On the eve of the influential annual Jackson Hole confab for central bankers, it seems appropriate to consider the current path of Fed policy and some of the outcome implications for the financial markets. Despite the trading obsession on when exactly the Fed will move away from its zero-interest rate (ZIRP) policy ("lift-off" is the bank's term), I will leave that issue mostly to the side: Guessing policy moves is not something I recommend.
My central concern is the near- and long-term implications for the markets. The recent rally of the S&P 500 that started with a bounce off the trendline that dates back to the beginning of QE-3 has benefited from a few days of relative quiet in the Ukraine (which could come back to bite us) and more importantly, the combination of the release of the FOMC minutes Wednesday and the anticipation of further dovish cooing from Fed chair Janet Yellen and ECB president Mario Draghi on Friday when they deliver their respective encyclicals in Jackson Hole.
I don't know what Yellen is going to say, but I do know that she doesn't have to promise any additional easing or accommodation to keep equities in rally mode - she need only not turn hawkish. Stocks don't need positive surprises in a momentum market, only the absence of negative ones. As soon as it becomes clear Friday morning that she is not proposing a 500 basis-point rate increase retroactive to January, relieved traders ("she's got our back!") will probably bid the S&P 500 up past the symbolic level of 2000
I call the current Fed-economy-markets scenario a "battle" because it is one: the domestic theater of operations, to borrow World War II terminology. Operating in one wing of the theater is our central bank, in another the rest of the government that comprises Congress and the executive branch. Other major forces include the banking system, the markets, corporate boardroom fashion and the influence of overseas competition.
Our legislative branch has had little impact on growth in recent years; polarization has left it paralyzed and unable to move except at cliff's edge. Fiscal policy has been a mild negative for about four years now. Acting as an enabler of the deadbeat stasis is the modest success that central banks around the globe have had in keeping developed-world economies from going down the toilet. The central bank-aided rebound in financial markets and general liquidity has entrenched legislative inaction: in the absence of crises that would force legislators to make hard choices, they won't.
Some believe that the Washington landscape might change dramatically with the November elections, but I don't believe that to be the case. Congress is already deadlocked; even if Republicans wrest back the Senate, Obama will still be president. It would probably mean a return to the political theatre of the second Clinton administration, impeachment proceedings and all (be it Benghazi, making appointments out of session, or taking an extra mulligan on the golf course), but little to the economy (unless the Republicans shut down the government again over the budget).
A serious consequence of Washington's inactivity has been a shift in Fed posture from the desperation of QE-1 and QE-2 (also birthed at Jackson Hole) Ben Bernanke to do something to one of acceptance of a role as the economy's chief steward - and an enlarged role at that. Frustrated by an economy stuck on 2% growth, beset by a loss of hope for any fiscal help for the rest of the current administration's term, the bank has become increasingly obsessed with maintaining not just financial stability, but a kind of artificial womb-like comfort level for the financial markets.
The economy's growth rate stubbornly refuses to get better, despite the constant reassurances that it will. For the fourth year in a row, the prediction is being made that economic growth is about to accelerate and interest rates rise (here's a sample from Franklin Templeton, posted on Seeking Alpha earlier in the week), but the only thing that has changed in that time is the calendar. The economy is on the same trend - minimal growth - while stocks are on the same trend - minimal risk, courtesy of central banks.
Isn't housing getting better? Not really. The starts data is admittedly volatile and subject to large revisions, but through the first seven months of the year, single-family starts are up only 3.2% over 2013. The apparent big decrease in June was revised away to a smaller decrease, but the same fate is likely to await July's apparent big increase, which came courtesy of the biggest single month for multi-family (over 5 units) starts since May of 1988 - not to mention it was a 50% increase over the previous month. I don't doubt the shift towards rental living, but the number is likely to get revised downward. It also points to the gulf between mortgage lending, which remains excruciatingly tight (a loan broker friend tells me her job now largely consists of being an unofficial auditor for the IRS), and credit in commercial construction, which continues to ease.
One of the current hot topics is wage growth, or the lack thereof; indeed labor is the focus of the Jackson Hole meetings. Charles Plosser addressed the issue briefly on CNBC Thursday, the gist of it being that there isn't much the Fed can do about it (and so should not obsess on it). He's right. Senior management at corporations are behaving in rational self-interest, in this respect - the sweet spot of their compensation is so tied to the stock price and dividends (taxed at much lower rates) that every cost needs to be minimized. BlackRock's Larry Fink may have issued a plea for corporations to pick up capital spending, but Franklin's Donald Taylor (see the link above) takes a view more representative of the investment community:
However, the market hasn't generally been keen on rewarding companies that make large-scale capital expenditures. We think investors could be fearful that companies could end up wasting shareholder capital by building or acquiring plants and equipment that they really don't need.
We have seen companies generally being rewarded when they take a more pragmatic approach to managing their capital by pursuing acquisitions, repurchasing their shares or boosting their dividends.
Raising wage costs isn't on the agenda, despite the usual insistence that increasingly tight markets mean higher wages, just like higher growth, are right around the corner.
Besides the stubborn economy - Rogoff and Reinhart's work on financial crises suggested that the average recovery period from a credit-induced recession is about seven years, so the experience is hardly unusual - the Fed has to contend with the growing itch from the Southern right to "rein in" the bank by passing a set of rules for it. The goal of course is to weaken the bank's discretion and reach, something the South has been yearning for since before the time the bank was created. Like any other central bank, the Fed would be well-advised to ward off attempts to politicize it, so it will likely try very hard not to let anything happen that might inflame the country's financial anxieties before a November election that could change the majority in the Senate.
It's important to keep in mind that the Fed's first rate increase, whether it comes sooner or later, is most unlikely to sink the stock market right away. Stock prices typically keep rising through initial rate increases by the central bank because they are more sensitive to falling profits and recession than they are to the mere fact of a higher fed funds rate. The usual pattern is for steadily higher rates to eventually cause credit to contract, and thus the economy, and so finally the stock market. The end of QE should engender a far more immediate effect, and that end probably won't even be announced until the meeting at the end of October.
Would an increase to 1% in the funds rate by mid-2015 cause a recession? I don't see why it should, unless the financial markets panicked, and to that end the Fed seems to be intent on stressing a gentle, fully lit path for the markets.
Many have been quite disappointed that the Fed's unorthodox post-crisis programs have not resulted in hyper-inflation, anarchy and chaos (though they remain ever-hopeful for the apocalypse). I don't think that anyone, including the members of the FOMC, really knows how the end game for the Fed's balance sheet will play out, but I don't believe that hyper-inflation is the necessary result. Like many others, I do see the larger threat as coming from yet another asset price bubble deflating suddenly, but I don't see such an event as likely to happen this year without an outside agent or a system meltdown.
The stock market is approaching short-term dangerously overbought levels (a Friday post-Yellen rally could put us into the red zone) and is enough over-valued that a sudden crisis could finally break the magical QE trendline I wrote about last week. Between the end of QE and geopolitics, there are certainly the ingredients for the long-deferred correction of 10% or more. But the Fed won't be doing anything big enough this year to bring an end to the bull market or the economic recovery. An external shock would have to intervene.
The Fed needs to wean the stock market off the idea that it is the market's guarantor, but the committee hasn't shown any indication yet that it has much of an idea how it might accomplish that. I freely volunteer that it cannot succeed by rushing forward with money and promises of indefinite accommodation every time there is a hiccup; it will be interesting to see if there are any hints of behavioral improvement coming out of Jackson Hole.
In the meantime, growing economic difficulties in Europe and Japan have many economists and strategists - nearly always those with a connection to equity markets - becoming adamant that the two countries' respective central banks simply must resort to more aggressive easing. The impact on stock prices from such programs would be immediate, but the growing mountains on the globe's central bank balance sheets could indeed end up being catastrophic in the end. Yet so long as legislators are content to remain dogmatically rigid and leave all the work to the banks, the risk of a near miss turning into a catastrophic collision grows, along with the risk of the battle turning into a war already lost.
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