Yesterday’s move by the Fed to begin tapering was
accompanied by a deliberately mixed bag of contradictory statements and
forecasts designed to sooth the market without actually changing much of anything,
although the stock market bought into the Fed’s reasoning with great enthusiasm
that is likely to be temporary. It
reminds us of the big one-day jump that greeted the Fed’s move to lower
interest rates in September 2007 just weeks before the market peaked.
The Fed tried to justify the tapering on the grounds that
the economy was improving, while simultaneously conceding that it was so
fragile it needed about two or more years of zero fed funds rates even though
the expansion is already in its 52nd month.. Yet the facts, as we outline below show very
little, if any improvement while the Fed’s own forecasts were not much changed
from their September projection.
In our view, the Fed is recognizing the diminishing
returns and potential damage from the continuation of QE3, and is thinking that
it had better start tapering now. In order
to justify the move, Bernanke had to talk about a better economy now, while
soothing the market with the stated intention of extending zero fed funds rates
well beyond the previous 6.5% unemployment rate benchmark.
While almost everyone seems to think that the economy has
shown a lot of recent improvement, the facts don’t seem to bear this out. For
the last few years, the economic numbers have bounced around from month to
month, but basically have stayed within a limited range without breaking out on
either the upside or the downside.
Payroll employment increased by an average of 191,000 per
month in the year ending November 2013, compared to 184,000 in November 2012,
and a high proportion were in part-time or low-paying jobs. Real consumer spending rose by 2.1% in the
year ended October 2013, compared to 1.8% in October 2012 and 2.3% in October 2011. Real Disposable income climbed 1.8% in the
year ended October 2013, and 1.7% in each of the prior two years. Industrial production was up 3.2%, 3.3% and
3.4%, respectively, in each of the last three years. Core new orders for durable goods have
slipped 4.3% in the last four months. Existing
home sales have declined on a year-to-year basis for the first time in 29 months
and the ongoing drop in pending home sales and the mortgage purchase index
indicate that the decline has further to go.
We also note that the Fed’s economic forecasts have consistently
overstated the economy’s strength. Using
the mid-point of their average forecast range, in January 2011, they projected
GDP growth of 3.7%, 4% and 4% for 2011, 2012 and 2013, respectively. The
results were 1.7%, 1.8% and an estimated 2%, respectively. In November 2011, the Fed forecast for 2014
was 3.6%%, and is now 2.8%. Their
September 2012 forecast for 2015 was 3.4% and has now been reduced to 2.9%.
Even the Fed’s so-called long-run GDP forecast has been
subject to reduction. It was 2.7% in January
2011, and 2.2% now. It has been reduced
in each of the Fed’s last three forecasts, which are made every three months. And interestingly enough, their current projections
for 2014 and 2015 GDP are actually lower than when QE3 started.
None of this is meant to blame the Fed. Forecasting the economy is an inherently tough
job, and nobody really gets it consistently right. In addition, monetary policy is not equipped
to deal with the many complexities of a modern industrial economy, particularly
with a dysfunctional fiscal policy pulling in the opposite direction.
We have maintained for a number of years that, following
a major credit crisis, household debt deleveraging would hold back economic
growth for many years, and that is what has been happening. We underestimated the positive effect Quantitative
Easing would have on the market as well as the ability of corporations to
increase profit margins in the face of tepid revenues. Now, with wages at an historical low and
profit margins at an historical high relative to GDP, the rubber band has been stretched
about as far as it can go, and the coming readjustment is likely to be painful
for the economy and for stocks.
