Thursday, April 05, 2012

Guest Post: First Quarter Economic Update by Dorothy Jaworski

The Fed Goes Too Far

First, let me say, we owe the Federal Reserve our gratitude. Their actions to ease in many ways during and after the financial crisis averted financial meltdown and produced results in an economy that is regaining its footing, albeit at a “frustratingly slow” pace.

The Fed lowered the Fed Funds rate to 0%, where it has stood for over three years. They purchased securities during the crisis and stepped up where they could as a lender of last resort. They embarked on quantitative easing, or “QE,” programs twice in 2009 and 2010, buying up $2.3 trillion of securities. Last summer, they went where no Fed has gone before and “promised” to keep rates low until 2013, then earlier this year extended the “promise” until the end of 2014. Last Fall, they embarked on “Operation Twist,” to sell shorter dated securities and buy longer dated ones in an effort to push long term rates down, especially to get mortgage rates lower to help the still struggling housing market. Ben Bernanke has been holding press conferences and the Fed recently published their first-ever rate forecasts—even though it was published on a scatterplot—that shows Fed members’ thoughts on where short term rates will go.

But we know that only three things in life are certain—death, taxes, and a Fed that goes too far. Despite the trillions of dollars used to buy securities and zero cost money, economic growth is struggling at 1.7% over the past year, which is one of the weakest recovery rates since the early 1980s. Of course, coming out of one of the worst recessions since the 1930s, any pace of growth has been nothing short of miraculous.

So what do we make of the latest idea that the Fed is floating? They want to go into a third round of QE, but they would purchase securities and borrow the money back short term. This latest idea would be a form of “sterilized” easing—allowing the Fed to buy long term securities (to push down long term rates) and borrow the money short term to keep the money supply from growing, and thus keep inflationary expectations under control.

So what will “sterilized” easing accomplish? In my opinion, nothing. It is not about money anymore, it is about psychology and a belief that we can do better as an economy without government interference and being flooded all over by money that will someday be difficult to pull out of the economy when the time to tighten policy arrives. Philly Fed president Plosser has stated recently that the Fed should only use its balance sheet as a crisis tool, not as a regular tool for monetary policy. For once, I agree with him.

Goodbye, Yield Curve

At this point, I believe this new idea would prove that they are clearly going too far. The sole purpose of such a move is to artificially push long term rates even lower than the unbelievable lows we have currently attained in an effort to manipulate the yield curve. This manipulation adds to their “promise” and “Operation Twist” and distorts the yield curve even further. The problem is that the yield curve has been one of our most reliable market indicators over the past several decades.

Generally, we use a yield curve to deduce whether inflation is an issue or the economy is expected to grow—through an upward sloping yield curve—or whether there is a poor economic outlook or recession coming—through a negatively sloping yield curve. Flat yield curves have typically resulted from Fed tightening and the creation of one from Fed easing will be highly unusual, but, alas, I think that is their plan.

From yield curves, we can calculate market expectations of rates in the future. Without such a reliable indicator, what objective signals will we get that the recovery is strong or weak? Fed “promises?” Scatterplots? I think we all know how this experiment is going to turn out.

A Fed That is Mad at Us

Chairman Bernanke has been on the warpath for the past several days. Apparently, he is not thrilled about the recent selloff in the bond market, that took interest rates up by .40% to .50% from the end of January into the third week of March; there was an especially nasty stretch of nine days from March 8th through March 20th, where rates rose continually each day before finally tempering their advance and falling back since the peak. Historically, the nine day streak is only the second of its kind since a similar streak in 1974—the other being during June, 2006.

Bernanke has been talking down recent economic good news and chastising the bond markets for allowing rates to rise, which could hamper growth. He must be angry that so many of us opposed his “sterilized” money scheme and are a little skeptical of his extended “promise” to keep rates low until the end of 2014. Maybe he was mad that investors were reallocating money from bonds into stocks. He didn’t mention the real villain—rising gasoline prices, which today stand at $3.90 per gallon, according to AAA, for the highest level ever recorded this early in the year.

The Tipping Point

Just when economic growth started looking better, with new job growth of 200,000 per month in four of the past six months, we run into the same old nemesis—rising gas prices. It is no surprise that growth slowed in 2011 as gas prices reached a “tipping point” of $4.00 per gallon in May that caused consumers to dramatically slow other spending.

The media keeps speculating that gas prices will reach $5.00 per gallon by Memorial Day. This doesn’t help with consumer psychology and, if gas does reach $4.00 or more, we can expect the same psychological reaction from consumers—reduced spending—just as they would react to higher taxes. Let’s hope that the rise in oil and gas prices this year will again prove to be “transitory,” as Ben Bernanke has been claiming once again. Every one cent rise in gas prices leads to $1 billion annually in extra consumer spending on this volatile liquid and $1 billion less spending on other goods and services.

Slow growth, slow improvement. That is what is happening in the economy. The recovery is at its most vulnerable. High oil and gas prices could push us to slow growth, no improvement, which could once again cause job losses. We do not want to see consumer psychology in this scenario.

Stocks Rock On

It is no surprise that stocks began to do much better as the economic data began to strengthen late in 2011 and into this year. Stocks were virtually flat in 2011 as the markets improved early, sold off in a horrible third quarter, and quickly regained the flat line. Year-to-date in 2012, the S&P 500 and Nasdaq indices are up 12.6% and 20%, respectively. The price-earnings multiple on the S&P is 13.4 times and the dividend yield of 2.1% is approximately equal to the ten year Treasury yield.

Stronger growth, with real GDP at record dollar levels, has been translating into stronger corporate profits. The S&P now tops 1,400 for the first time since late 2007 and Nasdaq now tops 3,000 for the first time since 2000. Momentum is clearly driving the markets, as well as Bernanke’s campaign to keep returns on bonds artificially low for a long time. But remember that the markets do not usually go up in a single straight line—especially during a presidential election year. Stay tuned.

Thanks for reading! DJ 03/27/12

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.

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