Expect A Long, Slow, Gradual, Uneven Taper: Macro Economic Fiscal Policy Isn't Working

Includes: EEM, GLD, IDU, SLV
by: Robert Wagner

People that are expecting a quick resolution to the Fed's QE programs and a speedy execution of the "taper" are almost certain to be disappointed. The Fed has repeatedly made statements that the implementation of the "taper" will be data driven. The Fed has made extremely clear statements as to the goals, metrics and targets of the "taper."

Stage #2: May be a lengthy period where the Fed passively observes the economy as it slowly works its way towards the 6.5% unemployment and 2% inflation target. Mr. Bernanke made a point to state that "not before 6.5% unemployment" and that reaching those targets wouldn't automatically result in any Fed action other than an analysis on the economy and the appropriate policy at that time.

First the basics:

Investors interested in following the "taper" and building expectations as to the future actions of the Fed need to follow a few basic charts.

The first and most important chart is unemployment. Unemployment is likely to be the determining factor as to the implementation of the "taper." Rarely does the Fed start to increase interest rates when the labor market is unsettled and unemployment is high or increasing. The reason is simple, it is hard to have sustained inflation without low unemployment. Unemployment represents excess capacity which acts as a buffer against inflation. Unemployment is a widely inaccurate number however and has many problems with its calculations which I will cover later in this article. To start however people should follow the unemployment rate as calculated by the Bureau of Labor Statistics. The current rate is 7.3%. The Fed's maximum target is 6.5%, so we are a full 0.8% above the level where the Fed would even begin to consider raising short-term rates and aggressively implementing the "taper."

The second macro economic metric of the "taper" triumvirate is the inflation rate. The Fed is targeting 2.0%, and uses the Personal Consumption Expenditures or PCE as its primary inflation gauge.

In contrast, the FOMC focuses on PCE inflation in its quarterly economic projections and also states its longer-run inflation goal in terms of headline PCE. The FOMC focused on CPI inflation prior to 2000 but, after extensive analysis, changed to PCE inflation for three main reasons: The expenditure weights in the PCE can change as people substitute away from some goods and services toward others, the PCE includes more comprehensive coverage of goods and services, and historical PCE data can be revised (more than for seasonal factors only).

The problem this will create for the "taper" is that the PCE shows lower inflation than the Consumer Price Index or CPI, so this will provide justification for the Fed to slow down the implementation of the "taper."

But a little-noticed factor has been lower inflation. I say little-noticed because inflation isn't lower based on its most widely followed measure, the consumer price index. Both total and core CPI (which excludes food and energy) are up 2% in the last 12 months, in line with its long-term trend and the Federal Reserve's 2% target.

However, based on the lesser-known price index of personal consumption expenditures (PCE), headline and core inflation are only 1.3% (see nearby chart). This is more than a technical curiosity. The PCE index is used to calculate real consumer spending. Using the CPI, real spending would be up only 0.4%, instead of 0.6%, in the last two months. Over the last year, using the PCE index instead of the CPI adds 0.7% to the growth in both real consumption and real incomes.

This is the graphic referenced in the above quote:

The current CPI shows an annual inflation rate of 2.0%, right at the Fed's lower target level.

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.2 percent in July on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported. Over the last 12 months, the all items index increased 2.0 percent before seasonal adjustment.

The current PCE on the other hand shows an annual rate of increase of 0.68%, and it has been falling. The previous quarter was 1.10%, and was as high as 1.83% 4th quarter 2011. By using the PCE instead of the CPI, the Fed is likely to be slower to implement the "taper" than it would be if it was using the CPI.

The third major macro economic metric needed to broadly define the "taper" is the growth rate of the Gross Domestic Product or GDP. Economic growth isn't specifically stated by the Fed, but the other two factors of unemployment and inflation are dependent upon it. The economy must create 180,000 new jobs each month just to keep up with population growth.

Each month, more people join the working age population than retire or die. Consequently, the economy needs to add about 180,000 jobs a month just to keep up with population growth.

The classic relationship between unemployment and economic growth is called Okuns Law.

Okun's law investigates the statistical relationship between a country's unemployment rate and the growth rate of its economy. The economics research arm of the Federal Reserve Bank of St. Louis explains that Okun's law "is intended to tell us how much of a country's gross domestic product (OTC:GDP) may be lost when the unemployment rate is above its natural rate."

The current real GDP growth rate as calculated by the Bureau of Economic Analysis or BEA is 2.5%. According to Okun's Law, 2.5% economic growth is just enough to maintain the current unemployment rate, and on the edge of a shrinking economy.

Real gross domestic product - the output of goods and services produced by labor and property located in the United States - increased at an annual rate of 2.5 percent in the second quarter of 2013 (that is, from the first quarter to the second quarter), according to the "second" estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP increased 1.1 percent.

The relationship between unemployment and inflation is called "The Phillips' Curve." It captures the conflicting objectives the dual mandate of the Fed creates. As unemployment goes down, inflation goes up, so the Fed had a delicate balancing act to keep unemployment low, but not so low that it triggers unemployment.

Fiscal Policy Drives Monetary Policy:

The key then to predicting the rate at which the Fed will progress through the "taper" is to accurately predict unemployment and inflation. To do that investors must handicap the effectiveness of fiscal policy because it is fiscal policy that will determine the strength of the economic recovery. The problem is fiscal policy is very difficult to handicap because you can't put an economy into a test tube and run experiments on it to see what works and what doesn't, all we can rely on is history and theories.

The Returns of Keynes:

The best historical references I can find to explain the current economic situation is 1) The Great Depression and 2) The 1980 Reagan Carter election. In 1980 the US economy was suffering from "stagflation" and the nation seemed to be headed in the wrong direction. The Nixon and Carter era caused economists to rethink their faith in Keynesian economics, and by the time I was entering college Keynesian economics was being discredited, and a new form of economic thought was sweeping the economics departments across the nation called "supply side economics." Reagonomics as it was called reversed the spiraling inflation, high unemployment, stagnant growth, oil shortage, high interest rates and coming ice age into a full employment booming economy with falling inflation, falling interest rates and an oil glut. Having lived through those years it was truly remarkable. The nation went from hopelessness and despair to once again being on top of the world. The current administration is about as far from Reagonomics as one can get, so I wouldn't expect a repeat of the 1980s.

A better analogy to today is the Great Depression, when FDR fully embraced Keynesian economics. The problem with Keynesian economics is that it simply doesn't work, unless you consider the economics of the 1930s and 1970s as working. FDR used to hire people to count birds and rake leaves in the national parks to "create" jobs. That is pure nonsense, but it makes sense to a Keynesian economist. The best example of pure Keynesian economics I can think of is the "bridge to nowhere." Keynesians love "infrastructure" projects, but the problem is "infrastructure" building is stimulative only if it goes to facilitating economic growth that can deliver a positive ROR on the taxpayer's money. The "bridge to nowhere" didn't create jobs, it simply displaced jobs from productive uses to unproductive uses, displaced capital from productive uses to unproductive uses and left society a huge liability of maintaining a bridge with no usefulness. It was a complete and utter waste of money that results in a negative ROR to the economy and society gets nothing but a long-term liability. Today we have entire industries to nowhere being created as the federal government is playing venture capitalist to the green economy. Simply spending money with no concern whatsoever to the ROR is the fatal flaw of Keynesian economics. The Hoover Dam, Golden Gate Bridge and Rockefeller Center were all built during the Great Depression and they didn't even put a dent in unemployment.

"We have tried spending money. We are spending more than we have ever spent before and it does not work...I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises...I say after eight years of this Administration we have just as much unemployment as when we started. … And an enormous debt to boot!"

Henry Morgenthau Jr. Treasury to President Franklin D. Roosevelt - and key architect of FDR's New Deal.

That isn't to say infrastructure spending can't stimulate growth, infrastructure spending is necessary for growth. Here where I live there is a huge infrastructure project underway to support a casino. That is smart infrastructure spending because unlike the "bridge to nowhere" this infrastructure spending is going to support a project with a very positive ROR to taxpayers. The casino will pay far more in taxes than the amount of money spent by the taxpayers to widen the road to enable the casino to generate its positive ROR.

This video does a fantastic job highlighting just how misguided Keynesian economists are. Keynesian Paul Krugman and Henry Blodget are arguing that the reason the economy isn't doing much better is because the government didn't spend enough. Paul Krugman believes the stimulus package should have been 3x what it was. Somehow filling more pot holes, hiring more teachers, police and firemen, building more bridges to nowhere and investing more money in bankrupt companies like Fisker and Solyndra would have helped the economy. That is simply a failed economic policy based more upon political populism than any hope or real results. The closest thing to big Government Keynesism is communism, and that system has a horrific track record, but it works well on paper and people seem to love it in principle. Free lunches and claiming that money grows on trees (i.e. the Rich People) are easy sells to economies in distress.

Krugman's solution is pure nonsense and demonstrates a complete and utter lack of understanding of how the economy works. 2008 was a financial panic, and the reason the economy isn't in a depression is because of the monetary policy of the Federal Reserve, not the Fiscal Policy of Washington. Give any competent administration 0% interest rates for an extended period of time and this economy would be booming, but give this Keynesian administration unprecedented monetary stimulus and the economy can't get out of first gear. The reason is simple, just like during the Great Depression, change instills uncertainty in the markets and uncertain markets contract, they don't expand. The fact that the video and Krugman only focus on government spending as the only solution highlight just how narrow-minded and ideological Keynesian economists tend to be. How else can you explain rational people continuing to support the economic policies that gave us the Great Depression, the stagflation of the 1970s and the current post-2008 Great Recession?

Just today, 09/09/2013, 5 years past the 2008 crisis, many manufacturers are citing government policy as a major obstacle to economic recovery. It is hard to have a sustainable economic recovery when the government is manufacturing the major economic headwinds. The unfortunate reality is that Keynesians like Krugman and Blodget appear oblivious to these concerns expressed by the nation's manufacturers, the people that actually create the jobs. If Keynesian economists don't take the time to understand even the basics, it is unlikely they will properly diagnose the problem, and without a proper diagnosis you can't develop a proper treatment plan to cure our economic ills.

NEW YORK (Reuters) - U.S. manufacturers are "cautiously optimistic" that growth will continue this year amid an uptick in sales and production, though many cite uncertainty over U.S. government policy as a concern, according to a survey from the National Association of Manufacturers (NAM)...Government policy continues to be a concern, according to the survey, with nearly three-fourths of manufacturers citing rising healthcare costs as their biggest challenge..."Many respondents noted uncertainties in the implementation of the Affordable Care Act as a major concern, and many are still unaware of their premium costs for next year," wrote Chad Moutray, chief economist at the National Association of Manufacturers. "There is a strong perception that these costs will rise significantly, particularly at the small and medium-sized level."

No amount of government spending can accommodate for the fact that uncertainty is holding this economy back. Government spending during a period where fiscal policy is contractionary is like spraying primer in a carburetor of an engine with its fuel line detached. Sure you get a sputter, but without an attached fuel line, the engine will simply die, there will be no sustainable running of the engine. By focusing on government, and ignoring the private sector, Keynesians have the carriage in front of the horse. Until Keynesians figure out that it is the private sector that grows the economy, and government spending is dependent upon tax revenues derived from the private sector, their experiments will continue to fail, no matter how many articles they publish in the New York Times or how many unemployed citizens vote for their candidates. Keynesian economics slowly strangle the Golden Goose of the economy, whereas Reaganomics force fed the Golden Goose antibiotic and steroid laced high protein feed. Ironically, Bill Clinton was a practitioner of Reaganomics. After failing to implement the Keynesian "Hillarycare," he cut capital gains taxes, deregulated the internet and unleashed the free market. He also was fortunate enough to have inherited peace and prosperity entering office shortly after Reagan/Bush won the cold war, so he was able to balance the budget after the Republicans took over Congress in 1994.

Compare Clinton's era to today. Obamacare, changing taxes, changing regulations especially related to carbon and banking and misguided spending priorities, and blocking job creating projects like the Keystone Pipeline simply won't result in a strong economic recovery. Money is the fuel to any economic expansion, and with banks fearful of lending and Obamacare providing an incentive for employers to cut back employment, it is simply difficult to create any expectation of a strong recovery. Government simply can't tax and regulate their way to economic prosperity. If Keynesian spending was the answer, Japan and Greece would be the strongest economies on earth ... but they aren't, not even close.

The facts are, this economy is abysmal. Five years past 2008, and the unemployment statistics highlighted in this video are horrific. Labor force participation rate is hitting a 35 year low, job creation rate is declining, almost the entire drop in the unemployment rate from 10.0 to 7.3 is due to people dropping out of the labor force, there is a persistently high unemployment rate, disability claims have been surging and if all the people that have dropped out of the labor force are counted the real unemployment rate would be 14%. 14% is a Great Depression Era level of unemployment, and this is 5 years post 2008, and unlike the Great Depression, monetary policy has been highly stimulative. The people that have dropped out of the labor force due to being "discouraged," are likely to return, so as the economy does begin to strengthen, unemployment would be expected to initially increase, as hope replaces despair and the discouraged workers return to the labor force. This paradox of stronger economic growth resulting in higher unemployment will certainly provide a confusing situation for the Fed and will likely prolong the "taper."

In conclusion, because the current administration is following a Keynesian model it is highly unlikely that the US economy will recover at a pace necessary to unwind the "taper" in a timely manner. Going forward I would expect economic growth to be anemic, inflation to remain subdued and unemployment to remain stubbornly high, and maybe even increase as more and more of Obamacare is implemented. The persistently high unemployment will prevent the Fed from quickly implementing the "taper" and will delay any increases in interest rates. I would imagine that 3% will serve as a ceiling for the 10-year Treasury bond rates, and represent resistance that will only be penetrated once a real recovery is underway. What this means for investors is that interest rate sensitive sectors like utilities/iShares US Utilities (NYSEARCA:IDU) that have been hit hard lately are likely near a bottom of this correction cycle, further talk of more QE will prolong the slow death of gold/SPDR Gold Trust (NYSEARCA:GLD) and silver/iShares Silver Trust (NYSEARCA:SLV) and interest rates should remain below average for the foreseeable future. Emerging Markets/iShares MSCI Emerging Markets (NYSEARCA:EEM) that have been harmed by the back up in rates will have their days of reckoning extended. Bottom line, as long as the current administration embraces Keynesian economics, I would not count on a sustainable and robust recovery anytime soon, and if we don't get a robust recovery, the Fed will be slow in executing the "taper."

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here