The Federal Reserve’s open window for ending quantitative easing may not last longer than this FOMC meeting or the next. Any number of economic, political or bureaucratic developments could slam the window shut. If the Fed is to act on a change of monetary policy, it may have no choice but to move now, despite the equivocal nature of the economic evidence.
Here is the logic for tapering:
1. The economy is better. Maybe the improvement is minimal but it is enough for the Fed’s purpose. The risk of recession is discounted. Although job creation has been declining slowly over the past twelve months, from 208,000 and 207,000 in the last quarter of 2012 and the first quarter of this year, to 182,000 in the second quarter and to 137,000 in the first two months of the third quarter, it remains passable. That would change quickly with a poor report for September and the revisions in August are worrisome.
GDP jumped to 2.5% annualized in the second quarter from 1.1% in the first. Neither payrolls nor GDP are likely to match first half performance in the second. The economic history of the past three years with better statistics and activity in the first half of the year is a warning. Between an economic past that is acceptable and a future that is at best uncertain and could be derailed by a run of bad statistics or any number of events in a dangerous world this may be the best economic window that the Fed will see.
2. Quantitative easing was intended to be a temporary expedient. In the Fed’s own analysis it has not been very effective at fostering economic growth. Its intent was largely psychological, to create a ‘wealth effect’ through higher equity prices that would circle back to the real economy in higher consumer spending and perhaps investment. The Dow is up 20% this year on 1.8% economic growth in the first half. If the ‘wealth effect’ were real, the economy would be booming. Whatever the positive impact of easing, it has probably run its course.
3. Quantitative easing is producing distortions in some important markets. Equities have become highly dependent on the perception of unlimited Fed support, as have bonds. When Ben Bernanke seemed to confirm on June 19 that quantitative easing would diminish by $20 billion at the September meeting, the Dow dropped 764 points, 4.9% to June 24th.
From May 2012 to April 2013 the yield on the 10-year generic Treasury averaged 1.74%. The 20-year average is 4.6%. The 10-year Treasury yield has been rising and bond prices falling since early May. Bernanke’s June 19 assertion sent that into overdrive. While it makes economic sense to make the adjustment to more normal rates as gentle as possible, hence the Fed’s jawboning on rates in July, the longer the wait to begin the more difficult the weaning of the markets will be.
The Case/Shiller 20 city year-on-year home price index was 12.7% higher in June, the fourth month in a row of double digit gains. Prices are nowhere near as frothy as at height of the housing bubble. From 2003 to 2005 prices rose an average of 14.1% each year, a 42% gain in three years, with many individual markets far outstripping the nationwide performance.
Unemployment averaged 5.5% in those years with an employment rate (labor force participation rate) of 66.1%. Unemployment is currently 7.4% with the participation rate at a 35 year low of 63.2%. Household income is lower than at the start of the recession.
Even with the fall in home prices since the collapse of the housing bubble, prices are still above the long term Federal Housing Finance Agency trend. It is hard not to assume that a good portion of the recent trend in prices is due to the market support from excessively low interest rates. Housing starts and building permits have dropped 10% and 5% respectively from their levels earlier in the year.
The farther the markets rise, the greater the potential fall and economic damage when rates normalize.