Thursday, December 13, 2012 - Federal Reserve Targets

Federal Reserve Targets

by Sinclair Noe

DOW – 74 = 13,170
SPX – 9 = 1419
NAS – 21 = 2992
10 YR YLD +.03 = 1.73%
OIL - .67 = 86.10
GOLD – 14.30 = 1697.30
SILV - .91 = 32.64

What happens when the unemployment rate gets to 6.7%? Or when the inflation rate gets to about 2.4%%? Yesterday, the Federal Reserve announced it would keep interest rates at super-duper low levels and they would buy about $85 billion dollars a month in mortgage backed securities and Treasury bonds until the unemployment rate drops to 6.5% or until inflation kicks up to about 2.5%. So, what happens when the unemployment rate hits 6.7% or inflation hits 2.4%?

The next question, and it is probably going to turn into an obsession for market traders trying to figure which target gets hit first, inflation or unemployment. Of course, that is working on the assumption that Fed policy will improve the jobs picture and that the Fed's policy will result in inflation. Maybe. What we know with greater certainty is that the Fed's policy is a boon for banks. They can offer loans and keep a very wide spread, also known as a profit. And the banks can be very particular about the quality or vintage of loan they make; which in turn keeps the spread high. The banks don't really need to make mortgage loans to consumers;Ttey can get an even bigger spread on high interest credit card accounts; they can get an even higher interest on payday loans (yes, some of the biggest banks are involved in payday lending, not in their own name, but they make short-term loans at rates that would make Tony Soprano blush), and of course, the banks can make really big spreads gambling on derivatives. (Remember the London Whale?)

Low interest rates should lower the cost of capital, and that should encourage businesses to borrow money for expansion and hiring. The problem is that businesses only expand and hire when they are growing their business, not just because money is cheap. You don't hire a new employee because interest rates are at historic lows, you hire a new employee because you need to fill an order. The problem is that most businesses aren't getting new orders because consumers are holding onto their dollars until the eagle grins. The only way to get more business is to have more people in more jobs earning more money. While there have been jobs added to the economy since the Meltdown of 2008, there are just enough jobs to keep up with the population growth, and the median wage keeps dropping.

Corporate profits keep growing; they're at the highest share of the overall economy than at any time in the post World War II era, but wages are taking the smallest share than at any time since the post World War II era. So, the Federal Reserve has stepped into the breach with a fairly clear cut definition of their job responsibilities; their dual mandate is price stability and maximum employment; even though the employment part has largely seemed an afterthought for most of the history of the Fed. Nonetheless, Fed Chairman Bernanke sounded sincere when he said yesterday: "The conditions now prevailing in the job market represent an enormous waste of human and economic potential."

And the Fed's plan to buy Treasuries and MBS doesn't really go to the heart of the problem. So what happens when the inflation rate gets to about 2.4% or the unemployment rate gets to about 6.7%? Well, first off, it is highly unlikely that both the inflation rate and unemployment rate will move with pure synchronicity. If inflation picks up but hiring doesn't, well tough luck job seekers. And if the jobs picture improves without sparking inflation, why not just keep the policy in place and see if we can find a job for everyone who wants to work?

Previously, the Fed had promised to keep rates near zero until mid-2015. Fed officials still think that’s the earliest they’ll tighten, but feel more comfortable tying that decision to the state of the economy than the calendar. Yesterday, Bernanke claimed that the target isn't really a target, saying: “What it is, is a guidepost [to] when the beginning of the reduction of accommodation could begin. It could be later than that, but at least by that time, no earlier than that time. So it's really more like a reaction function or a Taylor rule, if you will -- I'm ready to get the phone call from John Taylor. It is not a Taylor rule, but it has the same feature that it [says] how our policy will evolve over time as the economy evolves.”

By the way, the Taylor Rule isn't really a rule, it's more like a guidepost, and it says the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions, and the basic rule of thumb is that for each one-percent increase in inflation the central bank should raise the nominal interest rate by more than one percentage point.

I'm sure Mr. Bernanke has given this careful consideration but we haven't really heard how the Fed will get out of this mess. If thresholds were simply another way to express the liftoff date for the Fed funds rate, it really wouldn't be a big deal. But set against several steps taken earlier this year, it's actually a fundamental re-positioning of how the Fed operates. It began in January when the Fed articulated that unemployment and inflation would get equal consideration in deciding when and how much to adjust interest rates. In September came the application of this new way of thinking; they announced the Fed would buy $40 billion a month of mortgage backed securities by creating money (“quantitative easing”, or QE) until the labor market had improved “substantially.”

With the latest decision it has quantified “substantially”; it is 6.5% unemployment..., or 2.5% inflation. What all these steps do is attempt to harness the public's expectations to leverage the stimulative effect of monetary policy. If investors believe the Fed will tolerate inflation above target, they will drive long-term interest rates lower even in the face of inflationary pressure. If the public believes the Fed is serious about unemployment, they will spend and invest more, helping to bring lower unemployment about. At least in theory.

But what if it is not at all clear the Fed's tools can deliver the lower unemployment it wants. If the public shares that skepticism, the expectations effect won't work. The Fed did say it would step up QE to $85 billion a month, and the markets responded with a yawn and actually closed down on the news yesterday. What if QE4, or whatever we're not supposed to call it, suppose it doesn't work. Or consider the analogy from PIMCO's Mohamed El-Erian, who said: “Consider ... the competing emotions a patient feels when confronted with news of a new drug that is yet to go through clinical testing. Professional investors welcomed the news that the Fed is "all in" when it comes to trying new drugs to stimulate the economy. And they fully understand that the transmission mechanism runs right through the equity markets. As Bernanke has stated, the Fed is looking to "push investors to take more risks." Hence the initial positive reaction to the announcement...As the day proceeded, investors realized that, like any experimental drug, there is a material risk of complications. After all, the Fed's operational modalities are not straightforward; the analytical underpinnings are far from robust; and the Fed's prior experimental measures have not succeeded in generating sustainable growth.”

Even Fed Chair Bernanke seemed to have doubts; he said: “the ability to provide additional accommodation is not unlimited.” In other words, this better work, or the whole thing is going to get ugly, and the Fed has limited tools, or at least tools that the Fed is not willing to display to the public. The truth is that the Fed is clothed in immense monetary power, and they have many, many more tools at their disposal, although some of those tools are extremely controversial. Still, you have to think this was a way for Bernanke to say to the knucklehead politicians that they need to get their acts together.

And on top of that, there has been no answer to the question: what happens if or when inflation gets to 2.4% or unemployment gets to 6.7%? At some point the Fed has to exit QE to infinity and beyond. And now the markets have a specific target, or at least guideposts. And you've got to suspect the bond vigilantes are sitting back and waiting to pounce. Unemployment near target? Look for a massive short on Treasuries, look for credit default swaps to jump, look for stocks to take a nose-dive, which in turn would cause businesses to batten down the hatches, freeze hiring, and possibly crater the economy. It's possible that by setting a target, we'll never get there. Of course, it's not easy for the bond vigilantes; remember it is not just the Fed but really all the central banks of the world have come together; and remember the old saying, don't fight the Fed.