Last week I described the economy as stuck in the middle, a description of the recovery from the perspective of middle America – improving, but not at a pace to make much progress in the labor market. This week I offer an alternative assessment: For market participants, this economy is in a sweet spot. Fast enough to push corporate profits upward, not fast enough to attract the attention of the Fed. The combination of steady, solid growth with low interest rates and no inflation is about as good as it can get for Wall Street – the sudden work ethic on the part of SEC officials not withstanding.
Consider this piece from Bloomberg last week:
The latest surge in U.S. stocks may have more to do with historically low interest rates than any rebound in the economy and corporate earnings, according to Peter Boockvar, an equity strategist at Miller Tabak & Co.
As the CHART OF THE DAY illustrates, the Federal Reserve’s benchmark interest rate has been negative since November in real terms, adjusted for inflation. The Standard & Poor’s 500 Index, also included in the chart, showed a 17 percent gain for the period as of yesterday.
The central bank’s target rate for overnight loans between banks, or federal funds, currently stands at minus 2 percent on an inflation-adjusted basis. This figure is based on the upper end of the Fed’s range, zero to 0.25 percent, and the year-to- year change in consumer prices.
Yesterday, the S&P 500 closed above 1,200 for the first time since September 2008. The milestone followed a two-month rally that accounts for most of the index’s advance since the real rate fell below zero.
“What’s real and what’s artificial, what’s organic growth and what’s juiced by easy money” can’t be determined with rates at current levels, Boockvar wrote today in an e-mailed note. The question will only be answered, he added, when rates start to increase and the economy must function “without the crutch of cheap money.”
Yes, monetary policy works. On Wall Street, if not enough on Main Street. One intent of low rates and easy money is to push market participants into riskier assets. Does this make it more difficult to discern between real and artificial? Probably, yes. Should we care? Depends on who you are asking. You care if you are looking three or four years down the road or if you are a policymaker debating the end of stimulus. Should investors care as long as they can ride the trend up? Probably best not to think too much about it, and instead just enjoy the ride.
The real question is when will the easy money end. And on that point, Fed officials last week suggested they intend to let the good times roll and remain on the sidelines. Atlanta Federal Reserve President Dennis Lockhart provided a rather tepid assessment of the recovery, obviously still worried about the anticipated drags on activity later this year:
The Atlanta Fed’s base case forecast for the near term looks for growth to continue. The pace of growth will probably be somewhat slow. I expect moderate growth because the economy is working through some formidable adjustments that act as drags on growth….
…Given the current state of the economy, I am very comfortable taking a personal position that is neither sanguine about these potential torpedoes nor unduly alarmist or defeatist. I take comfort that each big problem that is actionable is being addressed, and the recovery is moving forward. As I said earlier, so far so good.
Having said that, I believe the recovery requires continued support of accommodative monetary policy. I think there is risk associated with starting a process of tightening too soon. In my view, the strong medicine of low rates should remain in place to facilitate adjustment processes that are by their nature gradual.
St. Louis Fed President James Bullard is arguably slightly more optimistic:
Bullard said that he expects growth in the second quarter to be better than the first, and said that while the recovery is not “superstrong” it is “very reasonable.
Sound like the “stuck in the middle” story – very reasonable would be near trend growth, but falls short of the momentum necessary to generate a true V-shaped recovery. San Francisco Fed President Janet Yellen, offers a pretty optimistic view of the recovery, although, like Bullard, it falls short of a V:
It’s fair to say that my own thinking has recently turned a corner and I am becoming more and more confident that the economy is on the right track. For some time, we were confronted with about the grimmest economic landscape we had ever seen. But about the middle of last year, the economy stabilized and then returned to growth. The latest indicators show a broadening and deepening of the recovery, and point to solid, if not spectacular, expansion in the first half of this year. We won’t get an official reading of the nation’s first-quarter gross domestic product until the end of this month. But based on the information we have in hand, it looks like inflation-adjusted GDP grew somewhere around 3 percent during the first three months of 2010. Assuming that holds up, we’ve now got three straight quarters of growth under our belts. I expect the pace of recovery to gain momentum over the course of this year and next as households and businesses regain confidence, overall financial conditions continue to improve, and lenders increase the supply of credit. For the full year, my forecast calls for output to rise about 3½ percent, picking up to about 4½ percent in 2011. Those are decent numbers, but nowhere as strong as some past V-shaped recoveries, for reasons I’ll go into in a few minutes.
Yellen – often considered to be a dove – is confident enough to place a little uncertainty in the “extended period” language:
I’d like to close with a few words about monetary policy. As I noted earlier, we have pushed the federal funds rate down to zero for all practical purposes. Such an accommodative policy is appropriate because the economy is operating well below its potential, inflation is subdued, and such conditions are likely to continue for a while. Consistent with that view, the Fed’s main policymaking body, the Federal Open Market Committee, last month repeated its statement that it expects low interest rates to continue for an extended period. I agree with this assessment. At some point though, as the economy continues to expand, the Fed will have to pull back some of this extraordinary stimulus.
When will “some point” arrive? Job growth is critical on this point, and the last week’s initial unemployment claims do not provide much hope that the jobs situation is changing soon. This, of course leaves us with an unhappy mix of data for job seeker, as while the Fed is not inclined to pump additional money into the economy in this environment. Mathew Yglesias repeats a now long-standing criticism:
… policymakers aren’t just supposed to offer grim forecasts, they’re supposed to take action to improve things.
The complacency around these issues continues to be staggering, and I can only [con]clude that the sociological concentration of unemployment among non-whites, young people, and those without college degrees is responsible. My guess is that few members of congress, or top FOMC members, or newspaper editors, spend a great deal of time socializing with members of the hardest-hit demographic groups which makes it a lot psychologically easier to keep glossing over the fact that they’re planning to do nothing about a problem that they recognize is severe.
Bottom Line: A more aggressive policy stance might be correct for Main Street, but I suspect would upend what is currently a nice little equilibrium on Wall Street. Raising the prospect that the Fed was trying to raise the inflation target would cement fear that interest rates will move dramatically higher in the years ahead. In contrast, the current state of the economy, with steady growth combined with low inflation and high unemployment, offers considerable certainty for market participants by putting the Fed on the sidelines. And that certainty is a valuable commodity.