The Fed And The Chances Of A 2017-2018 U.S. Bull Market
Pascal Bedard | Oct 17, 2016 01:40PM ET
Janet Yellen spoke on October 14th and sent a clear signal. Yellen's Fed is more "dovish" than past Feds, and that is probably a good thing. There has been an almost paranoid focus on inflation in the past 2 decades all over the world, while NO proof exists that 3% or even 5% inflation is any worse than 2% for growth and prosperity. Yellen has communicated her views to the world, and all traders, business people, and fund managers must listen, because the implications are far-reaching. This post helps you make sense of it all in clear, simple language.
Yellen's message in a nutshell
There is NO hurry to tighten monetary policy, because there are NO signs of inflation, while growth remains sluggish and the employment rate remains extremely low relative to pre-2008 levels. The demographic undercurrent of the aging population all over the industrialized world has been accelerated by the Great Recession, but it seems that the fall of the US employment rate has been excessive, even taking into account demographics. This means that there remains plenty of slack in the labor market, even with the unemployment rate close to 5%, and that slack explains at least in part the absence of inflation.
The US employment rate was roughly 63% pre-2008 and now hovers around 60%, which means roughly that there are 3% less US workers as a fraction of the 15-64 population than before that are actively working and contributing to the production of goods and services. That is about 3% of about 204 million people, or about 6 million less workers, which corresponds to about 600 BILLION dollars less in production activity EVERY YEAR (because each worker produces on average a bit more than 100k per year in production value)! That means a net loss of 6 trillion over the next decade. That means less jobs, less profits, less income tax and other tax receipts for the government, lots of lost potential and business opportunities, and also less global demand, since the US is a major contributor to demand for many other countries such as China, Japan, Canada, etc.
Now perhaps PART of that fall in the employment rate is indeed caused by the aging demographics which was "accelerated" by the slump, but certainly not all of it and probably not even most of it.
How Yellen's Fed sees this
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Essentially, the Fed sees the sluggish growth and the absence of inflation as signs that there remains major weaknesses in the economy and plenty of slack, and Yellen sees this as "scars from the recession" that have yet to heal. This is the point of view of hysteresis (which I share, by the way): major negative shocks to aggregate demand could cause permanent damage to the SUPPLY (production side) of the economy: companies close due to lack of opportunities and demand and less new companies open than otherwise would have been, more people abandon the labor market, less opportunities bubble up, and a general "negative vibe" gains households and SME business people, along with fiscal issues for governments. All this creates a sluggish economy, which then feeds on itself in a negative feedback loop.
This is a subject of debate, as some economists believe that demand and production are NOT related in the long run, and that only production (supply-side) aspects matter in the long run: growth in the number of workers, productivity growth, innovation and technological advancement, and that these are mostly driven by institutional aspects as well as tax and regulatory policies.
I have no issue with this more orthodox view, but I believe (as do many at the Fed) that the lack of demand for a prolongued period of time could lead to lack of business investment and a lack of opportunities for small-and-medium-sized companies. In other words, demand and supply DO interact even in the long run for those who believe in hysteresis, which is the case of Janet Yellen (and her husband, George Akerlof, a Nobel in economics from UC Berkeley).
What Yellen's Fed wants to do about it
If policymakers consider growth to be lower than it could be in a long run perspective, they will want to do something about it, and without the threat of inflation, they will act. The first thing to do is do "fix" supply-side aspects that block or kill production and employment: high corporate tax rates, red tape, a rigid labor market that causes firms to hesitate in hiring workers, etc. This is out of the hands of central banks, as it is related to changes in corporate taxation and regulation, labor market laws and regulations, among many others, which are all the responsibility of representatives at the (dysfunctional) Congress and Senate.
So the only thing the central bank can do is to boost demand with super-stimulative monetary policy to create demand and "pull the production side up." This means to let interest rates lower than most people expect and to "print" money to finance government spending that boosts demand if the need arises. All this has one general objective: to create a temporary "overheating" of the economy so that all those idle workers are reabsorbed into the labor force, businesses start to spend, hire, and invest more, mood becomes really good and potitive about the future, and inflation finally picks up to normal levels, even perhaps above-target for a while. They may even aim for a higher inflation target such as 3% some day, which would have a few advantages, but I don't want to talk about that for now.
Risks of this strategy
The risks to such an approach is that super low rates for a very long time and huge amounts of liquidity in markets all amount to one big red flag: the danger of bubbles. All that money eventually ends up "somewhere" and all that credit is taken on as debt by "someone"... you can end up with bubbles in stocks, bonds, housing, land, household debt, corporate debt, land, oil and other resources, and so on. Big bubbles generally pop in ugly ways, as we have seen in 1929 and 2008, so this is a delicate balance to strike, and Fed economists are well aware of this, as is clear from the remarks from Yellen and several other FOMC members.
What to make of all this for the USD and interest rates going forward?
In general, keep an eye on inflation, especially core personal consumption expenditure inflation (now around 1.7%) and don't think the Fed will react strongly even if it goes above the 2% target. The whole point is to create "overheating" for a while, to heal the supply-side scars of the recession that still hinder growth and employment. I personally fully agree with this approach, as long as bubbles are not created, which means we need a much greater role for macro prudential policies, but that is another subject...
All this means that Fed policy will be looser than most expect into 2017 and beyond and the USD will have a general tendency to depreciate while the economy grows and unemployment drops... BUT it will have short periods of appreciation once US elections are over and into the December Fed meeting, which could give ONE rate hike just to contain bubbles, but don't expect much tightening after that... If it comes, the rate hike will come with very moderate talk (dovish flavor, with a hawkish twist to contain bubbles). The value of the USD will fluctuate due to the disconnect between market expectations and interpretations of solid growth and increasing inflation (which causes the market to expect appreciation, which itself causes a short run appreciation) and Fed policy which could aim for some "overheating", which remains looser policy than normal and a more depreciated USD...
I see the USD volatile until the end of the year, with bursts of appreciation caused by upcoming events (elections and Fed meeting and perhaps some good data on the economy)... but I see the USD generally depreciating as of early 2017 due to Fed policy stance, unless of course the ECB and BOJ also start printing and stimulating even more, in which case the net effect will have to be reassessed. If a massive fiscal expansion comes in the USA (government spending program) after the next elections, it could spur appreciation as well. Just keep all this in mind as things unfold and you will understand what is going on at all times.
If in doubt and you get confused about Fed policy, look at 3 things:
- Core PCE inflation... and expect tolerance by the Fed well into the 2%-3% range.
- The unemployment rate, which could go well below 5%.
- The employment rate, which the Fed would probably like to see go towards at least 61% and ideally more around 62% (is it now a bit below 60%).
The loss of production capacity and jobs from the recession poses a threat to becoming permanent and costing trillions, and "overheating the economy for a while" may indeed be required to jolt the US economy back on track. Higher inflation and a bit of overheating are small prices to pay relative to a permanently damaged economy. The cost-benefit is in favor of looser-than-normal-policy and above-target inflation for some time. That said, this policy creates risks of asset bubbles, which could end in ugly ways. This is why there may be one rate hike, but that remains to be seen. It also leaves out the elephant in the room: policies aimed at making production and job creation interesting again on US soil... a pro-production set of policies, which have yet to be discussed by the US candidates in the ongoing "humor show" that is the current presidential debate between two quite different candidates.
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