Additional INSIGHT from Tad Rivelle

Trading Secrets: The Fed’s Coming Rendezvous with Reality

April 17, 2013

The Fed is printing $85 billion in reserves each month. And while the Fed excels at money creation, it actually has very limited control as to how all this money gets spent. Yet, the bluntness of the tool has done nothing to deter monetary officialdom from decreeing that the QE will continue until labor market morale improves. So far as the Fed is concerned, lifting the demand for labor – as measured by a nebulous and shifting combination of changes in the unemployment rate, wage growth, and labor force participation ratios – is the grail that defines the contours of U.S. monetary policy. While no one quarrels with the stated goal of putting people back to work, we might consider whether the Fed’s “all in” approach to stimulus is, in fact, leading us to the promised land of full employment or condemning us to wander that much longer in a desert of economic malaise. The consequences for continuing with or increasing the magnitude of the existing policy configuration will dramatically influence returns across a variety of asset classes. Hence, achieving a proper understanding of what monetary policy can – and cannot – do is not about “voting” for one or another academic theory or political ideology. And it also must be more than just grasping the immediate and readily observable effects of policy. Rather, it is about assessing the longer term consequences for growth and inflation, and what these may mean for capital market returns.

Instructively, back in the truly dark days of late 2008/early 2009, the Fed correctly calculated that extraordinary times called for extraordinary measures. Such measures were expected to produce results that would also be, well, extraordinary. Did they deliver? The Fed’s “central tendency” forecast for GDP growth called for 2.5% - 3.5% for 2010, 3.4% - 4.5% for 2011, and 3.5% -4.8% for 2012. The actual numbers? 2.4% for 2010, 2.0% for 2011, and 1.7% for 2012. All big misses and, worse, an unsettling pattern of sequential year-over-year declines in the U.S. growth rate. So, more money, less growth? N’est pas, maintains the central bank. Rather, the economy has been “held back” by a series of unfortunate events: the Euro, the banks, tragedy in Japan, and, of course, the persistent woes of the housing market. So, right policy but unlucky economy? Or, has the Fed and, by extension, U.S. policy-making become rigid and now needs a rendezvous with reality?

Some see causes for optimism. The housing spring has arrived. Real estate, the apple of the Fed’s eye, owes its revival to a QE that has funneled trillions in sub-market priced credit to the housing market and to a zero rate policy that has fostered portfolio shifts into real-estate as savers flee the inflation “levy” on cash. Yet, with food fights returning to many regional housing markets, we are at a point at which if “all in” monetary policy is going to prove itself at all, the time to see that unambiguous improvement in the labor market should be soon. Indeed, many monetary doves view the uptick in housing prices as incontrovertible evidence that the Keynesian prosperity is right around the corner. They are convicted in the belief that Washington-directed policies that stoke aggregate demand are close to solving the labor conundrum. Credit spigots wide open serve – to this way of thinking – to lower business investment hurdle rates and power a relentless “search for yield” whose effect is to ensure that no would-be borrower is turned away. A nouveau wealth effect from housing and stocks is meant to unleash the Keynesian animal spirits and get consumers consuming and corporations hiring. Essentially, the Fed’s working “theory” is that the unemployment problem of 2013 is solvable with macro tools. This belief pre-supposes an essentially healthy “supply side” ready and able to produce more, to hire more, if consumers would just spend more. Yet, “all in” monetarism has not fixed the labor market:

Slowest Labor “Recovery” Since 1945

Sources: BLS, TCW

Real Earnings Have Been Stagnant

Sources: BLS, TCW

Further, with housing and stocks up, and credit flowing cheaply and abundantly, monetary policy in the current environment represents more relative stimulus than at any point since the financial crisis! Yet, all the while, labor force participation rates have fallen and real wages have stagnated. A Beveridge curve analysis suggests that along with large cohorts of the unemployed there stands, side-by-side, an anomalously elevated number of job openings. That is usually interpreted to mean that unemployment has gone beyond the “cyclical” to the “structural.” Indeed, both Beveridge curve and fundamental economic logic suggests that the U.S. may be suffering from an ill more complex than a Keynesian “aggregate demand” deficit. For years, the Fed has managed interest rates down below market clearing levels so as to foster credit creation above that which the private markets would otherwise have intermediated. In this respect, the Fed has substituted its “central planner’s” judgment for that of millions of decentralized firms and individuals. Does anyone seriously think that such a dynamic enhances economic efficiency? The Fed’s working assumption that the essential problem we face is one of too little aggregate demand seems off the- mark. Rather, the U.S. may, in fact, be suffering from its own version of a competitiveness problem, analogous to the challenge confronting peripheral Europe (if the Greek government dropped out of the Euro and then printed billions of Drachmas, would that lift aggregate demand in Greece and solve its unemployment problem?).

“Modified” Beveridge Curve

Sources: BLS, TCW

The rub of it all may be this: while easy money leads to more growth for now, the costs of these central bank “manipulations” may be that the micro-actors (businesses and consumers) who are the “real economy” are handed faulty prices and hence faulty incentives. Credit that is “too cheap” keeps marginal companies on “life support.” As such, they become like the Japanese “zombie” companies of another time: inefficiently utilizing resources and without any growth prospects. Further, low rates facilitate a level of national government borrowing that would be unfeasible were rates higher. Hence, more resource flows into subsidized student loans (some of which delays the entry into the workforce of the young and energized) and disability payments (some of which accelerates the exit from the workforce of the older and skilled). Even as aggregate demand is supported, perverse incentives limit the vibrancy and flexibility of the labor market. In short, more money may be impairing growth over time.

If, as we surmise, easy money is seriously interfering with the free market’s ability to direct economic resources, then today’s feel good policies may very well end in a stagflationary hangover. Our “beef” with Fed policy is that it ignores the most basic principle of economics: you can only consume to the extent that you have produced. Money printing has no magical powers. If a person, business, or society wishes to consume more, he, she, or it must increase his output. When quantity of credit creation trumps quality of credit creation, micro-efficiencies that foster growth are disincented in favor of activities that get you closer to the “new” money spewing into the economy. Fed policies have fostered a housing “wealth effect” – but to what end? If you doubled the price of everyone’s home, would that mean that their labor output and wage income doubled as well? Obviously not. A home is a manifestation of wealth not a creator of wealth. Longer-term, you can’t con the markets: home prices are ultimately a derivative of such economic “fundamentals” as wage income, interest rates, and availability of credit. So, without rising incomes, rising home “values” aren’t going to make everyone prosperous and get the unemployed working again. Indeed, higher home prices may, in fact, serve to divert resources away from productivity-enhancing endeavors and towards fancier landscaping. In short, higher home prices may give you a thrill, but they don’t help pay the bills!

The Fed Is Getting Its “Nouveau” Wealth Effect

Sources: TCW, Bloomberg

Our observations can be summed this way: the Fed, perhaps hearing the echo of Keynes that “in the long run we are all dead,” insists on using the macro tools it has to fix the unemployment problem. If their demand creation tools are as potent as the Fed’s leadership believes, we should see jobs growth sustainably accelerate thereby obviating the need for any more QE. QE ends with a bang. Rates will head much higher and we will all welcome the prosperity that will accompany the bear market in bonds.

Alternatively, more and more money fails to remediate the labor market; the money, so to speak, gets spent “elsewhere.” Where might those “elsewheres” be? Just take a gander at the home price gains seen this past year in San Francisco and Phoenix! In that event, a central bank commitment to stay with the “big easy” will ultimately lose credibility. Instead, overheated asset markets and rising inflation expectations force an “early” abort of QE. QE would end with a whimper, in more ways than one.

Whether QE ends well or badly, interest rates will then find a level substantially above where they are today. The rendevous with reality can be delayed but not avoided.

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