This was a big week for economic data. In addition to the predictable announcements coming out of Europe and Japan, the minutes from the September FOMC meeting and the September employment report were released. Both reports yielded positive headlines and negative implications for the markets.
It is important to remind readers that minutes are not transcripts, so they are not a tell all, but they do provide some important insights. The most recent minutes were unusually detailed with explanations of the staff reports some detail about the deliberation and what to expect from the actual Committee.
The staff reports indicate not only what the internal research at the Fed shows, but how the Fed is allocating its significant research resources. The staff spent considerable time examining the economic implications of continued European instability, slowing growth in Asia and uncertainty around U.S. fiscal policy. The policy recommendations they made seem to be premised on the idea that European instability will continue, Asian growth will stagnate and U.S. fiscal policy will be tighter next year. Given these conditions and the fact that they are still projecting low and stable inflation coupled with high unemployment, it is easy to see why the staff proposed additional QE.
The report also demonstrates that the staff did not look only at MBS purchases for QE3; they also evaluated several different types of asset purchase plans. Once they concluded that MBS purchases were the best course of action, the staff spent a great deal of effort convincing Committee members that policy "normalization" would not be complicated by additional MBS purchases. Basically, the staff spent considerable time trying to convince the Committee that QE3 would not make it impossible to tighten policy when the time comes.
Just because the staff worked hard to convince the Committee does not mean the Committee believed them. In particular, the minutes repeatedly note members expressing fear of the downside risk of QE3 if the economy improves more rapidly than expected. This fear was countered by the greater fear that political gridlock would prevent necessary changes to fiscal policy and create a sharp contraction next year if we drive off the "fiscal cliff." Basically, the minutes show that despite the Fed's aversion to politics, the implication of political failures on fiscal policy has once again factored into the Fed's decision to stimulate the economy.
The remainder of the minutes explain two great debates before the FOMC right now. The first is the question of whether unemployment is structural or cyclical. Ultimately, the majority of committee must think it is cyclical, or else they would not be voting in favor of monetary mechanisms designed (at least partially) to stimulate employment. The other debate is about the Fed's forward guidance and continuing to use a firm date to dictate policy. Several regional bank presidents have recently noted that they want to see low rate guidance ties to specific employment and inflation objectives, but the committee clearly couldn't agree on those objectives so they are continuing guidance toward a particular date.
It is a good thing that the FOMC decided against the numerical thresholds for guidance because Friday's employment report demonstrates how misleading employment statistics can be. While the official unemployment rate declined rapidly from 8.1% in August to 7.8% in September, the underlying data was far less positive. Only 114,000 jobs were gained, but the household survey indicated hundreds of thousands of workers back in the workforce. This muddled data initially caused a confidence based rally, but as analysts dug into the numbers, the weaknesses were obvious.
While it is easy to question the Bureau of Labor Statistics methodology on employment data, their credibility is unassailable. So, setting aside the comedy of the absurd that was Jack Welch's statement, this data is just messy. The bottom line is that we are consistently gaining jobs and the labor market is improving, but the high youth unemployment rate coupled with the enormous numbers of discouraged workers who are yet to reenter the labor force indicate that we still have a long way to go.
The Fed's minutes indicate that policymakers are facing nearly as much global economic uncertainty as the rest of us. As has been true throughout his tenure, the Bernanke Fed aired on the side of doing too much, rather than too little. Over the last few years, that "too much" has continually been demonstrated to be too little in the face of constant economic headwinds from around the globe and the halls of Congress. So, it should be no surprise that the Fed acted.
The minutes also indicate that Fed personnel are actively concerned about making policy moves that might "undermine the Committee's credibility." They referenced this when discussing a rate targeting policy, but this statement demonstrates the tenuous situation the Fed is now in; if they do nothing, the economy might suffer. If Fed policymakers do too much or the wrong thing, they lose credibility and the economy will suffer in the long run. Some will argue that the Fed has already lost its credibility, but if you look at how the market responded to the announcement of QE3, you can see that smart investors still take Fed policy very seriously.
Whether it is the FOMC minutes or the employment report, the lesson this week is to set ideology aside when you are investing and focus on the data, not just the headlines. The headlines have been pretty good lately, but the data has been less positive. Investors have begun to catch up to this softer data, and it will likely continue to restrain equity market gains over the next few weeks. This soft market is likely to last at least until after the election and probably until the fiscal cliff is settled, substantive news comes out of Europe, or Chinese economic growth accelerates.