“Dow up on optimism tepid jobs report keeps Fed stimulus going”
— headline, CNBC, today
In other words, a lousy labor market is good QE-bait.
Like I said before.
The Federal Open Market Committee concluded one of its most anticipated meetings in a long time with the expected decision to keep its federal funds rate target near zero (0 – 0.25%) and, less expectedly, not to “taper,” i.e., announce that it would gradually reduce its monthly purchases of mortgage-backed securities and longer-term Treasury bonds. Those purchases are otherwise known as “quantitative easing” (QE).
From various market surveys and betting sites, it appeared that about half the market was expecting a taper. Just why is hard to figure. Excessive asset purchases by the Fed can be inflationary, but excessive is in the eye of the beholder, and inflation has been under, not over, the Fed’s target of 2%. There is the argument that these new and unusual QE policies are damaging to investor confidence, but they’re not that new anymore, and the investors in the stock market seem remarkably undamaged — the S&P 500 has more than doubled since early 2009, i.e., since shortly after the first round of QE was implemented. Then there is the opposite argument that QE has created a “sugar high” in the stock market and maybe the housing market, too. This last argument has to be taken seriously, in view of how the 2000s housing bubble was stoked in part by the Fed’s easy-money policies circa 2004, when economic recovery was well underway.
But not too seriously. The S&P 500 is only about 15% higher now than it was mid-2007; adjusting for inflation, it’s hardly any higher at all (and the jury’s still out over whether stocks, as opposed to housing, were a bubble in 2007). Moreover, corporate profits are at record highs, so the fundamentals look rather good. Home prices are rising fast, but they’re still at 2004 levels, and monthly mortgage payments are cheaper than rents. A true speculative bubble is when people are obviously overpaying for assets, especially when they do so knowingly, with the plan of selling to a greater sucker later on. Is there evidence of that here?
The evidence about the general state of the economy is much stronger, and the evidence is that it’s still pretty weak. In particular, employment — the indicator that the Fed is supposed to focus on, along with inflation — is dismal. The employment-to-population ratio is still under 76%, or 4 points below where it was before the crisis. (The graph below, by the way, is of the “prime-age” population, 25-54 year-olds; if it included 16-24 year-olds, it would look even worse.)
For more on unemployment and tape:
The stock market would be telling the Fed something like this:
Sounds crazy, but that’s how present discounted value works. (And thanks to my daughter for the meme.)
This week the Dow fell 3% this after Fed Chair Ben Bernanke’s announcement that eventually the economy would get better and then the Fed would gradually take its foot off the accelerator. That is, the Fed would taper off its quantitative easing (QE; emergency mass purchases of long-term bonds) when unemployment (now 7.6%) fell to 7.0% and then, as announced before, would start raising short-term interest rates back toward normal levels when unemployment fell to 6.5%. He didn’t say this was going to happen soon, and reiterated that the (near-) zero interest rate policy would continue until unemployment falls to 6.5%. Granted, he sounded mildly optimistic that the economy would recovery sooner than expected, but he presented no new data on that score, so it’s an easy prediction to shrug off. Not that the markets did.
The present-discounted-value approach to stock pricing says that a stock is worth its company’s expected future profits in all years to come, divided by a discount factor that is based on the long-term interest rate. The lower the interest rate, the higher the stock’s price should be. The odd thing here is that if the economy picks up, corporate profits should too, which should offset the higher interest rates that Bernanke is hinting at. It may be that corporate profits are already high and are not always easy to predict, whereas long-term interest rates are known now. The 10-year Treasury bond rate rose from 2.2% to 2.5% after Bernanke’s announcement, a 14% increase that is right about in line with the 15% drop in stock prices. (The 10-year Treasury yield is still at a near-historic low, by the way.)
The financial media tend to report any significant-looking drop in stock prices as an economic calamity, overlooking the most basic facts about the stock market, namely that it is volatile and its short-term swings have very little macroeconomic impact. The less we worry about short-term market reaction to the Fed, the better off we’ll be. Jared Bernstein has an excellent piece on the Fed’s announcement, to which I don’t have much to add, only to say that I don’t see much new in the announcement, other than some optimistic predictions and an exit strategy for QE (which had to end sometime).
I don’t claim to have the answer to this question. Those who propose an answer other than “nothing” don’t get a lot of airtime, but Dean Baker, one of my favorite gadfly economists, is one of them. He writes today that it is wrong, wrong, wrong to say that the Fed has run out of ammunition. While it is true that the Fed has lowered its usual policy target, the federal funds rate, as far as it can go (0-0.25%) and blown through two unusual policy actions known as quantitative easing (QE), there are other options that every policy economist has heard about. (Whether they’re wise options or not is the real question.) I’ll turn it over to Baker:
‘The Fed could do another round of quantitative easing, although this is likely to have a limited impact. It could also target a long-term interest rate, for example putting a 1.0 percent interest rate target on 5-year Treasury bonds.’
QE3 might well happen, although as Baker notes the impact is likely to be limited, as was the case with QE2. Since QE2 did not seem to roil financial markets, my sense is that there will be a QE3, with a slight downward push on medium- and long-term interest rates. But given the low business and consumer borrowing with today’s low interest rates, I doubt that nudging them further down will make a noticeable difference.
Targeting a long-term interest rate implies a more aggressive form of QE, where the Fed buys and sells long-term bonds in such a way as to control the market for those bonds. This is more than it does in its open market operations for Treasury bills, which are about hitting a target for the fed funds rate (the interest rate on loans of reserves between banks), not controlling the T-bill rate. I’m instinctively a bit leery of handing that much control over the bond market to the Fed, and I suspect financial markets would like it even less.
‘Alternatively, the Fed could pursue a path that Bernanke himself had advocated for Japan when he was still a Princeton professor. It could target a higher rate of inflation, for example 4 percent. This would have the effect of reducing real interest rates. It would also lower the debt burden of homeowners, which could allow them to spend more money.’
I’m really skeptical of this one on two fronts.
I’m still looking for alternative stimuli the Fed could try, including different forms that QE3 could take. If you’ve got any ideas, the comments section is happy to have ’em.
In today’s press conference Bernanke acknowledges the obvious: the economy is worse than we thought and likely to stay that way into 2012. The Fed lowered its official economic growth forecasts and raised its unemployment rate forecasts for 2011-2012. After almost two years of slow but steady recovery and myriad positive straws that one could grasp, the last couple of months have brought mostly lousy news, notably the latest jobs report, which showed a gain of just 54,000 jobs last month, only about a quarter or a sixth as many as we’d need to get unemployment down to normal levels in five years or so.
It’s notable that the imminent end of the Fed’s quantitative easing, all $600 billion of which will be over by the end of the month, brings few calls for another round — everyone seems to agree that we’re in a liquidity trap, in which further monetary stimulus fails to stimulate, because interest rates are already practically 0%, banks are not eager to lend, and companies are not eager to invest in new capital.*
Our best hope, it seems to me, is an almost nihilistic one: the economy somehow recovers on its own, through black-box mechanisms that we still don’t really understand. Business confidence returns, hiring finally picks up, and the economy roars forth. This may be a vain hope, but the “animal spirits” of investors (and consumers) that Keynes wrote about in The General Theory are not really visible, despite the several monthly surveys of business sentiment that are out there.
Our next best hope is another fiscal stimulus. It won’t be like the first one, which is about to run out and was too small anyway, not with a Republican majority in the House that believes spending = death and doesn’t even want to avert a financial crisis by raising the debt ceiling unless the Democrats agree to massive long-term spending cuts. But I could see the two parties agreeing on a big set of tax cuts, which is the usual form that a fiscal stimulus takes anyway (e.g., 1964, 1981, 2001). That has a couple of disadvantages: (1) the “multiplier” effect of a tax cut on GDP is typically empirically estimated to be smaller than that of a spending increase of equal size, because not all of a tax cut gets spent; (2) tax cuts are hard to reverse, as everyone hates seeing their taxes go up, so they could make the long-term debt problem much worse. Still, it’s probably the only politically viable option for a fiscal stimulus.
* The last part of that statement (companies are not eager to invest in new capital) is less true than I had thought. As the Wall Street Journal article linked to below notes, a survey of banks indicated that small businesses were demanding more loans, at least in the first quarter of the year.
UPDATE: This Associated Press article from the next day’s newspapers adds some helpful detail. The headline from the Syracuse Post-Standard’s version of that article says it all: “Slow Economy a Puzzle: Fed chief flummoxed, says troubles could last a while.” My quick take:
(1) The economy has long been in a liquidity trap (Krugman’s definition, i.e., a slump in which monetary policy is no longer effective).
(2) Bernanke has long suspected this himself, but as Fed Chairman he feels obligated to try to stimulate the economy through monetary policy, via unusual, unprecedented channels “that just might work” like QE2.
(3) QE2 has failed to measurably stimulate the economy, because the economy was in a liquidity trap.
(4) Liquidity trap or not, it’s not easy for the Fed to just throw in the towel, so a QE3 might well happen. But I doubt the Street will get all that excited about it, considering what a dud QE2 seems to have been.