Monday, June 24, 2013

Managing Fed’s Expectations—Why Austerity Now?

Popular Economics Weekly

It seems that Ben Bernanke’s Federal Reserve has lost its nerve. Last week’s FOMC meeting confirmed that its Open Market Committee has decided to end the monthly QE3 security purchases sooner rather than later. We already see the damage it has done to both stocks and bonds—worldwide. It also solves the puzzle about why President Obama basically fired him in a Charlie Rose interview when Obama said, “He’s already stayed a lot longer than he wanted or he was supposed to.” Obama must have known the Fed Governors’ decision in advance.

If not a loss of nerve, why would the Fed in effect reverse course? It had been trying to manage expectations that its easy money policies would lead to higher future growth and slightly higher inflation by saying that the U.S. unemployment rate had to drop to 6.5 percent before it would begin to raise interest rates.

Was the economy heating up? No. Was inflation out of control? No, it was still falling. Even 6.5 percent was an unemployment rate that would never have been tolerated in the past for long. But it is being tolerated now, and so is the agony of prolonged unemployment.

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Graph: Trading Economics

Instead the Bernanke’s abrupt announcement showed how easy it is to change the course of expectations by one press conference—on a dime, even. The markets’ reaction is telling the Fed that expectations have been reversed, that growth is not yet strong enough to warrant taking the foot off the gas pedal, to use Bernanke’s own metaphor.

Time will tell, of course, but with median household incomes still depressed—down some 7.8 percent since 2000 after inflation—there was the hope that Bernanke would stick to his word. Now he is saying even if the unemployment rate fell to 7 percent, they could begin to taper their security purchases later this year.

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Graph: dshort.com

That is what we heard. It can only mean that even the Federal Reserve is now locked in the grasp of what Paul Krugman and others have called the “monopolists”; those who espouse higher interest rates over higher employment. They are the money managers and owners who would rather pad their own pockets than that of their employees.

“So what’s really different about America in the 21st century,” asks Krugman? “The most significant answer, I’d suggest, is the growing importance of monopoly rents: profits that don’t represent returns on investment, but instead reflect the value of market dominance.”

The massive selloff of debt and equities means the markets must envision a massive slowdown in growth, as investors withdraw from the markets. And so the safest solution is hoard their cash, as was done during the Great Recession. Cash, after all, is the best recession hedge of all. It is the ultimate flight to quality when the odds increase for another downturn, which the Fed may inadvertently now be encouraging rather than preventing.

Harlan Green © 2013

Follow Harlan Green on Twitter: www.twitter.com/HarlanGreen

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