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Fed’s success hinges on effective market supervision

The Federal Reserve building in Washington, D.C.
Kevin Lamarque | Reuters
The Federal Reserve building in Washington, D.C.

Now that the Fed has initiated its process of policy adjustment, market timers are out in force with dire warnings, ranging from collapsing real estate markets, a bloodbath in high-yielding assets, soaring gold prices and an imminent recession of the American economy.

What are we to make of all this? Well, in the best of cases, the buy-sell timing calls are a complex guesswork based on observations of excessive supply-demand imbalances affecting large segments of the real economy and financial services.

So, before dismissing out of hand any of these headline-grabbing pronouncements, I believe that investors might wish to look carefully at the assumptions underlying such forecasts. It is simply a question of asking "why."

Remember that some of the people who got the last financial crisis right were those who correctly observed hugely destabilizing market imbalances and practices that were bound to undermine the soundness of the U.S. – and even global – financial system. A few of these market timers eventually ended up with a glowing reputation (and probably a lot of money) for their insights and analysis.

Don't forget the past

And let me give them even more credit that might infuriate my fellow economists. Indeed, it is even possible that some of these market timers perfectly understood the key economic and regulatory drivers that inexorably led the American economy to the financial precipice.

Then, as now, the Fed's policy was at the center of it all, simply because long years of loose monetary policies tend to lead to an equally loose credit-risk analysis.

What else would one expect to happen when financial institutions operate in an environment of cheap and abundant liquidity? Their core business is to sell loans with money they were getting at zero percent interest rates. And during a long period leading up to the last crisis, the sales of a vast array of financial products and services were literally free of any meaningful prudential supervision.

We know now that this frightening situation led us to the Great Recession, a virtual seizure of our entire financial system and massive bank and non-bank bailouts that exploded the Fed's balance sheet from $832.5 billion in June 2008 to $3932.4 billion reported on December 9, 2015.

That history should be enough to have us pay attention to market timers, because, cutting through their bombast, it is clear that they are again working with the assumption of destabilizing market excesses.

I hope that assumption is not true, but only the Fed knows what the truth is.

But let me go back to a less obscure field of analysis.

Market timers' idea of an impending American recession and crashing equity markets – based on the view that the Fed waited too long to begin raising interest rates – could only be plausible if we were facing an immediate and a credible prospect of a runaway inflation.

That, however, is not what we have. The consumer price inflation in November was 0.5 percent above the year earlier, and the employment cost index in the private industry rose 1.9 percent in the year to September, well below the 2.3 percent increase in the same month of 2014. Also, hourly compensations in the non-farm business sector grew at an annual rate of 2.9 percent during the first three quarters of this year, which is only slightly above their 2.7 percent increase in the year before.

There is no red flag anywhere in these cost and price inflation numbers.

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And neither do we have apparent capacity pressures that could significantly accelerate cost and price inflation in the months ahead. The manufacturing sector is operating three percentage points below its long-term capacity utilization rate of 80.1 percent. Service sector industries are doing much better; the most recent surveys are showing that they have come off their peaks, and that they are now expanding at a more sustainable pace.

All this indicates that the current state of the economy does not require the Fed to rush its credit tightening process.

Meanwhile, U.S. domestic demand is growing at a rate of 3.2 percent; it is strongly underpinned by a 3.6 percent increase in real personal disposable incomes and by 2.1 million new jobs created over the twelve months to November.

Unfortunately, the external sector is a powerful drag on growth and employment. America's export markets are shrinking, and exporters are struggling with the dollar's 10 percent trade-weighted appreciation since December of last year. The combined impact of a weakening foreign demand and less competitive U.S. goods and services is expected to reduce GDP growth by close to an entire percentage point this year and next.

Market timers have nothing to say about this. I would have expected them to urge Washington's trade diplomats to have Germany (the key to one-fifth of our exports to Europe) get off our back and do something for itself, instead of living off the rest of the world with its $290 billion current account surplus (8 percent of GDP).

If Washington did that, it would be knocking on an open door. The Italian Prime Minister Matteo Renzi told the German Chancellor Merkel last week during the EU Council meeting to stop picking on his fiscal policy because he wanted to stimulate his economy. That was music to the French and Spanish ears (to say nothing of the poor Greeks), but they got nowhere.

Could this be the time for Washington to get the heavy guns out? And maybe to have the same kind of chat with Beijing and Tokyo? China, Germany and Japan account for two-thirds of the U.S. trade deficit. Getting a better access for American companies to these large economies – representing 25 percent of world markets – would reduce the downward pressure on American growth and employment. That would also ease the burden on the Fed.

Investment thoughts

I don't believe market timers' implicit assumption that huge demand-supply imbalances in some segments of the U.S. economy are threatening the stability of the financial system and the viability of further growth and employment gains.

But I do believe that the re-pricing of credit risks and asset values will challenge American financial institutions as the process of interest rate adjustments continues to unfold.

Clearly, the case for the Fed's heightened supervisory vigilance cannot be overstated. And I am assuming that this is well understood.

On that note, I think that the U.S. equity market is not a spent force. So far, the long end of the yield curve has responded well to the Fed's largely symbolic interest rate increase. Profit shares will continue to grow in an expanding economy with slowly rising labor costs. But this transition to a new interest rate environment will require more selective portfolio choices.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.