It seems like an eternity since the markets have behaved "normally." For at least the past 6-7 years, there has been a wholly different driver of supply and demand in the stock market. Market peaks and valleys have been clearly and unambiguously correlated to the various pronouncements of monetary support by the Federal Reserve. The financial market distortions created by the Fed will have a lasting impact on the economy for years to come.
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This morning we learned that the economy created 209,000 jobs in the month of July. It was the sixth straight month of job growth in excess of 200K. The unemployment rate is now down to 6.2 percent from the high of 10 percent in October, 2009. And, importantly, the unemployment rate is also significantly below the Fed's self-imposed target of 6.5 percent. These all seem like pretty positive developments.
But, as has usually been the case in recent years, things don't look quite so rosy when you begin to dig a little deeper. A variety of metrics – including the labor participation rate, the underemployment rate, the number of long-term unemployed and wage/income growth – suggest there is still a significant amount of slack in the labor market. These underlying weaknesses in the labor market are providing cover for the Fed to keep interest rates lower for longer. The prospect of a zero fed-funds target well into 2015 is what is leading the stock market to recover its premarket losses this morning. In other words, the Fed remains in charge of the stock market.
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The labor-market data we received this morning is just the latest round of ambiguous signs we have been receiving. It is true that the increase in nonfarm payrolls, at 209,000, represented the sixth straight month of growth over 200K (good). But the number was still below the consensus estimate of 230K (bad) and below the June reading of 298K (bad). The unemployment rate ticked back up to 6.2% (bad), but only because greater opportunity led more people to re-entered the labor force (good). Average hourly earnings were flat (bad), but yesterday's +0.7 percent increase in the Employment Cost Index suggested some cause for optimism (good). Consumer confidence has risen to over a six-year high (good), but several other measures of confidence appear to have pulled back more recently (bad). Stock and housing prices have increased dramatically over the past few years (good), but these gains are overwhelming benefiting the affluent while middle class incomes barely keep up with inflation (bad). GDP for the second quarter came in at an annualized rate of 4.0 percent (good), but 1.7 percent of that total was due to inventory building (bad). The housing market has improved dramatically since the financial crisis lows (good), but recent data suggests the improvements have plateaued and activity has slowed (bad).
And so, as far as I can tell, we're still stuck in an environment of relatively slow economic growth (2 percent to 2.5 percent). This is not necessarily so bad. The process of recovering from a debt bubble explosion necessarily entails a long process of deleveraging. We have made some modest progress, but there is a long way to go. Consumers and governments are still carrying too much debt, and that's a problem. But the Fed can't fix that problem without creating a whole new set of unacceptable risks. First, and most obvious, the answer to the problem of too much debt is not the encouragement of more debt. This is exactly what the Fed is doing through its monetary policy.
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But secondly, and perhaps more importantly to the health of the economy, the Fed must consider asset prices in its assessment of inflation or else continue this relentless cycle of bubble creation. Look at it this way: Assets like houses, stocks and high-yield bonds, are necessary expenses for consumers just like any other expense. People need to save for retirement or risk running out of money late in life. If the Fed insists on driving up asset prices, this raises the cost of saving for retirement. Why shouldn't this inflation be part of the equation for the Fed?
Since the Fed began its unprecedented monetary easing, our biggest fear has been that the central bank would be unwilling to remove support until it's too late. We are well past that point. Is the economy booming as many had hoped by now? Of course not, but it's time for the Fed to stand down. Unfortunately, the most obvious indicator of the Fed's withdraw is likely to be lower stock prices.