Fed eyes normalized balance sheet for good reason: US is a safe haven

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Frightened by China's roller coaster equity prices and Europe's accelerating deconstruction, investors had an offer they could not refuse: America's central bankers were selling arguably the best and the safest fixed-income assets on the planet.

Between December 23, 2015 and January 6, 2016, the Fed shrank its balance sheet by $248.7 billion.

Judging by the strong demand for these assets, it seems that many investors did take advantage of the offer: The yield on bellwether ten-year Treasury note was driven down by 7.4 percent during the first trading week of the year.

Good work. The Fed could safely allow some of the maturing assets to roll off its balance sheet, while stepping up its selling into a strong bond market rally.

The feat was so alluring that it prompted some Fed officials' guesses last week on how long it would take to normalize the balance sheet.

Marc Lasry on the Fed
Marc Lasry on the Fed   

So, here is an easy quiz: Assuming the Fed continues to run down its fixed-income assets at a similar (monthly) rate, how long will it take to shrink its balance sheet from the current $3,638.0 billion to the pre-crisis average of $825 billion?

Repair mission accomplished

You may think of what the Fed did as a response to howls of laments that it was killing an economy allegedly verging on a recessionary relapse.

And it gets worse: Somber prediction are bandied about that (a) the Fed will soon have to reverse its recent interest rate increase, (b) we are facing a 2008-type financial crisis and (c) the Fed (along with other major central banks) will have no policy instruments to deal with it.

But I believe the Fed is right to ignore all that. Here is why.

The U.S. economy grew at an annual rate of 2.6 percent in the first three quarters of last year.

That is slightly better than the 2.4 percent growth during the same period of 2014, and it is also an entire percentage point higher than the non-inflationary growth rate allowed by the country's labor and (physical) capital resources.

That is not a bad record for a monetary policy that had to repair the serious blunders that led to the last financial crisis.

The Fed guided and supported (a) the recovery from the Great Recession, (b) a return to nearly full employment from a peak jobless rate of 9.6 percent in 2010 and (c) the restoration of an all-but-destroyed financial system.

The current growth dynamics are not bad either.

Retail sales volume in the three months to October was running at an annual rate of 5 percent, and the latest survey data suggest a strong holiday shopping season.

It is, therefore, possible that retail sales in November and December could have been running at about 6 percent above their year-earlier levels.

More generally, the service sector as a whole (about 90 percent of the economy) continues to expand for the sixth consecutive year, and its present operating levels are historically consistent with a GDP growth rate of 3 percent.

Thriving on chaos

Jobs and incomes certainly look strong enough to support that growth rate in the months ahead.

It is true that the 5 percent unemployment rate in December rests on a very low level of labor supply (i.e., a participation rate of 62.6 percent).

But it is also true that 800,000 jobs were created in the course of 2015, and that real hourly compensations in the first three quarters of last year rose at an annual rate of 3 percent.

That was three times faster than in the same period of 2014.

Jeremy Siegel
Siegel: Market will move 8-10% this year   

Employment growth, rising earnings and low inflation have led to a strong increase in real household disposable incomes: They were up 3.6 percent in the first nine months of last year – a marked acceleration from a 2.4 percent gain a year earlier.

Predictably, the growing jobs and incomes and low credit costs have underpinned a robust consumer loan demand.

The total consumer lending in November was 6.9 percent above its year-earlier level, with bank and non-bank loans rising 6.5 percent and 7.2 percent, respectively.

Americans' saving behavior is also more stable than it used to be.

At about 5 percent, the U.S. households' saving rate (i.e., personal saving as a percent of personal after-tax income) is now somewhere around the average of developed economies.

Such a relatively high level of saving balances means that the usual consumption patterns can be maintained even in cases of transitory problems with jobs and incomes.

That is what the Fed is looking at while deciding on the tempo of its return to "normal" interest rates (a federal funds rate of 3-4 percent from the current 0.5 percent) and an average pre-crisis balance sheet of $825 billion.

The Fed knows as well that inflation will not be permanently held down by sharply declining energy prices and a strong dollar.

Fed's Williams: 4 rate hikes consistent with gradual path
Fed's Williams: 4 rate hikes consistent with gradual path   

In fact, core CPI in November was 2 percent, and it has been at that level for more than a year.

Also, prices in sectors that are not exposed to international competition (such as services less energy, housing and medical care) are running at annual rates of 3 percent.

Unit labor costs are telling the same story.

During the first three quarters of last year, they rose at an annual rate of 2.3 percent, compared with a 1.8 percent increase in the same interval of 2014.

That is not exactly an alarm signal, but it does show that the Fed may not be far from its medium-term inflation target of 2 percent.

Investment thoughts

The Fed is right to take advantage of a quiescent inflation and an increasing safe-haven demand for dollar assets to step up the normalization of its crisis-bloated balance sheet.

Sadly, the chaos will continue.

China's root-and-branch reform of its financial system is arguably the most difficult (and dangerous) challenge since the country's Paramount Leader Deng Xiaoping set out to modernize the Celestial in the late 1970s.

People have to realize that Beijing has to create – literally, ex novo - a financial system that will fit its "social market economy with Chinese characteristics," and that will, at the same time, make possible its seamless integration into global capital flows.

Good luck with squaring the circle. Things are no better in Europe.

The ECB is holding the fort but its work is thwarted by forces of political disintegration.

Germans are now fighting each other in the streets of Cologne, and its refugee camps were home to terrorists committing horrendous crimes in France.

Hundreds of thousands of refugees are on the way, Poland is being threatened with sanctions, riots are continuing in Greece and the new political forces in France and Spain show no allegiance to European unity.

Does that sound like the U.S., and its financial markets, may well be the ultimate safe havens? It does to me.