QE Tapering: Factors That Challenge Fed's Target Inflation Rate And Economic Growth

Includes: DIA, SPY
by: Fx Stocks Data

The upcoming July FOMC meeting will be a closely watched event by the market participants for hints as to how long the Fed would continue with the quantitative easing program. The Fed's policy meeting would be wrapped up before the July payroll figures on 2nd August. This time around, we may see Ben Bernanke, repeating the promise he made during the congressional testimony by maintaining Fed's support with the stimulus program, retaining lower interest rates for the foreseeable future until the target inflation rate of 2% and unemployment levels of 6.5% could be attained, which could unquestionably induce the economic growth.

The question on inflation has been at the focal point every time the Fed discussed their intentions on the stimulus exit plan later this year. The consumer price index for June 2013 increased 0.5% on a seasonally adjusted basis. Over the last 12 months, the CPI increased 1.8 percent before seasonal adjustment. The majority of change, however, came from the gasoline index, which has accounted for about two-thirds of change, which suggests that excluding gasoline the inflation for all other items is particularly low.

The global markets over the past couple of months have been highly volatile on Fed's tapering fears, and the congressional testimony gave Bernanke a chance to settle the nerves of the market, which made a huge sell off during the past couple of months. Bernanke's positive comments on prolonged easing for the foreseeable future did help the markets settle down a bit.

The Fed is fully aware that the journey ahead is uncertain and the factors, which would control its target inflation and economic growth, are complex and dependent on several economic variables, domestically as well as globally.

Let us take a closer look at the important factors, which would significantly impact inflation and other economic variables within the U.S.

Asset Price Inflation:

Inflation in its simplest forms is the 'consumer price' inflation - which occurs either due to an increase in money supply or when there is an increase in price levels, and every dollar owned buys a relatively smaller percentage of goods or service. Thus, the purchasing power gradually declines when inflation moves higher. While a moderate inflation is good for the economy, higher inflation could lead to higher long-term interest rates. Since the launch of the quantitative easing program back in 2008, along with the recapitalization of the major banks and buying up of mortgage backed securities, the Fed's main intentions have been to lower the interest rates; by purchasing longer-term assets such as the 10-year Treasury bonds. The Fed hoped, the lower interest rates would encourage consumers to spend more and the banks would lend their surplus capital to spur the economic growth. Although the Fed could keep the U.S. economy afloat during the financial crisis, however, in the process, five years hence, the asset prices have inflated to record levels - with large inflow of capital into the equities, commodities and bond markets. However, significant concerns still remain - low economic growth, higher unemployment levels and a paltry GDP. The quantitative easing has caused asset price inflation not having much impact on the consumer prices as the capital flow into the end consumer has not occurred as intended, failing to affect the supply and demand of goods and services. Banks and other financial institutions took advantage of the low interest rates in speculative buying of stocks and treasury securities enabling the prices to rise sharply, irrespective of their real valuations.

One of the main reasons Bernanke tried to soothe the market nerves were due to jump in the bond market yields. The investors had reacted sharply to a possible interest rate rise in the near term, and the bond yields shot up quite dramatically after the Fed hinted at a possible tapering back on May 22nd. The Fed clearly saw the danger of a bond bubble and soothed the investor nerves during the congressional testimony by pledging to keep interest rates lower for the "foreseeable future." The U.S. 10-year treasury yields skyrocketed nearly 100 basis points during the last quarter and reached 2.75 percent on July 8, a level not seen since August 2011. The June employment figures also added fuel to the fire with investors wondering anxiously if the 30-year bull market run on the bond market had come to a collapse. The Fed's soothing comments have assured some comfort and the bond yields have since then settled below 2.5%. Similarly, other asset classes primarily gold, which saw a quarterly decline of 27% not seen since 1981, had recovered a bit with gold trading currently above $1,325.

Higher Unemployment Levels (and low wage rate):

Higher unemployment levels have been a curse since the financial recession of 2008. Higher Inflation is often closely related to higher wages, which enables the consumer with more purchasing power, helping to build a competitive market, where the price keeps rising with the increase in demand for goods and services. However, in the current scenario, the unemployment remains at 7.6%. Moreover, there remains a concern that the last months' gain in payrolls lacks quality, with the bulk of the gains - around 75,000, came in the hospitality industry of bartenders and waiters. The second best growth areas being the professional and business services with 53,000 jobs. The manufacturing jobs, on the other hand, declined by 6,000. Also, the wage pressures are considerably lower which is not helping the already employed to demand higher wages. This puts deflationary pressure keeping inflation to its lower end. The retail sales severely missed expectations in June, with the consumers spending less on the excess luxury or at restaurants and building materials. The retail sales contribute substantially to the GDP, and it appears the economy may remain weak going into the second half of the year, and unless the unemployment improves dramatically the possibility of some upside momentum on wages remain limited, which further limits the inflation going higher.

U.S. Dollar Volatility - Conflict between U.S. and Global expansive monetary policies:

The value of the U.S. dollar has been the most intriguing factor affecting the consumer price and the economic growth. Historical research carried out by the Fed had suggested a case for a weaker dollar to recover the economy from the recessionary pressure of the 2008 financial crisis, to achieve the target inflation. However, the unprecedented and the prolonged financial crisis required a number of monetary policy adjustments to be taken quite intermittently. The Fed had initiated and maintained the stimulus program in pursuit of a weaker dollar, in the hope that it will increase the money supply into the economy, and would result in lending, thereby spurring competition, which could normalize the domestic inflation levels and achieve price stability. However, the fluctuations in the dollar value played a significant part in retaining the downward pressure on the inflation levels. The dollar fluctuation has been mainly due to the expansive monetary policies implemented by other major economies which resulted in a tug of war scenario or the so called "currency war," resulting in the relative strengthening of the U.S. dollar. The stronger dollar is bad for the U.S. economy as it puts pressure on import prices shifting demand from domestic goods to imported ones. The domestic prices are then forced to match the import prices, resulting in deflationary pressures. Irrespective of the introduction of QE3 in September 2012, the PowerShares DB U.S. Dollar Index Bullish (NYSEARCA:UUP), has gained 6.5%, for the past 12 months. Moreover, the exchange rate instability in the emerging world has attracted the most stable U.S. dollar, with the majority of Fed's stimulus money flowing into the developing world as the main currency to carry out the business. This, in turn, had the effect of the dollar moving out of the U.S. economy, nullifying any increase in the domestic circulation of the dollar, eventually resulting in a stronger dollar keeping the consumer prices to the minimum. Trading activity had suffered with a stronger dollar, and the US export, therefore, had remained weak until recently. In short, the Fed's stimulus is used up mostly by the emerging world than domestically. Unless the global crisis could be contained, no matter how much money the Fed pumps into the U.S. economy, there would be only a partial effect within the U.S. economy, and the stronger U.S. dollar will only delay the Fed's stimulus exit plans.

Unstable Housing Market

The housing market, which regained some confidence in the earlier months of the year, has shown instability. Earlier this year there has been some optimism over the Fed's QE3, which added $45 billion a month to purchase mortgage backed securities, which initially, as per the Fed was to continue until 2015. This, along with the improving job numbers, gave the consumers more confidence to take advantage of the low mortgage rates. Subsequently, the Fed back in May, hinted at the stimulus scale back later this year, which created panic among the homebuyers and among the mortgage lenders. The mortgage rates started climbing higher, due to the uncertainty over the economy. This is quite evident in the June housing starts number, which had shown a significant decrease compared to the estimated figures (836K vs. 960K). The diminishing housing market is a great threat to any improvements in the economy and the inflation levels, which could force the Fed to delay the tapering.

Conflicting Fiscal and Monetary Policies:

The expansive monetary policy and tightening fiscal policy are contradicting one another. The Sequester, which came into effect on 1st March 2013, remains a threat to the economic growth. The expansive monetary policy has nullified the negative effects of fiscal policy by maintaining the Fed Funds rate near zero. With reductions of $85.4 during fiscal year 2013, the sequester aims to lower the spending by $1.1 trillion over a period of 8 years from 2013 to 2021. The CBO estimated that sequestration would reduce 2013 economic growth by about 0.6 percentage points (from 2.0% to 1.4% or about $90B) and affect the creation or retention of about 750,000 jobs by year-end.

Ben Bernanke, during the Congressional testimony, has pointed out "congress is the main impediment to a more robust economy and that fiscal policy will restrain economic growth over the next few quarters by more than we currently expect, or that the debate concerning other fiscal policy issues, such as the status of the debt ceiling, will evolve in a way that could hamper the recovery."

The Republicans favor an austerity-based approach to battle the annual deficits through spending cuts in the form of sequestration. Bernanke's warnings were that keeping those deep cuts in place much longer would slow growth for longer than expected.

Given, the Fed is also planning an exit to its $85 billion a month asset purchases, there is a big chance that the fiscal policy may delay the target inflation levels, also impacting on the market liquidity and economic growth.

Slowing Global Growth:

The Fed now literally acts as the central bank of the world with the emerging economies banking on the QE capital for liquidity and their currency stability. "China, Hong Kong and India are in the high risk danger zone, most vulnerable to the Fed's QE tapering, according to a recent research by Nomura Holdings Inc. The debt to gross domestic product across Asia had inflated to 167% in 2012. The loose U.S. monetary policy allowed Hong Kong's property market to enjoy the boom, with prices jumping 128% since December 2008. Singapore is also under a similar threat with sizeable investments in the property market. India and Indonesia, with large current account deficits, carry a major risk due to the reversal of capital flow when Fed decides to taper the on-going $85 billion a month stimulus program. Singapore, South Korea, Malaysia and Thailand are in the middle-risk range, ahead of Japan." The research also stressed, "in case a QE wind down occurred, investors will begin differentiating between economies favoring sustainable expansion rather than quick growth."

Ever since the Fed indication on May 22nd, 2013 about a possible stimulus scale back, the emerging markets have sold off sharply, accompanied by a considerable depreciation of the exchange rates. The investors are withdrawing money from the emerging markets back into U.S. treasuries and stock markets. For example, over the first seven months of the year, the two largest emerging markets ETFs - the Vanguard FTSE Emerging Markets (NYSEARCA:VWO) and the iShares MCSI Emerging Markets lost more than $11 billion in assets in 2013. Whereas, the Vanguard FTSE Developed Markets ETF (NYSEARCA:VEA), the PowerShares QQQ Trust ETF (NASDAQ:QQQ), the SPDR S&P 500 ETF (NYSEARCA:SPY) and the iShares MSCI EAFE ETF have collectively seen more than $13 billion inflows. The dent in the confidence of these high growth markets could impact the global growth and in turn could hamper the U.S. economic growth.

The slowdown in China is another major concern for the global economic growth. Many large European exporters are struggling with very little demand from the Chinese businesses and consumers and have suffered second quarter losses. Europe, which is in a forward guidance policy, needed a strong international consumer base to pick up their growth. The china slowdown will only make the matter worse for Europe and the United States. China is facing tighter credit, excess industrial capacity and a slowdown in economic activity with the Purchasing Managers' Index slipping in the past few months. The July preliminary survey pointed out an 11-month low PMI. Chinese GDP fell in the month of June missing estimates, to an annual rate of 7.5%, from 7.7% in the preceding month, posing a real danger for the global growth. The emerging markets are pinning hopes on the Fed continuing their loose monetary policy without any stimulus cuts for a year or so until we see a global recovery. The Fed, therefore, must pay closer attention to the global economy and rather than looking for a timeline for tapering, should ideally set a timeline for domestic and global growth, which would ensure any premature withdrawal of liquidity from the global markets.

As for the investors, the upcoming FOMC minutes on Wednesday is going to be quite significant, to figure out the Fed's plans with respect to the on-going quantitative easing program. The Fed is likely to stay put and repeat the dovish comments on the back of the struggling domestic and global economy. If the Fed failed to convince the markets, and assure the stimulus would stay for a reasonable time period, the coming months are going to be highly volatile for trading. With Dow Jones Industrial Average and S&P 500 at record levels, and the second quarter company earnings not upbeat, there will be bearish pressure in the near term. On the other hand, if Fed manages to highly convince the markets, the stock markets may hold on to gains and look for further direction on the upcoming economic data.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.