place, takes place in the first couple of years of the expansion. This is why I continue to make light of the analysts that seem to continually look for "green shoots" in the economic data.
If corporate profits are not expected to be too robust over the next year or two, the only thing that can continue to inflate stock prices is the credit that has either been pumped into the economy or to the credit that will be pumped into the economy by the Federal Reserve. As readers of my blog posts know, I believe that credit inflation can take place in asset prices through the financial circuits in the economy while, in the meantime, little or no credit inflation can erupt in the "real" circuits of the economy, the ones that produce more output and employment.
This means that any further advances in the stock market are based on the vast pools of liquidity that exist within the economy and, hence, rest on relatively shaky grounds. I have written about this recently: see, for example, this post or this one. The question, to me, is how much longer can the stock market maintain its elevated price levels given that corporate profits are not expected to show much of a rise?
The answer is, of course, the stock market can remain at a very elevated level for a very long time. Remember, John Maynard Keynes wrote that the market can stay at levels for a longer time than your assets can hold out for.
As far as interest rates are concerned, investors made a lot out of the fact that "the Fed also released a separate set of economic forecasts showing that officials had raised their expectations for the level of their benchmark rate at the end of 2015 to 1 percent from 0.75 percent."
To me, over the longer-term, interest rates will be what they will be. I have never been a fan of "forward guidance" and think that the Fed's efforts at "forward guidance" have been laughable.
Short-term interest rates will begin to rise when demand in the banking system picks up. If economic growth continues to be tepid or modest, bank loan demand will not be strong. Consequently, banks will not have a strong demand for short-term funds. This has been the case over the past five years and this is a reason why the Fed has felt very little pressure on short-term interest rates.
When demand picks up, short-term interest rates will rise... and the Federal Reserve, in my mind, will not reverse its policy to taper security purchases or reverse its policy to return to a "more normal" banking environment. Short-term interest rates will rise when they rise.
Thus, my take away from what we have learned about the Fed's recent meeting of its Open Market Committee is that economic growth will be modest in the near future and that monetary policy can do little or nothing to change this outcome. To me, this is nothing new, but I believe that it is important for others to accept the fact that this is what our future looks like.