Comstock Partners, Inc.January 26, 2012
The Fed Is Worried----And You Should Be Too
The Fed is worried, and you should be too. That is the major take-away from yesterday's FOMC statement, combined with its release of updated projections and Bernanke's press conference. Despite the market's cheering of the promise of a near-zero fed funds rate until late 2014 and the prospect of QE3, the Fed is fighting a lonely battle against severe economic headwinds----and they know it. In answering a reporter's question, Bernanke made it crystal-clear that he does not believe that the recently optimistic economic releases are sustainable. He has good reason to think so.
The FOMC reduced its current central tendency 2012 GDP growth projection from 2.5%- 2.9% to 2.2%-2.7% and its 2013 number from 3.0%-3.5% to 2.8%-3.2%. The previous projections were made in November. Although they reduced their unemployment projection slightly, they are still projecting unemployment rates as high as 8.2% to 8.5% for 2012 and 7.4% to 8.1% in 2013.
It's significant that these reductions were made despite better than expected economic releases in the last few months in jobs, production and consumption. Although some may wonder what the Fed knows that others don't, the reasons for their caution are no mystery to anyone familiar with the numbers. Disposable income is growing very slowly, and even this tepid pace is a largely a result of temporary tax cuts and transfer payments, while real wages are flat. Consumer spending growth was supported mainly by a reduction in household savings rates from 5% in June to 3.5% in November. December retail sales have already weakened as holiday sales were disappointing.
Employment growth is still not enough to raise real wages or reduce unemployment by much. While initial unemployment claims have declined, new hiring is still disappointing and household wealth has been declining as a result of the continuing slide in home prices. We also point out again that household debt is still far too high and there is a long period of deleveraging ahead, meaning more saving and less spending.
Capital spending growth is likely to slow down as well. While today's report on durable goods orders for December was fairly strong, few mentioned that the 100% tax credit for capital goods spending expired at year-end. It is highly likely that potential orders for 2012 were crammed into 2011. Exports, too, will probably be impacted by the turmoil in Europe and the slowdown in global growth including the emerging nations and China.
All of these headwinds are valid concerns even before considering the risks associated with the EU debt crisis, potential conflict with Iran, the outcome of the Arab Spring and uncertainty in Iraq, Afghanistan and Pakistan. And let's not forget the continuing paralysis in Congress regarding debt ceilings, deficits, budgets, taxes and efforts to increase jobs in the middle of an election year.
In our view the Fed's new policy is an act of desperation rather than something to celebrate. The FOMC has used all of its conventional weapons and a lot of unconventional ones and is essentially out of ammunition. The banking system is swimming in excess reserves that it is not using----adding more won't make much of a difference. This is a classic liquidity trap where further easing will not be much help. The stock market strength assumes that the economy is getting stronger and that company earnings will remain at elevated levels. We think that this will not be the case, and that the market is subject to substantial downside risk.