Wednesday’s spike in the equity markets seemed dramatic, until you realize that all it did was reverse most (and not all) of Friday’s selloff while leaving the rest of last week’s selloff intact. Wednesday’s rally was driven by relief at the ruling from the German high court, which said that Germany could continue to participate in bailouts of desperate EU countries as long as the Chancellor involved the legislature. That’s really not a wonderful result for Ms. Merkel, since there isn’t much chance that the legislature – increasingly populated by people who won their seats by opposing bailouts of desperate EU countries – will give the Chancellor everything she wants. However, it is better than the worst case, which was that the high court could have declared the entire bailout mechanism illegal.
Within minutes after the ruling, the ECB swung back into action to buy Italian bonds, whose yields had risen to over 5.50%. The ECB had been silently letting the bonds fall, probably wanting to avoid provoking the German jurists (since one question about the whole mechanism, although not addressed in the suits, was whether the ECB has the authority to buy the bonds of member countries in a price-keeping operation). Italian and Spanish bonds rallied, although interestingly not as much as in the first operation a few weeks ago. Italian 10-year yields are still at 5.25%.
Also helping equities on Wednesday was a speech by Chicago Fed President Evans, who argued in favor of a “rebalancing” of the Fed’s dual mandate more towards the employment part and away from the inflation part. It is worth remembering that Greenspan routinely observed that there is no tradeoff between inflation and employment in the long run – stable-inflation policies are what is best for the long-term growth of the economy. This lesson, one of the few that Greenspan taught, has been forgotten. President Evans suggests that the Fed should declare they will keep the fed funds rate around zero until the unemployment rate has fallen to 7%-7.5%, provided that core inflation does not exceed 3%. Yesterday, former Fed governor Larry Meyer seconded the motion that the Fed should retreat from its inflation “obsession” to focus more on jobs.
There is no ‘wiggle room’ in the Fed’s mandate, which is bestowed by Congress, so the Fed in fact can’t declare such a thing without thumbing its nose at its authorizing legislation. I am not a fan of the dual mandate, which I think is an impossible assignment that attempts to have it all. However, it is the law of the land. Now, the Fed can pursue that dual mandate in the way it wishes to, and may in fact employ Evans’ strategy; they simply must be circumspect about it. That said, the political reality is that few in Congress will complain about the Fed being too easy (some will, most won’t), but many will grouse if they are too tight.
These were optimistic thoughts on Wednesday – that maybe a Germany-backed ECB can turn back the tide in Europe and perhaps the Fed can let inflation slide a little higher and get unemployment back down. But by Thursday, those brief moments of sunshine were past.
An article in the Wall Street Journal opined that the Fed is actively considering a wide variety of tools to deploy, but did not give a lot of hope that the decision has been made and help is on the way. Initial Claims nudged up, and Chairman Bernanke spoke.
What the Chairman did not do in his speech yesterday was to make any promises, or even any concrete hints, that a near-term QE3 is likely. Listeners who expect QE3 this month were disappointed, expecting to hear a trial balloon; they didn’t get one.
While much of the speech is eminently forgettable, there’s actually some reason for hope. In places, he sounds like he has figured out some things that the Fed has gotten wrong for a while. For example, it has become routine for Fed officials and honest third-party observers to report that there is a “lack of credit demand” and that is why bank lending isn’t expanding. This has always been untrue, and in this speech the Chairman at last recognizes the true state of affairs:
Credit availability has improved for many borrowers, though it remains tight in categories–such as small business lending–in which the balance sheets and income prospects of potential borrowers remain impaired.
Since, after all, it is small business that provides most of the new employment in this country, this is no small matter. His emphasis is still wrong – it is far worse for the economy that small business owners cannot get loans than it would be if large companies, which have many sources of capital, could not tap bank loans. Large companies use bank financing to maintain dividend policies and to lever the company appropriately in order to minimize the weighted-average cost of capital. Small companies use bank loans to finance growing businesses that tend to be cash-flow negative.
There is also, unfortunately, the continued reliance on magical elixirs and divine intervention. A common theme recently from the Administration has been the “I will gladly pay you Tuesday for a hamburger today” approach: run bigger deficits today and make it up with smaller deficits in the future. While this is exactly the approach we’ve taken for the last thirty years, and it has gotten us into a deep hole, it is apparently preferred. And Bernanke supports this approach (perhaps he figures there is no alternative):
But, while prompt and decisive action to put the federal government’s finances on a sustainable trajectory is urgently needed, fiscal policymakers should not, as a consequence, disregard the fragility of the economic recovery. Fortunately, the two goals–achieving fiscal sustainability, which is the result of responsible policies set in place for the longer term, and avoiding creation of fiscal headwinds for the recovery–are not incompatible. Acting now to put in place a credible plan for reducing future deficits over the long term, while being attentive to the implications of fiscal choices for the recovery in the near term, can help serve both objectives.
I won’t spend much virtual ink on Bernanke’s dismissal of inflation pressures, because he relies on the usual concoction of “stable inflation expectations” (which – since they are not measured well – have not been demonstrated to restrain inflation, although the Fed has speculated that they do), “substantial amount of resource slack” (there are numerous examples of inflation occurring despite resource slack), and “subdued unit labor costs” (labor costs clearly follow inflation; they do not lead inflation). It is sad that the Chairman would continue to repeat these mantras, but he is looking for excuses to ease, not reasons to tighten, so we can’t really expect him to give much weight to the counterarguments even if they include models that actually work. For example, models that consider the growth rate of the money supply, which as of today’s numbers is now up at 23.5% (annualized) over the last 13 weeks, 14.5% over the last 26, and 10.3% over the last year. Each of these is a new high for the last several years, and disturbing to anyone who doesn’t think stable inflation expectations are more important than the amount of money sloshing around the system.
Last night's speech by President Obama didn't rock any boats. There were promises to do more of the same (spend money to create jobs in the short-term), lots of finger pointing, and a stern expression. None of this will have market impact, unless it is to make the dollar which has recently been strengthening look weak once again.
Last Friday saw a serious waterfall close lower, and it turned out to be justified as Merkel lost an election and the troika walked out of talks with Greece. That doesn’t mean we will see stocks decline markedly every Friday, but investors will probably be reducing risk this weekend. Since there are many more longs than shorts in the stock market, that likely means there is a bias to close lower.