“Overall, if we were in a car, you might say we’re motoring along, but well under the speed limit. The fact that we’re cruising at a moderate speed instead of still stuck in the ditch is due in part to the Federal Reserve’s unprecedented efforts to keep interest rates low. We may not be getting there as fast as we’d like, but we’re definitely moving in the right direction.”
If the economy were a car, Congress would be in the driver’s seat and the U.S. Federal Reserve would be behind it, pushing.
In May, Federal Reserve Bank of San Francisco President John Williams delivered a speech on the economy outlook and monetary policy that outlined one basic idea: we’re moving in the right direction. Like other members of the Federal Reserve System, Williams built a case for the improving health housing market — 45 percent increase in new housing construction starts, 16.6 percent increase in residential construction outlays, 29 percent increase in home sales, and a 10.2 percent increase in home prices — and suggested that businesses, though still cautious, are increasing both spending and hiring.
To be clear, the strength of the recovery in the housing market has a lot to do with monetary easing. Accommodating policy even at near-zero interest rates has helped keep mortgage rates low — currently approximately 3.5 percent for a 30-year fixed rate — and has made credit more easily available to builders than it otherwise would be given the economic downturn. The overall effect is increased supply and demand, which are both good, although there are some problems with how this is currently playing out (read more on this).
Lower interest rates have also been a stimulant for equities, which are currently trading at or near record highs. Although the bull market has helped return a lot of wealth lost during the crash, the good mojo hasn’t been spread out evenly among income classes. Data from Pew Research show that more than half (53 percent) of Americans own absolutely no stocks, including retirement accounts. What’s more, just 15 percent of households earning less than $30,000 per year are invested in the stock market, meaning that most of the gains from the bull market have been distributed among higher income earners.
The trick in evaluating economic health in the post-recession era is how to differentiate between what is real and what is artificially inflated from loose monetary policy. Few things have been more discussed recently than the effect that ongoing quantitative easing has had on stock prices, and what sort of withdrawal the markets will suffer when the program is tapered and eventually ends.
There is little doubt that Mr. Market will react to any announcement that QE will be tapered. The question investors are asking themselves are: when will that be, and by how much? The second question is arguably much more difficult to answer, and in many ways depends on Mr. Market’s mood. But the Fed has gone a long way in answering the first question.
Chairman Ben Bernanke’s recent testimony before Congress demonstrated that even nebulous speculation about the future of quantitative easing has the ability to turn global markets on their head. Markets around the world experienced a period of volatility, some of which is still being felt, after his comments and the release of the minutes from the previous FOMC meeting.
The current balancing act between the markets and the Fed is one of information equity. The markets want to know exactly what to expect, and when. With this in mind, the Fed adopted an additional unconventional policy and explicitly set a 2.5 percent inflation threshold and 6.5 percent unemployment target as the minimum criteria for a policy rate move.
By setting forward guidance as a function of labor market conditions, the Fed is trying to avoid a pessimistic signal problem. Bernanke and other Fed System members have made it clear that they are taking a data-driven wait-and-see approach to policy. Speaking before Congress, Bernanke said that: “We’re trying to make an assessment of whether or not we have seen real and sustainable improvement in the labor market outlook. This is a judgement that the committee will have to make.”
This judgement component of the strategy is what seems to have markets on edge. During the hearing, Bernanke said that if conditions change fast enough, policy could change in the next few months. Speaking in Sweden on Monday, San Francisco Fed President Williams suggested that conditions are at or nearing the condition of sufficient improvement.
“It really is a question for me of watching for continuing signs in the U.S. labor market, continuing signs of more greater confidence in the momentum in the U.S. economy, but also watching carefully where the underlying inflation rate is and what the outlook for inflation is,” Williams told reporters.
The balancing act that the Fed is dealing with right now is largely the result of mixed economic signals. Unemployment has edged down at a fairly quick rate over the past few months, but it’s unclear to some economists whether this is real growth or a byproduct in the reduction of the labor force participation rate. A healing labor market and improving consumer confidence suggest a robust recovery, but GDP growth remains slightly below what many economists would call ideal.
On the other side of the equation, low inflation and concerns about mounting deflationary pressures sends signals that the Fed should increase purchases. Williams noted that underlying inflation is roughly 1 percent, well below the Fed’s 2 percent target. “If we see continued low inflation and, more worrisome, a fall in long-term inflation expectations, well below 2 percent, then those would be factors that argue for, all else equal, greater total purchases for our program than otherwise,” he said.
Echoing a sentiment expressed by Bernanke about what the markets should expect from the Fed, Williams said that with the current forward guidance in place, “members of the public can adjust their expectations for future Fed policy as new information on the economy becomes available. They don’t need to wait for the Fed to issue a new statement. For example, a slowdown in economic growth might cause the public to think that the prospect of reaching a 6½ percent unemployment rate was falling further back in time. They would then expect the Fed to wait longer to raise the federal funds rate, which would prompt them to push long-term interest rates down. And those lower long-term rates would help us achieve our monetary policy goals.”
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