Each quarter the Fed releases their assessment of the economy along with their forward looking projections for three years into the future. (See Fed Projections Myth Vs. Reality for the June analysis) I started tracking these projections beginning in early 2011 and comparing the Fed’s forecasts with what eventually became reality. The problem has, and continues to be, is that their track record for forecasting has been left wanting. The reality is, however, is that the Federal Reserve simply cannot verbally state what they really see during each highly publicized meeting as it would roil the markets. Instead, they use their communications to guide the markets expectations toward reality in the hopes of reducing the risks of market dislocations.
The most recent release of the Fed’s economic projections on the economy, inflation and unemployment continue to follow the same previous trends of weaker growth, lower inflation and a complete misunderstanding of the real labor market.
When it comes to the economy the Fed has consistently overstated economic strength. Take a look at the chart and table. In January of 2011 the Fed was predicting GDP growth for 2013 at 4.0%. Actual real GDP (inflation adjusted) is currently running at 1.8% for the first half of the year or a negative 55% difference. The estimates at that time for long run economic growth was 2.7% which has now fallen to 2.3% which was guided down from 2.5% in June.
We have been stating repeatedly over the last 2 years that we are in for a low growth economy due to the debt deleveraging, deficits and continued fiscal and monetary policies that are retardants for economic prosperity. The simple fact is that when an economy requires more than $5 of debt to provide $1 of economic growth – the engine of prosperity is broken.
As of the latest Fed meeting the forecast for 2013 and 2014 economic growth has been revised down to just 2.1% and 2.95% respectively as the realization of a slow-growth economy is recognized. However, the current annualized trend of GDP suggests growth rates in the next two years are likely to be lower that that.
With more than 48 months of economic expansion behind us; this current expansion is longer than the historical average. Economic data continues to show signs of weakness, despite intermittent pops of activity, and the global economy remains drag on domestic exports. With higher taxes, government spending cuts and the debt ceiling debate looming the fiscal drag on the economy could be larger than expected. As I stated previously – this is most likely the reason that the Federal Reserve opted NOT to reduce their current ongoing quantitative easing programs despite market expectations to the contrary.
What is very important is the long run outlook of 2.3% economic growth. That rate of growth is not strong enough to achieve the “escape velocity” required to substantially improve the level of incomes and employment that were enjoyed in previous decades.
The Fed’s new goal of targeting a specific unemployment level to monetary policy could potentially put the Fed into a box. Currently, the Fed sees 2014 unemployment falling to 6.55% and ultimately returning to a 5.6% “full employment” rate in the long run. That long run rate was adjusted higher from the June meeting. The issue with this “full employment”prediction really becomes what the definition of “reality” is.
Today, average Americans have begun to question the credibility of the BLS employment reports. Even Congress has made an inquiry into the data collection and analysis methods used to determine employment reports. Since the end of the last recession employment has improved modestly. However, that improvement, as shown in full-time employment to population ratio chart below, has primarily due to increases in temporary and lower wage paying positions. More importantly, where the Fed is concerned, the drop in the unemployment rate has been due to a shrinkage of the labor pool rather than an increase in employment.
While the unemployment “rate” is declining, it is a very poor measure from which to benchmark the health of the economy. The drop in unemployment is primarily due to temporary hires, labor hoarding and falling labor participation rates. Real full-time employment as a percentage of the working population shows that employment has only marginally increased since the financial crisis. The drop in jobless claims does not necessarily represent an increasing employment picture but rather labor hoarding by companies after deep levels of employment reductions over the past 4 years.
When it comes to inflation, and the Fed’s outlook, the debate comes down to what type of inflation you are actually talking about. The table and chart below show the actual versus projected levels of inflation.
The Fed significantly underestimated official rates of inflation in 2011. However, in 2012 their projections and reality became much more aligned. Unfortunately, in 2013 the deviation between expectations and reality has once again surfaced as deflationary pressures have risen and current inflation, as well as forecasts, have dropped. The Fed’s greatest economic fear is deflation and the current drop in annual rates of inflation will keep pressure on the Fed to continue to accommodative policy active for longer than most expect.
However, for the average American the inflation story is entirely different. Reported inflation has little meaning to the consumer as the real cost of living has risen sharply in recent years. Whether it has been the cost of health insurance, school tuition, food, gas or energy – these everyday costs have continued to rise substantially faster than their incomes. This is why personal savings rates continue to fall, and consumer credit has risen, as incomes remain stagnant or weaken. It is the rising “cost of living” that is weighing on the American psyche and ultimately on economic growth.
The FOMC lives in a fantasy world. The economy is not improving materially and deflationary pressures are rising as the bulk of the globe is in recession or worse. The problem is that the current proposed policy is an exercise in wishful thinking. While the Fed blames fiscal policy out of Washington; the reality is that monetary policy does not work in reducing real unemployment or interest rates. However, what monetary policy does do is promote asset bubbles that are dangerous; particularly when they are concentrated in riskiest of assets from stocks to junk bonds.
The problem that the Fed will eventually face, with respect to their monetary policy decisions, is that effectively the economy could be running at “full rates” of employment but with a very large pool of individuals excluded from the labor force. Of course, this also explains that continued rise in the number of individuals claiming disability and participating in the nutritional assistance programs. While the Fed could very well achieve its goal of fostering a “full employment” rate of 6.5% – it certainly does not mean that 93.5% of working age Americans will be gainfully employed. It could well just be a victory in name only
With the Fed committed to continuing its Large Scale Asset Purchase program (Quantitative Easing or Q.E.), and deploying specific performance targets, the question of effectiveness looms large. Bernanke has been quite vocal in his testimonies over the last year that monetary stimulus is not a panacea. In his most recently statement he specifically stated that “fiscal policy is restraining economic growth.”
With the Fed now fully engaged, and few if any policy tools left, the economic effectiveness of continued artificial stimulation is clearly waning. Lower mortgages rates, interest rates and excess liquidity served well in priming the pumps of the real estate and financial markets when valuations were extremely depressed. However, four years later, stock valuations are no longer low, earnings are no longer depressed and the majority of real estate related activity has likely been completed. More importantly, the recent surge in leverage and asset prices smacks of an asset bubble in the making.
The reality is that Fed may have finally found the limits of their effectiveness as earnings growth slows, economic data weakens and real unemployment remains high. Reminiscent of the choices of Goldilocks – the reality is that the Fed’s estimates for economic growth in 2013 were too hot, employment was too cold and inflation estimates were just about right. The real unspoken concern should be the continued threat of deflation and the next recession.
One thing is for certain; the Fed faces an uphill battle from here.
Courtesy: Lance Roberts
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