A Bill for Every Lunch

September 18, 2012

Markets this week will continue to digest the latest fare from the Federal Reserve. 

-David Kelly, chief global strategist, JP Morgan

In my first undergraduate lecture in economics I learnt that there is no such thing as a free lunch.  Moreover, the professor made no distinction between healthy, nutritious lunches, full of whole grains and vitamins and unhealthy ones, larded with fat and high-fructose corn syrup.  Every lunch had to be paid for.

Markets this week will continue to digest the latest fare from the Federal Reserve.  The main course was a decision to provide an open-ended commitment to buy an extra $40 billion in agency mortgage-backed securities each month.  For dessert they produced an expectation that economic conditions would warrant an exceptionally low level of the federal funds rate until at least mid-2015.  The FOMC statement explicitly said that the committee expected these moves to apply downward pressure to long-term interest rates and that they intended to continue with this extremely dovish monetary policy until there was a substantial reduction in the unemployment rate. 

It is not clear that these policy moves can or will depress long-term interest rates from what are already extremely low levels.  It is even less certain that lower long-term interest rates, at this stage, can stimulate stronger economic growth, although a combination of a Fed commitment to buy mortgage securities and a potentially reduced risk of mortgage put-backs may boost the supply of mortgages. 

The extension of quantitative easing also increasingly begs the question of how this will all be unwound - in other words, who will eventually pay for this largesse.  The most likely scenario is that economic growth will pick up, causing unemployment to drop to levels at which wages begin to accelerate.  Indeed, this may well happen a little more quickly than anticipated by the Fed. 

At that point, the Fed will be forced to raise the federal funds rate and the interest paid on reserves in tandem, even as long-term interest rates rise, undermining the fair market value of the Treasuries it has bought in such huge quantities over the past few years.  At an extreme, the Fed could find itself both running at an operating loss and with a fair market value of its liabilities exceeding that of its assets.  The taxpayer could, of course, step in both to bolster the Fed's balance sheet and make up for the loss of considerable interest income that it currently receives from the Fed.  However, this would only worsen what will prove to be a very painful process of moving back to a balanced federal budget.   

There are other possibilities.  However, in most of them, the bond market looks far more vulnerable than the stock market.  Perhaps because of this, equities rather than bonds were the primary beneficiary of the FOMC statement, building on a rally that has been supported by the ECB's far more justifiable commitment to protect sovereign bond markets.  Of course, this equity market rally can be a positive for economic growth on its own, through a wealth effect and can also help economic growth indirectly by adding to business and consumer confidence.

This confidence should be further supported by numbers due out this week.  On the manufacturing side, the Empire State Index, due out on Monday and the Philly Fed Index due out on Thursday, should both show moderate improvement in activity in early September while the "Flash" Markit PMI Index, although possibly posting a month-over-month loss, should still indicate that manufacturing is expanding.

Housing numbers due out this week should be more unambiguously positive with both Housing Starts and Existing Home Sales seeing strong gains and the Home-Builder Confidence Index possibly continuing a recently strong trend of improvement.  Unemployment Claims will be much harder to read as they could be distorted both by the lingering effects of Hurricane Isaac as well as layoffs triggered by the Chicago teachers' strike.  

The U.S. economy still faces considerable uncertainty, most notably from the fiscal cliff and the potential for eventual military action by the U.S. and Israel against Iran.  The Fed's actions, on balance, are adding to that uncertainty.  However, weighed against all of this is the fact that equities still look somewhat cheap, and cash and bonds look very expensive for a slow-growing but stable economy,  For this reason, despite worries about both U.S. fiscal and monetary policy, investors should still consider a generally balanced approach to investing with a slight over-weight to risk assets.