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Based on many
pronouncements by economic policy makers, reams of articles by the top financial
journalists and near continuous discussion on the financial news channels, it
appears that the quantitative easing juggernaut that has steamed the high
seas of macroeconomics for the last three years is finally pulling into
port...supposedly for the last time. According to the dominant narrative, QEI
and QEII helped stabilize the economy during the Great Recession and now the
Federal Reserve is ready to take the training wheels off. If so, the economy
may need a helmet because there is virtually no chance that it can avoid
major contractions without central banking support.
It is ironic,
but there is no doubt that the proposed removal of artificial stimulus would
be the best thing for the country in the long term. But very few observers
understand how it will inflict short term pain. So confident is the Fed that
earlier this week, St. Louis Fed President James Bullard indicated that any
notion of additional quantitative easing is off the table. In fact, he said
the central bank may tighten policy in 2011 by allowing its balance sheet to
shrink. Investors would do well to remember that Bullard was the first Fed
official to support the second round of bond purchases now known as QEII. It
is likely that he will make a similar reversal if the economy shows any signs
of weakening in the months ahead.
Fed policy
makers like Bullard are guilty of reckless optimism if they believe the
economy has truly healed. The evidence of a pending slowdown is abundant. The
Empire State's business conditions index decreased 10 points from April to
just 11.9 in May. Meanwhile, the prices paid index rose sharply, with about
70% of respondents reporting price increases for inputs, and none reporting
price reductions. That inflation index advanced 12 points to 69.9, its
highest level since mid-2008. And things are even worse in Philadelphia. The
Federal Reserve Bank of Philadelphia's general economic index fell to 3.9 in
May from 18.5 a month earlier.
Turning to
the labor front, the four week moving average of initial jobless claims rose
to 439,000 last week, from 437,750 in the week prior. Of course, the real
estate market continues in its malaise. According to the National Association
of Realtors, April existing home sales dropped to an annual rate of just 5.05
million. Prices continue to set new post crash lows, with prices down
5% YOY. Despite the fact that the government still accounts for nearly the
entire mortgage market and the Fed has rates near zero percent, inventory of
existing homes jumped from 3.52 to 3.87 million units and the months' supply
climbed from 8.3 to 9.2. Does it sound like the economy is ready to get up on
its own two feet?
But the Fed
is under pressure to do something about the growing inflation threat. Year
over year increases of CPI, PPI and Import prices are 3.2%, 6.8% and 11.1%,
respectively. As price increases hit middle class consumers, the Fed is
facing intense pressure to push down inflation by draining the balance sheet
and raising interest rates. It's a dangerous game.
In its
simplest terms quantitative easing is nothing more than the government's
attempt to boost consumption by borrowing trillions of dollars. Over the long
haul this is no way to run an economy, and a sustainable recovery will be
impossible as long as such borrowing continues. But in the short term, a
cessation of government borrowing will lift the veil on our artificial
economy, and reveal how dependent we have become. U.S. fiscal and monetary
austerity will cause GDP to fall as the deleveraging process that was
interrupted in 2009 returns with a vengeance. I do not believe the Fed or the
Administration has the intestinal fortitude to let that happen.
A bona fide
Fed exit from interest rate manipulation means that both nominal and real
interest rates would rise significantly. The ten year note yield is less than
half its average over the past 40 years. Normalization of rates would provide
a serious headwind to markets and the economy.
The high
leverage that brought on the Great Recession has not been addressed in the
slightest. U.S. household, corporate and government debt as a percentage of
GDP has never been greater. So, if interest rates were to rise, why should we
expect a different result from what occurred in 2008?
Whether or
not the Fed is bluffing has dramatic implications for investors and the
country. Mr. Bernanke will eventually have to choose whether he wants another
depression or more of the inflation the Fed is so adept at causing and then
denying.
Michael Pento
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