To understand the way the Federal Reserve views the economic recovery, think about a long, bumpy train ride.
The train is moving toward its destination—but it could well be “five to six years,” as the Fed put it in the minutes released Wednesday of its June meeting—before it moves as fast it can.
Here’s what the central bank said in Fedspeak:
“Participants generally anticipated that, in light of the severity of the economic downturn, it would take some time for the economy to converge fully to its longer-run path as characterized by sustainable rates of output growth, unemployment, and inflation ... most expected the convergence process to take no more than five to six years."
That time frame had been out there, but previous Fed minutes said that only a minority of participants of the rate-setting Federal Open Market Committee (FOMC) believed that to be the case. Now it appears to be conventional wisdom. This explanation has been a long time in coming.
In normal times, you would expect the Fed to either be hitting its targets for inflation, growth and unemployment now, or to do so within a three-year window.
The Fed drives the train. So if it’s not where it wants to be, it can speed up or slow as needed. If a majority of Fed officials, for example, don’t believe that the unemployment rate will be in the 5 percent range by 2012, the Fed should lower rates.
But not since July 2008 has the average forecast for the 17 members of the FOMCprojected an unemployment rate three years out that was around 5 percent, the presumed potential of the economy. That was also the last time the Fed thought it would hit its inflation target of around 2 percent in a three-year window.
So not only the Fed has been unable to get the train up to speed, it’s been acknowledging it wouldn’t get there.
What does it mean that it could take up to five to six years to get the economy performing to its potential? First, it does not mean we will be in recession that entire time. In fact, the Fed sees growth of 3 percent this year (a bit lower than its forecast in April), accelerating to 4 percent in 2012.
That’s good. People will be put to work in that environment. People can make money in the stock market. But it’s not good enough or strong enough to put the bulk of the 15 million unemployed Americans back to work quickly.
So, second, it means we will have a lot of slack in the economy for a number of years. Wage gains could remain modest; inflation will likely remain low.
Ultimately, those 3 percent to 4 percent growth rates end up easing back to 2.5 percent to 3 percent as an economy that runs high levels of slack can’t sustain trend growth.
Meaning, third, interest rates and the Fed are likely to remain low for MANY years. The Fed may raise rates in a year or two, but if the Fed’s forecast is right, they should remain below average for most of that five- to six-year period.
What about stocks? It’s hard to imagine a period of serious multiple expansion in an economy that will underperform for so long. Companies can still make money. Profits can still grow. Recent earnings from Intel suggests that industry leaders can even expand their margins.
A word of caution: The FOMC aren’t very good forecasters. A paper written by famed economists Paul and Christina Romer (the latter now working for the Obama administration), suggested the Fed presidents shouldn’t even bother forecasting.
The paper said that the Federal Reserve staff (as opposed to the governors or presidents) provide the most accurate economic forecast, routinely doing better even than private-sector economists. (Fed watching hint: That’s why you listen so carefully to the chairman and the governors; they are most likely to rely on the staff forecast.)
Still, you need to follow these forecasts because, right or wrong: They are the ones upon which Fed officials are basing their policy decisions. Also, the five- to six-year time frame is consistent with research conducted by Carmen M. Reinhart and Kenneth S. Rogoff, in their book, This Time Is Different: Eight Centuries of Financial Folly, (of course, the irony is they were arguing that it isn’t different) showing that it takes longer, up to five years on average, to recover from financial crises as opposed to garden-variety recessions.
Should the Fed do more? Many Fed members, even some doves from my read, that doing more at this time will help. If things get appreciably worse, perhaps they come back in to maintain the status quo. But if it’s just a slowdown, don’t look for the Fed to act. They seem to have settled on the long-slow slog of a train ride.
When I lived in Russia, I took a lot of overnight trains. It always seemed safer to me than flying. I did that, too. The trains lumbered and clickety-clacked over degraded rails; by the next morning, the cars always reeked. The trains almost never went full speed, but they got there.
Russians always found that a bottle of vodka helped.
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