Fed and Markets: Who Is Guiding Whom?
Those of you who have followed this post since its inception last November might recall that investment strategy options it recommended at that time were clearly defined: sell bonds, buy equities, mind the caution flag on gold whose price had gone too far.
And this is what happened: Yields on the U.S. 10-year Treasury note rose from the end of last November to July 5 of this year from 1.62 percent to 2.74 percent; over the same period, the Dow Jones Industrial Average soared 16.6 percent and the price of gold fell 30.5 percent.
Assumptions underlying these investment strategy thoughts were simple and straightforward - and they have not changed since: The U.S. economy was seen on a growth path that would gather pace as the strengthening banking system stepped up lending to businesses and households.
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This assessment also included the view that the U.S. Federal Reserve's monetary stimulus would partly offset fiscal restraint imposed by automatic government spending cuts and tax increases.
Monetary Policy Works – Always, Everywhere
The big losers in this game are those who doubted the effectiveness of the monetary policy. In their view, the Fed's monetary stimulus had no traction because it was caught up in the "liquidity trap," the classic metaphor for an ineffective, "pushing on the string," monetary policy.
They, therefore, concluded that the U.S. economy was flat on its back. So, "head for the hills," they called, and load up on bonds and gold.
The tragedy is that people who had been damaged by this utter nonsense are unlikely to be bond traders. As always, they probably got out on time. Those left "holding the bag" were bond market investors. And all they could do is to flee the bond market in droves in an exercise of damage limitation.
Predictably, the blame game followed. To justify their failure to see the obvious, bond market operators found the scapegoat in the Fed Chairman Ben Bernanke. They made him responsible for the bond market sell-off because Mr. Bernanke suggested, in mid-June, that Fed's asset purchases might end by the middle of next year.
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According to the Federal Open Market Committee (FOMC) forecast, that is when the unemployment rate is expected to be somewhere between 6.5 percent and 6.8 percent.
Having been accused of improper "market guidance," Mr. Bernanke rushed in to obligingly "clarify" his remarks by saying that "asset purchases were tied to what happens in the economy," and that "if the economy does not improve along the lines that we expect, we will provide additional support."
The irony is that Mr. Bernanke said much less than what was revealed a few weeks earlier in the minutes of the FOMC meeting held on April 30-May 1, 2013.
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These minutes recorded that a number of participants in this policy-setting committee "expressed willingness to adjust the flow of purchases downward as early as the June (2013) meeting, if the economic information received by that time showed evidence of sufficiently strong and sustained growth." The only question was to identify indicators that would be used to trigger such a policy change.
Trying to understand the criticism leveled at Mr. Bernanke and the FOMC for poor "market guidance," one must wonder about what, exactly, financial markets expected.
Markets Are Forcing the Fed's Hand
The point here is not the bond market gurus' implausible criticism of the Fed. The key issue is that Mr. Bernanke's "hunch" that the Fed might soon have to begin reducing asset purchases seems correct in view of what is happening in the U.S. economy. And I believe that his comments will prove to have been stabilizing because they provoked the beginning of an overdue – and relatively orderly - market adjustment.
Indeed, activity and price signals indicate that the Fed had stabilized the financial system and set the U.S. economy on a path of broad-based and sustained growth.
Manufacturing and service sectors are expanding. Labor markets are improving. Wage gains are subdued and are almost entirely offset by productivity advances. As a result, corporate profits are growing and supporting capital outlays on equipment and software. I
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n the housing sector, double-digit growth rates bode well for private consumption and investment spending. Inflation rate at 1.4 percent is well within the Fed's "comfort zone," and the dollar's strong trade-weighted exchange rate is an additional shock-absorber for cost and price pressures.
Clearly, this is an economy that needs neither free money nor Fed's asset purchases. That is the message financial markets are sending by pushing up the bond yields.
In fact, the steepening yield curve is screaming: Asset purchases and zero interest rates have become unnecessary and counterproductive because they are no longer holding down credit costs. Even the key (30-year) mortgage rate rose over the last month by 130 basis points to 4.78 percent as of last Friday, after being roughly stable around 3.5 percent between July of last year and May of this year. That is the critical interest rate the Fed wanted to keep down with its massive asset purchases in order to support the recovery of the all-important housing market.
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And this is what comes next. With sharply rising bond yields, the Fed is approaching the point where (to calm the markets and to reassert its control over a stable and noninflationary growth) the only way forward will be to start raising interest rates to the level that would indicate a neutral monetary policy. That level would be an effective federal funds rate between 3 percent and 4 percent, assuming an inflation rate anchored around 2 percent for the foreseeable future.
That is quite a stretch from the 0.09 percent federal funds rate last Friday. But the sooner that adjustment begins, the better, because it will be less unsettling for the economy and asset markets.
That is the sort of "market guidance" the Fed needs to exercise. Apologies to bond market operators are obsequious gestures of confusion and indecision. Markets want to see that the Fed knows what it is doing – and that it is in control.
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 Business School.