The U.S. Federal Reserve (Fed) has a lot on its plate and some real concerns if not outright worries as it brings its massive asset purchase program to an end. Now, if the latter was not enough, the Fed has to deal with the sobering fact that its expectations for growth could be an unrealistic goal.
It would seem that whenever we start feeling good about the U.S. economy, another roadblock materializes and dampens expectations. This latest one is the hope for continued robust growth in the second half of the year. As of right now, hope is not matching facts on the ground.
Let us look at the math for a second here, the Fed's most recent projection (for growth), that was issued last March, calls for the gross domestic product (GDP) to grow between 2.8 to 3 percent. However, we just had a contraction of one percent in the first quarter. What does this mean? For the rest of the year the economy would have to recover with an amazing turnaround. It would have to grow at a clip of more than four percent just to reach the Fed's lofty goal.
Then there are other headwinds the U.S. economy is currently facing. As other indicators are going up, there is a problem in the housing market. It is soft to say the least. There is also a sharp increase noted in the U.S. trade deficit. Finally, we see problems in global economic growth. Despite expectations that emerging markets would return to normal this year, emerging markets are still struggling after five years of tepid post financial crisis gains.
Then we add the World Bank into the picture, which rattled the markets as it cut growth estimates. The World Bank cut global growth estimates from 3.2 percent to 2.8 percent and cut its U.S. projection for growth down to 2.1 percent from 2.8 percent. After that announcement, equity markets saw modest losses. The Dow Jones was down over 102 points as U.S. markets saw their worst hit in nearly a month.
This is an odd situation right now. We have seemingly improved prospects in the U.S., but it appears the rest of the world still needs time to heal from the financial crisis. This is evident from the World Bank's cut in global growth estimates. There are some investors who believe the U.S. growth will accelerate, however, not at the pace the Fed believes. A two percent growth in GDP is not bad. It is surely not the three percent the Fed expects. Many of us were shocked by the GDP contraction in Q1, and that is likely to drag the growth down for the rest of the year. It will certainly have a negative effect on the annual figure.
The U.S. has two concerns they need to focus on right now in order to sustain this recovery. First there is the housing weakness and a policy error as the Fed is tapering its asset purchase program while keeping rates near zero. The bank is keeping rates steady as it is still buying $45 billion a month in assets (Treasuries and mortgage back securities). The quantitative easing (QE) has bloated the Fed's balance sheet to almost $4.4 trillion.
The question is, should the Fed shake things up or do we need to heal some more? Do they continue to stretch the rubber band even more, which could mean it could snap back faster? These are some of the questions investors have right now and there is no clear answer, especially from the Fed. Communication is something the Fed must improve.
As other economic numbers show slower growth, like in manufacturing, concern will grow that the Fed will have to change its unemployment projection. We could see it adjusting to at least 6.3 percent; it is at 6.1 percent now. There can also be a rise in prices as supply tightens, causing it to raise the inflation projection to 1.6 percent. It is expecting 1.4 percent now. This means the Fed might have to raise rates faster than it would like.
The current complacency with the Fed's policy could prove to be dangerous. There are no big or obvious triggers for any immediate correction, however, the Fed's ability to forecast can be tested as we could suddenly have an unperceived shock. It is the unknown that is usually the greatest threat to market stability. If the Fed makes the wrong move, like raising rates too soon, that could be the unwanted shock markets fear.
Finally, there is that potential for Treasury yields to move higher. This could cause emerging markets to go back into the turmoil we saw last year as it will cause their borrowing costs to firm up.
Is this the way a recovery is supposed to work? We will have to wait and see.
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