Monday, March 17, 2014 - Empty Chambers and the Tools in the Toolbox

Empty Chambers and the Tools in the Toolbox

by Sinclair Noe

DOW + 181 = 16,247
SPX + 17 = 1858
NAS + 34 = 4279
10 YR YLD + .05 = 2.70%
OIL- .90 = 97.99
GOLD – 14.50 = 1368.50
SILV - .27 = 21.29

Russia held a referendum vote on taking Crimea from Ukraine. Crimean voters approved the takeover with 98% voting in favor; the 2% of voters who opposed the take-over are probably on a slow train to Siberia. Global financial markets ignored the annexation, and they went up in what was described as a “relief rally”.  Stock markets in the US, Europe, and even Russia all moved higher.

The United States and European Union countries imposed a new round of sanctions on 11 Russian and Ukrainian political figures, freezing assets and banning visas for Russians deemed responsible for interfering in Ukrainian sovereignty. The order means that any assets owned by the targeted Russians in the United States will be frozen and Americans will not be allowed to do business with them.

Few Americans are truly concerned about Ukraine, nor should they be. The United States has no real national interests there, and whether Crimea becomes part of Russia is irrelevant to broader US national security issues.

That doesn’t mean we shouldn’t pay attention; annexation of Crimea by Russia, and especially a further push by Moscow into Ukraine, would poison US-Russian relations for many, many years to come, and it will make cooperating with Russia on Syria, Iran and Afghanistan much more complicated. The cause for concern is that ill will between Washington and Moscow and a spiraling down of relations will have a devastating ripple effect on much else in international relations. It will also intensify pressure on the White House to halt the cuts in the Pentagon’s budget that Obama and Secretary of Defense Hagel have already proposed.

In this game of Russian roulette, the trigger was pulled and the chamber was empty. So, the referendum played out as expected; sanctions are in place; it’s an ugly spat, but no bombs are flying; what a relief; the Dow Industrials jump 181. I don’t know if there is any connection, or if the stocks moved higher because they’ve been down for the last 6 sessions.

The Federal Reserve FOMC is meeting this week to determine monetary policy. We will get the FOMC statement on Wednesday and Fed Chairwoman Janet Yellen will hold a press conference. It is widely anticipated the Fed will continue to taper off its bond purchase program by about $10 billion; the Fed is also expected to reiterate its commitment to keeping interest rates low for a long time. The Fed’s current pledge is to hold rates steady until “well past” the point when the unemployment rate falls below 6.5%. The unemployment rate is currently 6.7%, so the Fed might want to rethink that 6.5% unemployment target because we are so close to it. Most likely, the Fed will stay the course, with just minor nuances in their statement giving hints to the direction of the economy.

And that is the important thing to remember: the economy. Everybody is trying to figure out if it has gained some traction. For the past few months we’ve heard the argument that the weather has been hampering the economy; maybe, when the never-ending winter ends the economy will blossom; on the flip side, if the economy really has underlying strength then we shouldn’t have to listen to all these excuses about the weather.  

Whether it feels like it or not, the economy is improving; government is cutting a little less, businesses are hiring a little more, and consumers are spending a little more; not exactly the formula for an economic blastoff, but things are getting better. Even so, much of the American public is still not over the financial downturn. A Pew Research Center January survey found 16% of people rate the national economy as excellent or good while 83% rate it as fair or poor; that is pretty much in range with our opinions on the economy for the past 6 years. And only 39% rated their own personal financial situation as excellent or good. There has clearly been some improvement in the economy in the last 5 years, but our mood remains dark.

Whether you are optimistic or pessimistic depends in part on your partisan politics. Through George W. Bush’s two terms, Democrats were much less likely than others to say the economy was in excellent or good shape. Then, with Obama’s election, the reverse became true. Republicans became less positive and more pessimistic than Democrats. In Pew Research’s February poll, fully 47% of Republicans but only 17% of Democrats said they were hearing mostly bad economic news.

Another factor is your personal income; if your household earns north of $100,000 per year, the chances are you feel pretty good; less than that, not so much. In 2008, 53% of families felt they were in the middle class; that has now dropped to 43%. How can the economy be getting better when so many are families are falling out of the middle class?

Clearly the economic recovery has been uneven. Clearly the stock market is higher than it was 5 years ago, but if you don’t own stocks and if you don’t have a job, the stock market is not an important part of your life. Clearly housing prices have increased but if you lost your house to foreclosure 4 years ago, the housing recovery is working against you. Clearly the unemployment rate has dropped from 10% to 6.7%, and that’s good, but it doesn’t reflect the quality of jobs, the loss of benefits, and the stagnation of wages.

There are plenty of reasons for Americans to feel bad about the economy, but the pessimism started before the Great Recession or small “d” depression. Back in January 2000, 52% of all Americans termed economic conditions as good, and an additional 19% rated the economy as excellent. No more. By the end of 2000, the markets took a hit, and another hit in 2001; in 2006, the housing market bubble started to burst; and then the financial meltdown of 2008. That boom bust cycle has grown tiresome and debilitating.

So, the Federal Reserve is meeting this week and part of their challenge is to avoid booms and busts; part of their challenge is to equalize the recovery, and the simple fact is that their toolbox of quantitative easing and Zero Interest Rate Policy is ill-suited for the job. In the past year, as we’ve watched the Fed think about taper, threaten taper, head fake on taper, and then actually start to taper, we’ve seen some securities prone to large price movements related to the Fed’s maneuvers. Some of the securities that load on Fed risk are somewhat obvious: investment grade corporates and US government bonds are exposed primarily to interest rate and inflation risk, which the Fed can impact directly. Others are not so obvious: emerging market equity funds, consumer staples, and utilities, for example.

What we haven’t seen is the Fed being able to change the jobs picture, which is part of their dual mandate. Former Fed Chair Bernanke tried to take credit for the lower unemployment rate but it is questionable that the Fed’s policy had as much impact on the labor market as it did on the stock and bond markets.

And now we’re starting to hear some Fed policymakers talk about tight labor markets. It's hard to believe that this is even a debate when unemployment is still at 6.7% and inflation is about 1%. The new inflation hawks argue that these headline numbers overstate how much slack is left in the economy; that the labor force is smaller than it sounds, because firms won't even consider hiring the long-term unemployed; that our productive capacity is lower than it sounds, because we haven't invested in new factories for too long. And that wages and prices will start rising as companies pay more for the workers and work that they want. In other words, they think that the financial crisis has made us permanently poorer. That the economy can't grow as fast as it used to, so inflation will pick up sooner than it used to, and we need to get ready to raise rates. Welcome to the new normal.

If tighter labor markets were causing wage inflation, they'd have caused wage inflation, but that hasn't happened. There was a minor uptick in wages in February, but that was almost certainly weather related. The bad weather kept people off the job, and that tends to affect hourly workers more than salaried ones. So higher-paid people probably made up a bigger share of the workforce last month, and voilà, it looked like wages rose. But that was just statistical noise, and if you look at the bigger picture, wage growth is still stagnant and actually a little lower than before the financial meltdown.

Nobody knows how many of the people who stopped looking for work the past five years will start looking again now. Some of them retired, and won't return. But others just went back to school or temporarily gave up looking because things seemed so hopeless—and will come back sooner or later. A strong job market sucks workers back in. Look at the participation rate, and it is clear that isn’t happening.

At some point the Fed will need to look beyond their inflation fears and try to come up with some new tools to fulfill their dual mandate; and if they don’t have the tools in the toolbox, maybe they can shame the politicians into enacting fiscal policy to get people back on the ladder of opportunity.