Prior to the Federal Reserve’s September policy meeting the markets, and analysts, had almost universally accepted a cut in the current quantitative easing (QE) program of $10-15 billion in bond purchases each month from the existing $85 billion program. Those expectations were built upon the tacit belief that the economy was improving and set to expand much stronger in 2014. Even the Federal Reserve initially confirmed these sentiments by stating in their post-meeting announcement that:
“Information received since the Federal Open Market Committee met in July suggests that economic activity has been expanding at a moderate pace. Some indicators of labor market conditions have shown further improvement in recent months, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has been strengthening…”
However, the “shock” came when the Federal Reserve went against the consensus and stated that they would continue the current QE program “as is” with no reductions in the amount of bond purchases.
“However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.”
Here is the question that should be asked:
“If the economy, labor markets and housing are improving due to the current ‘appropriate policy accommodation’ then why is a reduction in the ‘life support’ not appropriate to determine if the these areas of the economy are indeed functioning organically?”
It would seem to be a prudent approach to reduce the amount of monetary stimulus to “test”the economic strength while also reducing the possibility of further inflating a speculative asset bubble. Mike O’Rourke at Jones Trading made a very interesting statement yesterday in this regard:
“Right now, the FOMC has ‘a tiger by its tail’ – it has lost control of monetary policy. The Fed can’t stop buying assets because interest rates will rise and choke the recovery. In short, today’s decision not to taper was driven by unimpressive economic data, the fear of a 3% yield on the 10 year Treasury and gridlock in Washington. If the economy cannot handle a 3% yield on the 10 year, then the S&P 500 should not be north of 1700. It is remarkable that the equity market continued to buy into easy money over economic growth. QE3 has been ongoing for nearly a year and the economy is not strong enough to ease off the accelerator (forget about applying the brake). Simultaneously, the S&P 500 is up 21% year to date and the average share gain in the index is over 25%. Maybe today’s action will turn out to be short covering, but if it was not then paying continually higher prices for equities in a potentially weakening economy is a very dangerous proposition.”
Mike is absolutely correct about the economy not being able to handle a 3% interest rate. The Fed missed an opportunity to “ease off the accelerator” and judge the results. The problem that the Fed faces now is not just the threat of a weak economy but the potential of an asset bubble driven by a speculative driven push into the equity markets. I do disagree with the statement that if the Fed stops buying bonds rates will rise. I discussed recently in “QE – The #1 Threat To The Economy:”
“The reality is that the Fed’s intervention programs are what is causing rates to rise currently. The chart below shows the 10-year Treasury rate on a 6-month rate of change basis. As you can see volatility in rates was more tied to variations in economic activity in years leading up to 2009. However, once the Fed begin its various intervention programs volatility spiked dramatically. “
This is important because the Fed specifically stated in their commentary that:
“Taken together these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.”
The problem is that these actions are not leading to stronger economic growth or lower interest rates. These programs are leading to speculative investment into the financial markets, as well as the housing market, which is potentially creating an asset bubble and pricing first time home buyers out of the market.
However, the weak economic reality is most likely NOT the reason that the Fed decided not to taper. The real reason was something far more immediate.
At the end of 2012, as the Republican Congress squared off with the Democratic Senate and White House over the “fiscal cliff” debate, Bernanke feared that the economy would be pushed into recession should a breakdown in fiscal policy occur. In a rush the Federal Reserve announced that they would increase their bond purchases to $85 billion a month to provide a floor of support beneath the financial markets and the economy. This action may have been a bit premature as the Republican Congress rolled over and acquiesced to a deal that bypassed the worst of the 2011 Budget Control Act. They then passed a “Continuing Resolution” which kept the government operating by temporarily eliminating the “debt ceiling.”
The problem for the Federal Reserve currently is that they are once again facing an issue that nearly cratered the markets, and the economy, back in 2011. As we quickly approach the limit of the government’s borrowing capability the threat of a government shut down and “debt ceiling” debate once again looms. Bernanke is currently fearful of such a repeat event given an already weak economy coupled with rising interest rates. Any shutdown of the government, fear of “default” or restrictive fiscal policies could collapse what incremental recovery there has been to date.
Therefore, at least for now, the clearest path for the Federal Reserve was to risk the building of an asset bubble, which they feel that they can control the deflation of, versus an economic drag that pulls the economy back into a recession. Unfortunately, there is absolutely no historical evidence that the Fed can control the deflation of an asset bubble.
The interesting question becomes what happens if the current Administration quickly comes to an agreement that raises the debt ceiling, increases government spending with few, or no, tax increases? The removal of such an impediment, supported by $85 billion a month in liquidity, could easily send stocks into a “melt up.” At that point will the Fed act between meeting to begin to reduce, or eliminate, the current QE programs? Or, will they allow asset prices to push higher as they wait for real economic growth the strengthen?
It seems like we are leaving an awful lot of our economic, and financial futures, based upon assumptions of a small group of economists. Maybe it really is time to worry?Courtesy: Lance Roberts
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