The FOMC Decision
As expected, the Fed failed to adopt fresh inflationary measures at its December meeting, which was greeted with disappointment by the financial markets. Why the markets appeared surprised by this is one of the enduring mysteries of trading on FOMC day. Given a recent slew of firmer US economic data (even though they will likely prove ephemeral), a rising stock market and a fierce gale of political headwinds, the Fed simply wasn't very likely to do anything this time around. Moreover, the three 'hawks' from the regional Fed districts that have voting power on this year's incarnation of the FOMC will be gone next year and replaced by a more dovish set. Essentially, the balance of hawkish and dovish voices will be the opposite of this year – with only Jeffrey Lacker of the Richmond Fed a likely dissenter when 'QE3' in the form of additional purchases of MBS comes down the pike in 2012. Obviously, from a political and public relations point of view it is regarded as better to have just one hawkish dissenter rather than three.
The statement can be read in its entirety here.
Essentially it was a carbon copy of the November statement, with über-dove Charles Evans from the Chicago Fed (who will be rotated into a non-voting spot next year as well) once again dissenting because he thinks that 'QE3' should have been started a few months ago already. So we continue to be witness to the flabbergasting spectacle of the lone dissenter thinking the Fed is 'too tight' after an expansion of the broad true money supply amounting to roughly 54% in less than four years.
As a reminder: at the beginning of 2008, broad money TMS-2 stood at $5.3 trillion; as at October 2011 the measure stood at $8.129 trillion. For a definition of money TMS and in what way it differs from the widely used 'official' money measures such as M2, see Michael Pollaro's excellent write-up.
One of the reasons – we think – that the FOMC statement was received so poorly by market participants is that it once again painted a bleak picture of the economy without offering fresh measures to 'do something' about the situation.
Of course from our own point of view, the less the Fed does, the better. However, we acknowledge that if it were to allow the market's natural corrective forces to proceed unhindered, this would likely lead to a considerable decline in asset prices in the short to medium term.
In summary, we continue to believe that implementation of 'QE3' is only a matter of time and opportunity. In order to proceed with this, the Fed will require some 'cover', which is likely to be provided by poor performance of financial asset prices and a renewed downturn in economic activity in early 2012.
Economic Data Evolution
In this context, we have come across a number of analyses in recent weeks that asserted that because the US economy was recently evidently stronger than anyone expected, we should look forward to a further strengthening in the months ahead.
At the moment we cannot agree with this conclusion. The evolution of economic data never happens in a straight line. Numerous factors must be considered when evaluating the data of the recent past. In the current case, the accelerated depreciation allowance has likely pulled some demand for capital goods forward, just as the 'cash for clunkers' scheme and the housing tax credit led to brief spikes in car sales and new home sales. Once the effects of these interventions dissipate, one is usually back at square one.
It is also noteworthy that the Economic Cycles Research Institute (ECRI) continues to view the economy's performance with great apprehension. As Lakshman Achuthan explains in this video at Bloomberg, a short term strengthening of certain data points should not be taken as proof that a budding contraction has been aborted. Importantly, he points out that the focus on GDP is especially mistaken, a view with which we heartily agree. Note in this context that Achuthan points to weakness in GDI data (gross domestic income) plainly contradicting recently reported strength in GDP – the former data set is however the more reliable, so future revisions to GDP are likely to be in a downward direction.
Lastly, we agree with Achuthan's call for a further weakening of economic activity because we hold that the interventionist measures undertaken to date – mainly in the form of money printing and deficit spending - have structurally weakened the economy further. While it is not possible to fashion a quantitative forecast from this recognition or a precise forecast as to the timing of the expected contraction, the downturn in ECRI's set of 'forward looking indicators' in the second half of this year should definitely be heeded as a warning.
Below is a chart showing the effective federal funds rate since the summer of 2009. As is well known, the official 'rate target' has been fixed in a corridor between zero and 25 basis points over the past few years. If private sector credit demand were to strengthen, we would expect the rate to repeatedly bump into the 'ceiling' of this corridor. So far in 2011, the exact opposite has happened – the effective rate has declined early this year and has since then remained in a very low range of roughly between 6 and 11 basis points (apart from a brief spike in August). This tells us indirectly that there is no strong upturn in private sector credit demand in sight. If the Fed were to refrain from pro-actively inflating the money supply, money supply growth would likely begin to stagnate and could well eventually go into reverse if more loans are paid back than are taken out.
Note that the strongest credit growth in recent months has occurred in student loans, which have largely become a subsidized preserve of the federal government. It is debatable how 'productive' this type of lending is, and in any event, the extent to which it may eventually contribute to economic growth by helping to beef up the skill set offered on the labor market is unquantifiable – not to mention that the effect is quite distant in terms of time.
To this it should be added that critics have rightly pointed out that the extremely high cost of higher education in many cases no longer seems to justify the eventual return, while creating a generation of debt-slaves who often realize too late that their studies have not equipped them with skills likely to produce an adequate income.
The effective federal funds rate remains at the lower end of the Fed's target corridor, which indicates that private sector credit demand remains very weak.
Source: Acting Man
