By Vincent J. Truglia
Until I read the minutes for the October 29-30 meeting of the FOMC, the main monetary policy committee, I had been a strong supporter of QE. The reasons for that support centered on my analysis of how central banks operate, and the misunderstanding by many of how different central banks are from other financial institutions. After reading the minutes, which were released earlier this week, it is clear to me that the FOMC is in total disarray, with no clear path for ending the latest round of QE or communicating its policy goals.
My conclusion from reading those minutes is the FOMC needs to start tapering as soon as possible, even if only modestly. The longer they wait, the greater the risk of further asset price distortions. FOMC members keep noting that they are trying to figure out a way of communicating the difference between QE and an accommodative monetary policy. Well frankly, they can’t. Markets will overreact at first, but after settling into the new norm, monetary policy tools can return to mundane normalcy.
Asset Price Bubble?
An example of my concern about asset prices is the stock market. Nobody knows if stocks are overvalued or undervalued. I have heard very convincing arguments on both sides. The point is that given the monetary policy morass we are now in, if there is bad economic news, stocks rise because they are convinced QE tapering will be delayed. If good economic news happens, it is often just used to justify so-called stock fundamentals. It is a one-way bet that will end disastrously if not stopped soon. Why? Because as with all mania’s, no one can truly prove that a peak has been reached until it has begun to reverse. As we saw in the case of Japan in the late 1980s, the bubble lasted for far too long, and the economy has never recovered from it.
Let’s explore more in detail those now infamous minutes. If you read the minutes, you can sense the uncertainty of the committee members as to how and when to start tapering without causing unintended side effects. As noted above, doing that is impossible.
The Fed got a taste of that conundrum starting last May, when in a simple speech, Bernanke mentioned that tapering might be in the cards in the not-so-distant future. That simple message caused huge falls in stock markets worldwide, and pushed up long-term interest rates.
Then, fast forward to the September meeting of the FOMC. Given the earlier messaging by FOMC members, market participants were expecting tapering to begin then. That didn’t happen, and markets were relieved, and on a roll again.
October was a very confusing month for everyone. Not only did market participants have to live without most economic data due to the government shutdown, but for a short-time, there was a fear that the government might default, as evidenced by some very strange, but arcane movements in short-term rates.
Staff Review of the Economy
The staff review of the economy pretty much repeated what we all know, and appropriately so. The review should not be analyzing the economy in a way that would cause surprise to other economists. The basic message was that the economy was growing, albeit at a moderate pace. Unemployment was still moving on a downward trajectory, but at a very slow pace. Inflation remains below the desired 2% rate. Bottom line — nothing new.
The next section, or the review of the financial situation was particularly interesting. “…the outcome and communications from that [September] meeting were seen as more accommodative than expected.” Read that to mean: markets overreacted.
The next section outlined the staff economic outlook. Again, there were no real surprises. The economy is expected to grow at a slower pace in Q4 because of the effects of the government shutdown, and softer growth in consumption. Then it says, “The staff anticipated that the pace of expansion in real GDP this year would be about the same as the growth rate of potential output but continued to project that real GDP would accelerate in 2014 and 2015, supported by an easing in the effects of fiscal policy restraint on economic growth, increases in consumer and business sentiment, further improvements in credit availability and financial conditions, and accommodative monetary policy. “ Put simply — expect higher growth in 2014-2015. Then a short list of everything that could derail that forecast was listed, all of which are reasonable possibilities.
FOMC Member Views
The next section outlines the FOMC members’ own views regarding the economy: “The acceleration over the medium term was expected to be bolstered by the gradual abatement of headwinds that have been slowing the pace of economic recovery–such as household-sector deleveraging, tight credit conditions for some households and businesses, and fiscal restraint–as well as improved prospects for global growth. While downside risks to the outlook for the economy and the labor market were generally viewed as having diminished, on balance, since last fall, several significant risks remained, including the uncertain effects of ongoing fiscal drag and of the continuing fiscal debate.” Translated, that means fiscal policy is their main concern.
From my perspective, despite the extremely low probability of reaching a long-term budget deal anytime soon, it’s hard to see how any new measures increasing fiscal drag will occur. My interpretation is that extraordinary QE measures are now far less necessary based on the economic outlook than was true in September 2012.
Policy Planning: Morass 101
The next section on Policy Planning is what causes me the most concern. The FOMC members are all over the map. Some wanted tapering sooner, rather than later. Some wanted to use different data thresholds for deciding that. The list of possibilities discussed is too numerous to put in a short blog.
If the FOMC does nothing but allows the asset price bubble to continue with stocks and bonds set on a one way path, then the day of reckoning will be far worse than if tapering begins now, despite the likelihood of some temporary negative side effects due to tapering. There are no historical norms to judge how to exit QE without disruption. However, there is a long history of asset price bubbles, and their serious consequences.
As always, Clear and Candid.