The message the economy is sending the Fed

On the heels of a downward revision to first-quarter U.S. GDP growth last month, full-year economic growth projections are coming down. The big question mark that arises as a result of these downward revisions is how the Federal Reserve will react?

The International Monetary Fund reduced its estimate for full-year U.S. GDP growth to 2.0 percent from 2.8 percent. The World Bank has lowered its estimate to 2.1 percent from 2.8 percent, based in no small part on the weak first quarter.

This was supposed to finally be the year that the economy would break out of its 2-percent growth malaise. Will the Fed have to stop or even reverse the taper? I don't think so ... yet.

Janet Yellen
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Janet Yellen

The reasons for the abysmal first quarter are well documented. Poor weather constrained investment and exports, while slower inventory growth (somewhat related to weather) was a major drag on growth as well. If ever there were good excuses for negative growth, these are they. Why? Because bad weather and inventory growth will prove to be temporary, transient drags on growth. I have little doubt that growth will return to more respectable and solidly-positive territory in the second quarter.

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Now, for the bad news. Even if the economy grows at a solid pace in the remaining three quarters, the full-year growth rate still won't be enough to pop the champagne corks. More importantly, in my opinion, economists should be somewhat alarmed that the economy is still unable to withstand minor, transitory setbacks (such as bad weather) without dipping into contractionary territory. To us, this means that the economy remains on shaky foundation. Instead of consistently positive economic growth each quarter, we keep hearing excuses about temporary drags on growth and why growth is likely to accelerate "next quarter." It reminds me of the movie "Animal House," in which the character Hoover (Delta house President) tells Dean Wormer, "We're hoping that our mid-term grades will really help our average!"

It is true that we have received some indisputably positive economic data in recent weeks, including various manufacturing indicators,consumer confidence, and vehicle sales. But there are other indicators (and perhaps more important ones) that suggest that we are not on course to break out of our 2-percent growth trend. Yes, the unemployment rate has drifted much lower over the past several years. But the quality of new jobs remains poor (read: low-paying). Moreover, wages and median incomes among those fortunate enough to have jobs have not been able to keep up with inflation. Real median household income remains well below its peak in 1999. And perhaps the most telling barometer of labor-market health, the participation rate, continues to hover at its recent lows. A low participation rate suggests that opportunities are not attractive enough to lure job seekers back into the pool.

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As for the housing sector, recent data suggest a slowdown from the mortgage-rate-induced spike in activity from 2011 to mid-2013. Housing-price increases have slowed while sales of existing homes have dropped sharply from last year's highs. Those making their living in the residential- housing sector (mortgage brokers, real-estate agents) will argue, "mortgage rates remain low compared to historical averages." But this is a fallacious argument as housing prices have reset to reflect the ultra-low mortgage rates of recent years. As a result, an increase of 1 percent or more has clearly had a negative effect on housing activity.

Last Thursday, we learned that retail sales grew just 0.3 percent in May while sales excluding autos and gas were flat. If consumer spending represents 70 percent of the economy, how can these numbers be construed as anything but ugly? Despite trillions of dollars in fiscal and monetary stimulus over a period of five years, the large majority of Americans are still not feeling confident or able enough to open their wallets. Underemployment is rampant, and wage growth is anemic. It remains hard to paint any other picture than our consumer-centric economy remains stuck in low gear. In other words, we need more than just stock and housing-price increases for the one percenters to get the economy on a clear and sustainable growth path.

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Importantly, the economy's failure to break out as many had hoped will likely result in a Federal Reserve that remains engaged in supporting asset prices. Having said that, as it stands today, it does not appear to me that the data have deteriorated enough to cause the Fed to stop or reverse the taper. However, I won't be surprised if and when it happens. The economy is simply not strong enough to support higher interest rates. And now we have a new wildcard being introduced into the equation: higher energy prices. Therefore, the evidence continues to suggest that there will be a ceiling on the pace of economic growth.

With regard to stock prices, it is clear that the Fed remains married to its strategy of boosting asset prices as a way to prime the economic pump. Even more troublesome to me, the Fed appears to have expanded its mandate so that it is now responsible for protecting the economy (and stock investors) from any given unforeseen shock. Therefore, the investor "complacency" that we've witnessed in recent years should not be construed as irrational. Instead, the Fed has conditioned investors to be complacent as it has repeatedly come to the rescue at any sign of trouble. This is clearly an unsustainable way to run a central bank.

Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor.