Fed Failing Both Mandates

by: Amit Chokshi, CFA

Despite numerous data points suggesting an economy facing a second half slowdown to a potential double-dip, the Federal Reserve has been surprisingly complacent in addressing this potential stumbling block. This is peculiar because the Fed has a dual mandate -- achieving maximum sustainable employment and maintaining stable prices -- and is clearly failing at both of these goals yet has made no moves to address either mandate.

According to the Congressional Budget Office ("CBO"), the peak of the American Recovery and Reinvestment Act ("ARRA" or stimulus) likely occurred in Q2 2010 and its impact on the economy will begin to decline steadily through the rest of the year. Perhaps not surprisingly, equity markets peaked during Q2 2010 in anticipation of the moderation in the economy in subsequent quarters. As fiscal stimulus rolls off, the economy will be left to fend for itself with unemployment at unacceptably high levels and with most of the inventory correction, which was a large contributor to GDP growth in recent quarters, largely over. The US economy will be shifting gears from having modest tailwinds that helped heal the economy to having staunch headwinds that could stunt the economic recovery.

Additional fiscal stimulus would make the most sense in getting the economy back on track but the first stimulus package was poorly structured and not large enough to be effective despite the $787B price tag. This may seem like a lot but in the context of the economic collapse, the overall stimulus package was far too small. This was noted during discussions of ARRA in early 2009 as a number of economists suggested a much larger and properly structured stimulus package was needed to address the economic shortfall.

In fact, in May 2009, the Center for Economic Policy & Research ("CEPR") published a report that predicted that ARRA's overall contribution to the economy would fall short of what was needed. This was because CEPR estimated that the collapse of the housing bubble and its second and third order effects would yield a decline in annual demand of $2.1T. The net impact of ARRA would be just about $183B on average under a variety of economic scenarios projected by CEPR.

The reason was because a number of ARRA's components would essentially be bandaids for various shortfalls rather than be truly stimulative programs. For example, state revenues were hammered due to the economic slowdown but must maintain balanced budgets. This led to a combination of spending cuts which would sap over $100B annually. ARRA's components in some cases were proceeds used to help offset these declines so relative to the baseline, these proceeds would have no net stimulative impact.

So while the data presented by CBO demonstrated that ARRA has had a positive contribution to GDP, overall it's been much weaker than it could have been and its duration is far too short given the health of the economy. More importantly, its ineffectiveness relative to what could have been has likely sapped the political firepower to enact a second, better targeted stimulus program. This is rather unfortunate given the message transmitted by capital markets (very low borrowing rates).

For example, Bloomberg reported that: "For the first time since the government started collecting the data, central banks, mutual funds and U.S. banks are buying more government securities at Treasury auctions than Wall Street’s bond dealers." This is a huge sign of risk aversion by market participants but also signals a growing concern for deflation. With bid-to-cover ratios at 14 year highs, there's significant demand for Treasuries which would mean the US could easily enact another stimulus program. Nonetheless, historically low yields and strong investor appetite for Treasuries are not likely sufficient to enable a second stimulus program.

This gets back to the Fed. While fiscal policy would be the best option to address the economy, the political climate appears to make it a non-starter. As a result, the Fed could implement monetary policy actions as another, albeit less optimal, option. The Fed should be getting aggressive, particularly when data illustrates that there is no inflationary fear that would threaten price stability and the fact that there's plenty of slack in the labor market.

The Fed has set its inflation target at 2% but recent data from the Consumer Price Index ("CPI") suggests that the US is close to deflation. Right now the favored word is disinflation but given three consecutive months of CPI declines of at least 0.1% indicates real deflationary price pressure. Deflation paired with an economy that is in the doldrums can be very problematic. The reason is because when participants observe price declines, it encourages postponing purchases and investments which is what drives economic growth. As these investments are delayed, hiring continues to be anemic as does wage growth. In fact, wages can experience additional pressure in a deflationary spiral.

With the reported unemployment rate at 9.5% and other, broader unemployment measures in the mid teens along with work week hours near historic lows, there's a tremendous amount of slack in the labor market. Combine that with the threat of deflation and the economy can be derailed in short order. A reader may question why the economic recovery could be this fragile or derailed this quickly and the answer is related to debt levels.

Wage and income growth has been stagnant for the past decade and are unlikely to rise at a healthy clip. The data clearly shows there are far too few openings relative to the employment force. The average time needed to find a job is just over 35 weeks, the longest in the post-war era. The closest comparison was 21.2 weeks during the 1980s, according to Harris Private Bank. In addition, the fiscal stance (lack of interest in stimulus) and general societal views regarding stimulus (through the initial poor structuring of it) amounts to a Marie Antoinette "Let them eat cake" attitude by policy makers.

As a result, even if the US can experience 3% GDP growth compared to the 2% GDP growth likely to be realized, it will take another three to four years to get unemployment down to pre-crisis levels. So it's very unlikely that there will be any real wage growth so if you are a household with a considerable level of debt through mortgages and consumer finance loans, it's going to be very difficult to get out from under that debt overhang solely though wage growth.

What's needed to alleviate household balance sheet pressure is inflation. Basically the Fed should realize that the data indicates that household debt levels will not improve through cash flow improvements (wage growth) but needs to improve through balance sheet improvements meaning the typical US household needs asset inflation. In a deflationary environment, asset values become compressed. If you have a $400,000 mortgage and a $500,000 home, it's possible that over the past two years that your home is worth $450,000 or less depending on where your location is. That mortgage is still the same value however and if deflation does take hold, then greater number of households will potentially be underwater across their various levels of debt.

If the Fed realizes wage growth will remain under pressure and thus inflationary risks stunted, it should raise its inflation target and implement actions to stoke inflation at 2-3%. In this case, even if real wage growth is at 0%, a household in this example could see the value of their home and commensurate equity improve over the course of 3-4 years. That would be a significant benefit to the economy as numerous studies have demonstrated that the housing wealth effect is a key driver of consumption. A 2006 paper by the National Bureau of Economic Research ("NBER") found that "the marginal propensity to consume from a $1 change in housing wealth is about 2 cents, with a final long-run effect around 9 cents." In addition, the report found that the "housing wealth effect that is substantially larger than the stock wealth effect."

These two conditions should encourage the Fed to break out the heavy artillery given we are at the cusp of deflation and highly stubborn levels of unemployment. However, some of the Fed members still discuss whether tighter policy is warranted which demonstrates a bit of a disconnect with reality. What the Fed should be doing is signaling that they want to deliver higher inflation rates down the road. This would in theory force economic activity to occur now rather than later.

One way of doing this would be for the Fed to enact Quantitative Easing 2.0 ("QE2"). The Fed could buy up longer dated US Treasuries. The challenge would be that at the zero-bound, the Fed would have to buy a massive amount to have a meaningful impact. For example, the Bank of Japan bought amounts of Japanese debt equal to Japan GDP over the years but despite this, about 20 years later, Japan is still mired in deflation. This example demonstrates inflationary concerns are really laughable in the context of the situation facing the US and that the Fed should take as aggressive a stance as possible to stamp out any potential deflationary threat. The Fed could buy up Treasury issued debt and rebate the interest back to the Treasury, basically stimulating the economy at a very low to essentially no cost. The Fed could also invest in private debt as well.

The Fed could also stop paying banks for sitting on reserves. Right now banks are paid interest by the Fed to maintain reserves. If the Fed stopped paying the banks, it could help them reduce excess liquidity in the banking system. As an investor in various banks, I am a bit more pragmatic about what that excess capital could be used for. Lending would be a good use of the capital but with many banks having high levels of liquidity and trading at low multiples of P/Tangible Book Value, these banks could also be incentivized to conduct massive share repurchases, in effect boosting their own equity values down the road as their balance sheets further recover.

The main challenge is that given the zero-bound the Fed is currently at, the impact of monetary policy will be muted relative to normal times. Fiscal policy measures would make the most sense but that appears to be off the table. As a result, while not the most optimal measure, the Fed really should start considering acting now to try to address the deflationary instances that are now creeping up on the US economy. Unfortunately, the Fed seems to believe its tools should be reserved to solely help banks and financial services companies and not the households struggling in part because of failed prior Fed policies which contributed to this economic downturn.

Originally posted on July 20

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