Fed’s bank stress tests are a strong policy statement

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Over the next two months, the soundness of major American banks will be tested for their ability to cope with scenarios of severely deteriorating domestic and international economic conditions. The Fed will then have until late June to evaluate and publish the test results.

The importance of this exercise takes on a particular meaning because it will be taking place at the beginning of a long process of the Fed's policy adjustment.

By providing the evidence on the amount of strain the banks' capital structures can take, these tests will also tell the Fed about the pace to follow in its future liquidity withdrawals.

Here is an example of what these withdrawals look like at the moment.

Between the end of last October and January 20, 2016, the Fed's monetary base (M0) was reduced by $314.4 billion. That amounts to a provisional monthly average (because we still need numbers for the remaining ten days of January) of $105 billion since the monetary base peaked out at $4.1 trillion in October of last year.

Please note that these liquidity withdrawals are liquidations of the Fed's Treasury debt holdings. That is done by allowing the maturing debt instruments to roll off the Fed's balance sheet, and by outright bond sales through open market operations.

Guarding the safe haven

So far, there has been no damage to bond prices, mainly because the Fed was selling at the time when concerns about deteriorating developing economies, Europe's unfolding migrant/refugee crisis, and security issues in the Middle East and East Asia made U.S. fixed-income assets look like the only remaining safe-haven investments.

That is still the case. The U.S. Treasury's benchmark ten-year note was trading last Friday at a yield of 1.92 percent, down from its recent peak of 2.29 percent at the end of December 2015.

Predictably, a portfolio shift of this magnitude was bound to cause huge losses in U.S. equity markets.

And that story is not over yet for two main reasons. First, speculations about the cyclical position of the Chinese economy and its structural difficulties will probably intensify. Second, the Fed is blamed for the slow growth of the U.S. economy, and for an allegedly brewing financial debacle – a replay, we are told, of the last crisis and the ensuing recession.

Financial markets seem puzzled by China's policy-driven change in the composition of its economic growth. That has now gone to the point where official economic indicators are dismissed in favor of alternative estimates purporting to show the economy's hard landing under an unmanageable debt burden.

These fairy tales will go on while China celebrates its Spring Festival the whole month of February. Hundreds of millions of people are on the move in high-speed trains where, according to media reports, more than 80 percent of the tickets were purchased online. Passengers apparently were also offered an option to order, along with their tickets, that quintessential American brew (Starbucks), noodles, dim sum, etc., to be delivered to their seats by stylishly clad stewardesses.

Meanwhile, the Republican Party frontrunner Donald Trump keeps screaming in Iowa "they are eating our lunch." And the Chinese are now getting the GE appliances to cook it. Indeed, the nicely performing U.S. economy gave China last year an estimated net trade income of $340 billion, amounting to one-half of America's total trade deficit.

But Trump is not complaining about the Fed. He says that his business and residential building has always "done well" in a low interest rate environment.

Structural policies needed

That makes sense, but it won't stop the Fed critics. They are blaming the Fed because, in their view, America's 2.4 percent economic growth last year is too slow. Never mind that this growth rate created 2.5 million jobs in the course of 2015, and that the growth rate of 2.4 percent kept the economy hitting, for two consecutive years, against the physical limits to (noninflationary) growth set by labor and (physical) capital resources.

The Fed critics are also ignoring that the underpinnings to U.S. economic growth are still sound – and improving.

Real personal disposable income grew 3.6 percent last year, almost a whole percentage point faster than in 2014. Household savings as a share of disposable income picked up to 5.4 percent in the fourth quarter of last year from 4.7 percent during the same period of the year earlier. By historical standards, that is a very high personal savings rate, which will provide a steady support to consumer spending in the months ahead.

We also have an almost fully-employed economy. At the 5 percent unemployment rate, any significant and sustainable further take-up of idle labor resources can only come through structural policies, such as retraining and relocation.

And then there is a cheap and readily available credit. The total consumer lending (by banks and non-banks) in November was 6.9 percent above the same month of 2014.

With growing jobs and incomes, the low credit costs have supported personal consumption and residential investments. These are the interest-sensitive components of aggregate demand that account for 72 percent of the U.S. economy.

Here is how that turned out. The growth of consumer spending last year accelerated to 3.1 percent from 2.7 percent in 2014. Much stronger gains were noted in residential investments: Their growth rate soared last year to 8.7 percent from a lackluster 1.8 percent increase in 2014.

Regrettably, the picture is exactly the opposite with regard to non-residential investments – a critical segment of the economy if we want to get to a sustainably faster growth path. Last year's 2.9 percent increase in business capital outlays was more than halved, mainly because the spending on capital goods slowed to 3.1 percent from 5.9 percent in 2014.

If you are tuning into the primary debates in anticipation of the Iowa caucus (to be held on Monday, February 1, 2016), you will see how much Trump's call resonates when he tells Apple to "start building their damn computers and things in the U.S." As a businessman, he certainly knows why is Apple producing and assembling computers and mobile phones in its foreign production facilities.

Maybe the next president can make good on President Obama's forgotten pledge that "we'll be making stuff here." That was one of those "Gee, I thought we could" things when he was confidently talking about repatriating some of our overseas manufacturing.

Investment thoughts

I'll say it again: The Fed has single-handedly guided the U.S. economy to the point where a faster noninflationary growth would require structural policies to raise productivity from its dismal 0.4 percent average growth over the last three years. The Fed alone cannot do that.

So, the daily yelling at the Fed is literally barking up the wrong tree, because structural policies to enhance the efficiency of our labor and capital stocks are in the hands of the Congress and the White House.

But the Fed can – and should – make sure that America's banking system remains the key pillar of economic stability. That is why the banks' stress tests and the Fed's close and permanent supervision of the banking industry are so crucially important.

They are also a message to doomsday peddlers that the Fed is on top of things, and that their 2008 replay nonsense is just that.

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