Despite Market Turmoil The Fed Must Taper More Now

By Vincent J. Truglia

Given the recent rout in emerging market (EM) currencies and stock markets around the world, it’s necessary to remind everyone that despite this, the Fed needs to continue tapering, and even possibly increase its pace. The next FOMC meeting (the Fed’s main monetary policy committee) is scheduled for this Tuesday-Wednesday, January 28-29. It will need to make some important decisions.

QE

As I have been writing for the last several months, the Fed’s policy of QE (quantitative easing) had reached a point following the September 2013 FOMC meeting, where financial asset prices were becoming so distorted that if QE were not reduced soon, the knock-on effects would make a future crisis worse. The sooner tapering would begin, which it did starting this month, the quicker financial markets would adjust to a less accommodative Fed policy over time. Doing this sooner rather than later lessens the pain of adjustment. That’s what we have begun to see last week.

The Eurozone

As I have written before, although German economic growth is rising more robustly, the Eurozone’s periphery remains weak, at best, and subject to a variety of political shocks that may emerge from any of a number of upcoming elections in member countries.  Even if growth in the overall Eurozone does pick up, it will be modest at best.  Europe will not be an engine of world growth.  In addition, the Fed cannot influence Eurozone restructuring.

China

China needs to rebalance its economy.  It’s now far too big to depend on exports as its primary economic growth engine.  It needs more domestic demand.  This will take time.  Also, Chinese credit markets need to be reined in, and are in fact beginning to be brought under some control. This will allow more normal monetary and fiscal policies to work more efficiently over time. We are beginning to see that rebalancing, albeit in its earliest stages.  Growth will remain robust by world standards, but it is not likely, nor healthy, for China to grow at rates near or above 8%. In fact, it would be better if the Chinese economy grew by 7-7.5%. That would likely indicate that the rebalancing process is working. However, with modestly lower growth, that means China will provide far less stimulus to other EM countries.

Japan

Japan has its own unique problems.  So-called Abenomics, or unorthodox monetary and fiscal policies, will continue. That means Japan’s net export balance will have to rise. Japan will not be an engine for world growth.

The US

As I have written before, when looking at the short-term unemployment rate, which monetary policy can affect, the US is rapidly approaching full-employment.  Long-term unemployment can only be dealt with through fiscal policy.  That’s why, despite an incredibly accommodative monetary policy, the percentage of long-term unemployed remains near record levels; the latest number indicated that 37.7% of the unemployed are part of the long-term unemployed. There’s a skills mismatch which monetary policy can’t solve.

Overall, now that fiscal drag has been reduced significantly, we should expect the US economy to grow at moderate rates, somewhere between 2.5-3%. Making matters worse for the rest of the world, the US current account deficit is falling, meaning the US is adding less to foreign demand than in the recent past.

Inflation

Near-term, inflationary pressures are emerging.  The US Department of Agriculture in November 2013 had already forecast that food prices would increase by 2.5-3.5% in 2014.  That forecast explicitly stated, however, “[A] resurgence of the drought in key agricultural areas or other severe weather events could potentially drive up food prices beyond current forecasts.” The drought is now far worse in the West, and we are seeing record cold affect other agricultural areas.  Food prices in 2014 will likely rise by more than 3.5%.

Energy Prices

Another price problem is emerging in US energy markets, most of which are temporary, but will likely have an important impact on inflationary psychology.

Propane, which is used to heat about 5.5 million homes, has recently risen in price by upper double-digit rates. Propane inventories are at record lows. Natural gas, which is used to heat 58.6 million homes, and is used to power many power plants has seen some supply disruptions related to pipeline problems, which will gradually normalize, but we are also seeing record demand caused by the need to heat homes and produce more electricity during our record cold snap.  Most households won’t see the full impact of recent natural gas price increases, because most utilities which supply gas to households or which purchase it to produce electricity have hedged themselves.  Nonetheless, home heating and electricity bills across much of the country will definitely be rising at rates not seen for years.

With food prices set to rise by at least 3.5% because of the drought and the cold snap, and propane, natural gas and electricity prices already rising at the highest rates in years, headline inflation will soon accelerate.

Although core rates will likely rise less than the headline rates, if the headline rate remains high over a number of months, inflationary psychology will shift.  Those who are employed will likely demand. and get, higher wages. More money going to buy food and pay for utility bills will mean less money is available for other goods and services.

We may soon find ourselves in a situation where moderate growth may be accompanied by higher inflation for several quarters.  Monetary policy, if it remains too accommodative, will simply amplify the inflationary pressures already in place.  That’s why, despite market turmoil, the Fed needs to keep the US economy on an even keel.  To do that, the Fed needs to speed up tapering, and likely bring forward the date when monetary policy becomes less accommodative. If not, economic turmoil in the future will be even worse.

EM Outlook

Given the likely growth trajectories in the world’s four largest economic regions, discussed above, EM countries are going to be hit hard.  If the Fed were to even temporarily stop tapering, not only would that amplify US inflationary pressures, but it would only delay EM rebalancing and would guarantee making the EM crisis worse in the future.

As always, Clear and Candid.