As expected, the Federal Reserve stuck to its pattern of reducing asset purchases by another $10 billion. The monthly pace is now down to just $35 billion, consisting of $20 billion in Treasury bonds and $15 billion in mortgage-backed securities (MBS). While we’re not surprised by the Fed’s announcement, we do think there may have been a bit more than the usual consternation over the decision this time. After all, everyone (including the IMF, the World Bank, and the Fed itself) is taking down their estimates for full-year GDP growth following the downward revision to the first quarter (from +0.1% to -1.0%).
The reasons for the abysmal first quarter are well documented. Poor weather constrained investment and exports, while slower inventory growth (somewhat related to weather) was a major drag on growth as well. If ever there were good excuses for negative growth, these are they. Why? Because bad weather and inventory growth will prove to be temporary, transient drags on growth. We have little doubt that growth will return to more respectable and solidly-positive territory in the second quarter.
Indeed, the storm seems to have passed for now. We have undoubtedly received some more positive economic data in recent weeks, including various manufacturing indicators, consumer confidence, and vehicle sales. This positive data, combined with a spike in the Consumer Price Index (CPI) in May, led most all economists to accurately predict a “stay-the-course” strategy for the Fed this time. A small minority, however, are beginning to speculate that the Fed may remove its monetary support at an even faster pace. These hawks point to the fastest increase in core CPI (excludes volatile food & energy costs) since August, 2011. Given that the Fed has a dual mandate of maximum employment and stable prices, it is easy to see how Fed members could have been spooked by that report.
But there are other economic indicators (and perhaps more important ones) that suggest to me that we are still not on course to break out of our 2% growth trend. Yes, the unemployment rate has drifted much lower over the past several years. But the quality of new jobs remains poor (read: low-paying). Moreover, wages and median incomes among those fortunate enough to have jobs have not been able to keep up with inflation. Real median household income remains well below its peak in 1999. And perhaps the most telling barometer of labor market health, the participation rate, continues to hover at its recent lows. A low participation rate suggests to me that opportunities are not attractive enough to lure job-seekers back into the pool.
With regard to the housing sector, recent data are suggestive of a slowdown from the mortgage-rate-induced spike in activity from 2011 to mid-2013. Housing price increases have slowed while sales of existing homes have dropped sharply from last year’s highs. Those making their living in the residential housing sector (mortgage brokers, real estate agents) will argue that “mortgage rates remain low compared to historical averages”. But this is a fallacious argument as housing prices have reset significantly higher to reflect the ultra-low mortgage rates of recent years. As a result, a 1% increase in mortgage rates has clearly had a negative effect on housing activity.
Last Thursday, we learned that Retail Sales grew just 0.3% in May while sales excluding autos and gas were flat. If consumer spending represents 70% of the economy, how can these numbers be construed as anything but disappointing? Despite trillions of dollars in fiscal and monetary stimulus over a period of five years, the large majority of Americans are still not feeling confident or able enough to open their wallets. Underemployment is rampant, and wage growth is anemic. It remains hard to paint any other picture than our consumer-centric economy remains stuck in low gear. In other words, we need more than just stock and housing price increases for the one-per centers to get the economy on a clear and sustainable growth path.
Importantly, the economy’s failure to break out as many had hoped will likely result in a Federal Reserve that remains engaged in supporting asset prices. Having said that, as it stands today, it does not appear to me that the data are dire enough to cause the Fed to stop or reverse the taper. However, I won’t be surprised if and when it happens. The economy is simply not strong enough to support higher interest rates. And now we have a new wildcard being introduced into the equation: higher energy prices. Therefore, the evidence continues to suggest that there will be a ceiling on the pace of economic growth we can expect for a while.
With regard to stock prices, it is clear that the Fed remains married to its strategy of boosting asset prices as a way to prime the economic pump. Even more troublesome to me, the Fed appears to have expanded its mandate so that it is now responsible for protecting the economy (and stock investors) from any given unforeseen shock. All significant “corrections” in the stock market over the past few years have consistently been met with a response from the central bank. Therefore, the investor “complacency” that we’ve witnessed in recent years should not be construed as irrational. Instead, the Fed has conditioned investors to be complacent as it has repeatedly come to the rescue at any sign of trouble. This is clearly an unsustainable way to run a central bank.