Michelle Girard: Fed May Keep Interest Rates Low Through Mid-2015 And Buy Bonds, All With Little Impact

Includes: DIA, QQQ, SPY
by: Harlan Levy

Michelle Girard is a managing director and senior economist at Royal Bank of Scotland.

Harlan Levy: Do you expect the Federal Reserve to do more easing or other action to stimulate the economy this week?

M.G.: We do expect the Fed to take action this week. We think they'll make changes to their guidance on interest rates, suggesting that rates will stay lower for even longer, perhaps through mid-2015. We also expect that the Fed will engage in more bond-buying, in this case, both Treasurys and mortgage-backed securities. That should continue to be supportive for what we call risk assets, including equities and corporate bonds.

I don't think it will have much economic impact. I think the problems that are holding the U.S. economy back are not monetary in nature. It's clearly not a lack of liquidity or high interest rates that are holding back growth. It's uncertainty over fiscal policy and the outcome of the election. Until we have more clarity on that front. I think there's nothing really the Fed can do to boost economic growth.

What we need is clarity on the outlook for taxes and spending. No matter which plan emerges, Republican or Democrat, we just need to know the plan, because businesses need to be able to make plans based on the environment they're going to be facing. Right now you have people talking about the possibility of a recession if the economy hits the fiscal cliff. There's also a perception that a Republican sweep would create a much friendlier environment and lead to stronger economic growth. The bottom line is that facing such a binary outcome with two extremes, either recession or 4 percent growth, companies need more evidence to suggest which of the outcomes are more likely.

H.L.: How should we solve the problem of the fiscal cliff?

M.G.: In the end everybody recognizes that compromise is needed and that everybody has to share the pain. You cannot solve the fiscal problem by raising taxes on only the wealthy. Likewise, you probably do need revenue increases combined with spending cuts, because you can't solve the problem by purely cutting spending. Ultimately, we have to find a solution somewhere in the middle. We're just waiting for the two parties to get to that point.

H.L.: Are lower taxes and less business regulations good answers to our economic problems?

M.G.: Clearly that would make it a better environment for companies, which would probably be a positive for growth. I just fear the move from too little regulation to too much regulation at a time when the economy is struggling, the burden of too much regulation just coming at the wrong time. Should we have more regulation than we have now? I don't think anyone would argue that, but right now the pendulum has swung too far, and that's the risk for the economy.

The other big thing is a lot of the regulations being discussed have not been finalized, so companies are waiting to see what the final regulations will be, which is another reason company decision-makers are sitting on their hands.

H.L.: Do you think Congress will let us go over the fiscal cliff?

M.G.: I believe the fiscal cliff will be avoided, because I simply cannot believe that politicians would allow tax rates across the board to go up at this time. As hard as it is to imagine the two parties coming to an agreement, it seems unfathomable that either party would put the U.S. economy at risk in that way. So I believe that very close to the end of the year we will see an agreement to temporarily extend all of the tax cuts and the automatic spending cuts as well into 2013, whether it's six months or the whole year I don't know. But I think they'll allow enough time for a new plan to be approved.

H.L.: With the latest new-job numbers - 95,000 in August, including 103,000 new private-sector jobs -- is the U.S. economy in a fragile recovery?

M.G.: The U.S. economy remains in a subpar recovery. I don't necessarily think it's fragile in the sense that it's at risk of slipping back into recession, but I do think at the moment businesses in particular are plagued by uncertainty, and, as a result, have been very restrained in both their hiring and capital spending.

As a result we're continuing to see very tepid payroll growth, which in turn then makes it difficult for the consumer sector to grow much more strongly.

H.L.: When do you see the unemployment rate dropping below 8 percent?

M.G.: We don't see it dropping below 8 percent this year. Our expectation is that the economy will continue to expand at only about 2 percent in the second half of 2012. That's not sufficient to bring the unemployment rate down in a meaningful way.

How quickly the unemployment rate can move under 8 percent in 2013 remains highly dependent on how the economy performs in early 2013. That remains highly dependent on whether or not we hit the fiscal cliff.

H.L.: When do you think the housing market will have a sustained recovery?

M.G.: I think we're seeing a sustained recovery in housing getting underway. We've seen an upturn in home prices this year, much to the surprise of many. I think the strengthening in housing will continue to be gradual. The improvement we've seen here is for real and will be sustained unless the economy falters, which we don't anticipate.

I think it will be years before the pace of housing activity begins to return to more historically normal levels. I think the inventory situation will continue to result in moderate construction activity, but until the inventories are cleared it's going to be hard for home prices to rise significantly. If the economy grows more strongly and the job market improves more sharply and demand picks up, inventory levels will clear more clearly. But I think we're looking at two of three years of working off inventory.

H.L.: Will corporate earnings weaken going into next year?

M.G.: I think companies remain well-positioned for growth. Their costs have been reduced, and balance sheets are strong so companies have been able to be profitable even in the face of a sub-par expansion. I do think earnings will continue to rise, but I think the year-over-year comparisons have become more challenging, and I think the overall growth rates of corporate profits are going to be more moderate going forward.

H.L.: Do you think the euro-zone countries will finally resolve their sovereign debt problems in the wake of the latest proposal by the European Central Bank of massive increases in purchases of troubled nations' bonds?

M.G.: Very similar to the U.S. and the Federal Reserve, I don't think the problems in Europe will be solved by monetary policy-makers. I think that the positive response that the markets have had to the ECB announcement will ultimately give way once again to a rethinking just how effective those actions will be in the long run and whether it moves them closer to a solution or to dissolution n the euro zone.

The problem is that the European Central Bank increasing its buying removes the punishment that markets inflict on countries that don't take the steps needed to get their fiscal houses in order. While the bond buying is supposed to be conditional, it's very hard for me to imagine that the ECB will stop buying the bonds of these countries if the necessary steps aren't taken. In that sense there will be less incentive for countries that are struggling with economic problems to take the very difficult steps that are needed in terms of fiscal reforms. If the central bank is buying and keeping rates low, then there's no punishment from the markets if they stray off course.

Ultimately, you can't have monetary union without fiscal and banking union, and that's become apparent. The question is just how long will it be before the countries will embrace that.

H.L.: Do you think they will?

M.G.: I don't know. Either way it's painful. It's just which way is more painful.

Disclosure: I am long AAPL. 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.