The big shortcoming being exposed by the Fed’s talk of tapering QE isn’t just that it’s premature. The central bank could have had its cake and eaten it too by using the “T” word and then in case of overreaction, sending minions out to reassure investors that it didn’t mean it, really, they just had to say it to appease the hawks (not in that formula, mind you, the mere fact of running around and looking concerned about markets having a bit of a swoon is more important than content). It’s that any QE exit subjects the Fed to conflicting objectives and Mr. Market may have finally awoken to that fact. It didn’t help matters that the World Bank injected a further dose of reality and cuts its growth forecast to 2.2% (aside: how anybody believed their initial rose-colored-glasses projections for the year is beyond me).
Plus, to make matters worse, the Fed clearly has no idea, really, how to exit (will it really just “taper” and announce a reduced amount per month? Will it cut the amount purchased one month or two and see how that goes and then announce a plan? Investors got a sense of confidence knowing the Fed would be buying on a regular basis, even though setting quantities meant the central bank was not and could not control the rate impact. So the focus on quantities rather than rates makes it very hard for the Fed to ease out gracefully).
Now Bernanke & Co. might have assumed that enough insiders understood that nothing was happening any time soon so that any market tsuris would be short lived. As Bloomberg reported last week:
Chairman Ben S. Bernanke needs to see four months of job growth averaging at least 200,000 to justify reducing the pace of asset purchases, according to Vincent Reinhart, a former director of the Fed’s Division of Monetary Affairs. Roberto Perli, a former researcher in the division, said the central bank would need to see that pace “through the summer.”…
“I don’t think today’s report says anything about tapering at all with unemployment going higher and metrics in terms of the work week and wages being very dour,” Gross, founder of Pacific Investment Management Co., said in a radio interview on “Bloomberg Surveillance” with Tom Keene and Mike McKee. Bernanke “won’t taper. But I think ultimately in order to get a more normal economy, the Fed has got to move interest rates up to more normal levels.”
Boston Fed president Eric Rosengren and Chicago’s Charles Evans, both voting members of the Federal Open Market Committee this year who have consistently supported increased stimulus, have cited job growth of 200,000 as a benchmark for labor-market improvement.
Now some economists thought the Fed might act on lower job numbers, But as our employment commentator Hugh pointed out in his assessment of the latest jobs report, May in fact is typically one of the best months of the year for job growth, and it was just not good enough. And that’s before you get to the fact that the taper talk alone has goosed some key rates, most important, mortgage rates. Admittedly, as we’ve also discussed, that could lead to a short-term buyer rush to lock in mortgages now, but that’s simply pulling housing demand forward and would be reflected in relative weakness later in the peak selling months even if rates stayed flat.
But the failure of anyone in a position of authority to come forward and qualify the “T” word has led to escalating investor worries. Some of this may be outcomes the Fed quietly approves of, like the yen’s rise to 94 to the dollar. That should please China and South Korean officials (the South Koreans were particularly vocal about the yen’s decline when it had reached 100 to the dollar), but has steepened the slide of the Nikkei, which was down over 6% today and entered official bear market territory, and Hang Seng fell over 2%. European equities are rocky too, with the FTSE down 1.1% and the DAX nearly 1.7% lower.
Although Abenomics apparently has produced a strong gain in Japan’s last quarter GDP, as far as the Nikkei is concerned, the index has lunched from 7,000 or so to roughly 14,000 or so for the last 20 years. It would be ironic if all these heroic measures did in the long run was raise the top of the range by 10%. The “T” talk more generally has led to an exodus from emerging markets, with Japan being treated as an honorary member of that group.
This is all having a 1937 or a 1997 feel about it. In both cases, the authorities (in the US in 1937, in Japan in 1997) talked themselves into thinking that stimulus had gone on long enough, that the economy was enough better, therefore it was time to take the foot of the pedal. In both cases, the economies went into reverse pronto. Now this time around, the result is likely to be less dramatic, at least in the US, because we’ve got more automatic stabilizers and the severity of the crisis, and the degree of overt stimulus, was vastly less than in our Depression or in the early part of the lost decades in Japan. But we are nevertheless cutting Federal spending prematurely. As we’ve discussed, when you have the business sector net saving (as it did even in the last expansion) and you have households saving (which they do in aggregate; a few quarters in the early 2000s were noteworthy departures from this long-established norm), and you are running a trade deficit, you NEED the government sector to run a deficit, or the economy contracts. And if the economy contracts, all those debt to GDP ratios certain economists fetishize get worse.
The Fed conundrum is that its rate policy appears to have an asymmetrical impact. As many economists have argued, it doesn’t and can’t do much for the real economy. But all Fed’s and Treasury’s insistent cheerleading and mortgage-bond focused QE have goosed the stock and housing markets and more animal spirits at least in some sectors and regions. Our reader economic reports from around the country suggest that certain affluent communities (large swathes of DC and Silicon Valley, some parts of Seattle and LA, Honolulu, for instance) are hot. North Dakota has low unemployment. But lots of the county appears to have come off the bottom but has more or less stagnated, or has an appearance of recovery in some sectors but on weak foundations. So the recovery is, consistent with national data, mainly an upper class phenomenon, with the rest of the country left behind. And while monetary policy isn’t so hot at producing real economy growth, raising rates will choke off activity. So it will be interesting to see, if the Fed does not decide to talk nice to the markets, how strong that effect will be at a low level of nominal rates. The further problem is with inflation continuing to fall, if the Fed does not talk interest rates back down, that the increase in nominal interest rates will exceed the increase in real rates.
The real reason for the volatility is that investors may fear not just an increase in rates, but a suspension of the Bernanke put. Unlike Greenspan, who made an art form of misdirection, Bernanke and his minions can’t figure out how to square the circle of letting investors believe they have a floor under the markets while withdrawing QE-induced negative real interest rates. We’re likely to see a continuation of volatility until either Fed officials soothe investors’ rattled nerves or economic data comes in soft enough to reassure them that the arrival of the dreaded “T” event is further away than the Fed tea-leaf readers had hoped.