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Each quarter the Fed releases their assessment of the economy along with their forward looking projections for three years into the future. (See Fed Projections Myth Vs. Reality for the September analysis) I started tracking these projections beginning in early 2011 and comparing the Fed’s forecasts with what eventually became reality. The problem has, and continues to be, is that their track record for forecasting has been left wanting. The reality is, however, is that the Federal Reserve simply cannot verbally state what they really see during each highly publicized meeting as it would roil the markets. Instead, they use their communications to guide the markets expectations toward reality in the hopes of reducing the risks of market dislocations.
The most recent release of the Fed’s economic projections on the economy, inflation and unemployment continue to follow the same previous trends of weaker growth, lower inflation and a complete misunderstanding of the real labor market.
When it comes to the economy, the Fed has consistently overstated economic strength. Take a look at the chart and table. In January of 2011, the Fed was predicting GDP growth for 2013 at 4.0%. Actual real GDP (inflation adjusted) is currently estimated at 2.0% for the year or a negative 50% difference. The estimates at that time for long run economic growth was 2.7% which has now fallen to 2.15% and was guided down from 2.3% in September and 2.5% in June.
We have been stating repeatedly over the last 2 years that we are in for a low growth economy due to the debt deleveraging, deficits and continued fiscal and monetary policies that are retardants for economic prosperity. The simple fact is that when an economy requires more than $5 of debt to provide $1 of economic growth – the engine of growth is broken.
As of the latest Fed meeting the forecast for 2014 and 2015 economic growth has been revised down to just 2.9% and 2.8% respectively as the realization of a slow-growth economy is recognized. However, the current annualized trend of GDP suggests growth rates in the next two years could likely be lower than that.
With more than 48 months of economic expansion behind us; this current expansion is longer than the historical average. Economic data continues to show signs of weakness, despite intermittent pops of activity, and the global economy remains drag on domestic exports. With higher taxes, government spending cuts and the debt ceiling debate looming the fiscal drag on the economy could be larger than expected.
What is very important is the long run outlook of 2.15% economic growth. That rate of growth is not strong enough to achieve the “escape velocity” required to substantially improve the level of incomes and employment that were enjoyed in previous decades.
The Fed’s new goal of targeting a specific unemployment level to monetary policy could potentially put the Fed into a box. Currently, the Fed sees 2014 unemployment falling to 6.45% and ultimately returning to a 5.6% “full employment” rate in the long run. That long run rate was adjusted higher from the June meeting. The issue with this “full employment”prediction really becomes what the definition of “reality” is.
Today, average Americans have begun to question the credibility of the BLS employment reports. Even Congress has made an inquiry into the data collection and analysis methods used to determine employment reports. Since the end of the last recession employment has improved modestly. However, that improvement, as shown in full-time employment to population ratio chart below, has primarily due to increases in temporary and lower wage paying positions. More importantly, where the Fed is concerned, the drop in the unemployment rate has been due to a shrinkage of the labor pool rather than an increase in employment.
While the unemployment “rate” is declining, it is a very poor measure from which to benchmark the health of the economy. The drop in unemployment is primarily due totemporary hires, labor hoarding and falling labor participation rates. Real full-time employment as a percentage of the working population shows that employment has only marginally increased since the financial crisis. The drop in jobless claims does not necessarily represent an increasing employment picture but rather labor hoarding by companies after deep levels of employment reductions over the past 4 years.
InflationWhen it comes to inflation, and the Fed’s outlook, the debate comes down to what type of inflation you are actually talking about. The table and chart below show the actual versus projected levels of inflation.
The Fed significantly underestimated official rates of inflation in 2011. However, in 2012 and 2013 their projections and reality became much more aligned. Unfortunately, inflation has fallen well below target levels of 2% which is weighing on economic growth. The Fed’s greatest economic fear is deflation and the current drop in annual rates of inflation will keep pressure on the Fed to continue to accommodative policy active for longer than most expect.
However, for the average American the inflation story is entirely different. Reported inflation has little meaning to the consumer as the real cost of living has risen sharply in recent years. Whether it has been the cost of health insurance, school tuition, food, gas or energy – these everyday costs have continued to rise substantially faster than their incomes. This is why personal savings rates continue to fall, and consumer credit has risen, as incomes remain stagnant or weaken. It is the rising “cost of living” that is weighing on the American psyche, and ultimately, on economic growth.
While the FOMC is vastly hopeful that the current economic improvement will be sustained; rising deflationary pressures, weak global growth rates and stagnant wages pose major headwinds. The problem is that the current proposed policy is an exercise in wishful thinking. While the Fed blames fiscal policy out of Washington; the reality is that monetary policy does not work in reducing real unemployment or interest rates. However, what monetary policy does do is promote asset bubbles that are dangerous; particularly when they are concentrated in the riskiest of assets from stocks to junk bonds.
The problem that the Fed will eventually face, with respect to their monetary policy decisions, is that effectively the economy could be running at “full rates” of employment but with a very large pool of individuals excluded from the labor force. Of course, this also explains the continued rise in the number of individuals claiming disability and participating in the nutritional assistance programs. While the Fed could very well achieve its goal of fostering a “full employment” rate of 6.5%, it certainly does not mean that 93.5% of working age Americans will be gainfully employed. It could well just be a victory in name only
With the Fed committed to continuing its Large Scale Asset Purchase program (Quantitative Easing or Q.E.), and deploying specific performance targets, the question of effectiveness looms large. Bernanke has been quite vocal in his testimonies over the last year that monetary stimulus is not a panacea. In his most recently statement, Bernanke specifically stated that “fiscal policy is restraining economic growth.”
However, the recent improvements in employment and economic activity allowed the FOMC to begin “tapering” their current rate of asset purchases from $85 to $75 billion per month.
“…the Committee sees the improvement in economic activity and labor market conditions over that period as consistent with growing underlying strength in the broader economy. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases.”
The problem for the Federal Reserve currently is that there are very few policy tools left, and the economic effectiveness of continued artificial stimulation is clearly waning. Lower mortgages rates, interest rates and excess liquidity served well in priming the pumps of the real estate and financial markets when valuations were extremely depressed. However, four years later, stock valuations are no longer low, earnings are no longer depressed and the majority of real estate related activity has likely been completed. More importantly, the recent surge in leverage and asset prices smacks of an asset bubble in the making.
Reminiscent of the choices of Goldilocks – the reality is that the Fed’s estimates for economic growth in 2013 was too hot, employment was too cold and inflation estimates were just about right. The real unspoken concern should be the continued threat of deflation and what actions will be available when the next recession eventually comes.
After studying and teaching Keynesian economics for 30 years, I conclude that the “sophisticated” Keynesians really do believe in magic and fairy dust. Lots of fairy dust. It may seem odd that this Austrian economist refers to fairies, but I got the term from Paul Krugman.
According to Krugman, too many people place false hopes in what he calls the “Confidence Fairy,” a creature created as a retort to economist Robert Higgs’s concept of “regime uncertainty.” Higgs coined that expression in a 1997 paper on the Great Depression in which he claimed that uncertainty caused by the policies of Franklin Roosevelt’s New Deal was a major factor in the Great Depression being so very, very long.
Nonsense, writes Krugman. Investors are not waiting for governments to “get their financial houses in order” and protect private property. Instead, he claims, investors are waiting for governments to spend in order to create enough “aggregate demand” in the economy to bring about new investments and, one hopes, full employment.
According to Higgs, the “humor columnist for the New York Times, Paul Krugman, has recently taken to defending his vulgar Keynesianism against its critics by accusing them of making arguments that rely on the existence of a ‘confidence fairy.’ By this mockery,” Higgs says, “Krugman seeks to dismiss the critics as unscientific blockheads, in contrast to his own supreme status as a Nobel Prize-winning economic scientist.”
It seems, however, that Krugman and the Keynesians have manufactured some fairies of their own: the Debt Fairy and the Inflation Fairy. These two creatures may not carry bags of fairy dust, but they might as well, given that their “tools” of using government debt and printing money to “revitalize” the economy have the same scientific credibility.
Let us first examine the Debt Fairy. According to the Keynesians, the U.S. economy (as well as the economies of Europe and Japan) languishes in a “liquidity trap.” This is a condition in which interest rates are near-zero and people hoard money instead of spending it. Lowering interest rates obviously won’t spur more business borrowing, so it is up to the government to take advantage of the low rates and borrow (and borrow).
If governments issue enough debt, argue Debt Fairy True Believers, the economy will gain “traction” as government spending, through the power of pixie dust, fuels a recovery. Governments spend, businesses magically gain confidence, and then they spend and invest. (At this point, we are apparently supposed to just overlook the fact that the Keynesians are saying that we need the Debt Fairy to resurrect the Keynesian version of the Confidence Fairy.)
The Inflation Fairy also plays an important role, according to Keynesians, for if bona fide inflation can take hold in the economy and people watch their money lose value, then they will spend more of their savings. In turn, this destruction of savings will, through the power of Keynesian sorcery, revive the economy. Thus inflation undermines what Keynesians call the “Paradox of Thrift,” a theory that says if a lot of people withhold some present consumption in order to save for future consumption, the economy quickly will implode and ultimately will slip into a Liquidity Trap in which no one will spend anything.
These fairies can work their magic if (and only if) one condition exists: factors of production are homogeneous, which means that government spending will enable all lines of production simultaneously. The actual record of the boom-and-bust cycle, however, tells a different story. It seems that the Debt and Inflation Fairies enable booms along certain lines of production (such as housing during the past decade), but as everyone knows, the fairy dust lost its magical powers and the booms collapsed into recessions.
Austrians such as Mises and Rothbard have well understood what Keynesians do not: the structures of production within an economy are heterogeneous and can be distorted by government intervention through inflation and massive borrowing. Far from being creatures that can “save” an economy, the Debt Fairy and the Inflation Fairy are the architects of economic disaster.
Despite Keynesian protestations that the U.S. and European governments are engaged in “austerity,” the twin fairies are active on both continents. The fairy dust they are sprinkling on the economy, however, is more akin to sprinkling ricin on humans. In the end, the good fairies turn into witches.
I recently wrote an article entitled “What Is A Liquidity Trap & Why Is Bernanke Caught In It?” wherein I discussed the definition of a liquidity trap as:
“A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in the general price levels.“
Importantly, this evidence is mounting that the Federal Reserve has now become trapped within this dynamic. The boost in asset prices caused by the increased levels of liquidity in the system has benefited the wealthy while doing little to jumpstart the real economy. As I stated previously:
“However, the real question is whether, or not, all of this excess liquidity and artificially low interest rates is spurring economic activity? To answer that question let’s take a look at a 4-panel chart of the most common measures of economic activity – Real GDP, Industrial Production, Employment and Real Consumption.”
“While an argument could be made that the early initial rounds of QE contributed to a bounce in economic activity; it is also important to remember several things about that particular period. First, if you refer to the long term chart of GDP above you will see that economic growth has ALWAYS surged post recessionary weakness. This is due to the pent-up demand that was built up during the recession that is unleashed back into the economy. Secondly, during 2009 there were multiple bailouts going on from ‘cash for houses’, ‘cash for clunkers’, direct bailouts of the banking system and the economy, etc. However, the real test for the success of the Fed’s interventions actually began in 2010 as the Fed became ‘the only game in town’. As shown above, at best, we can assume that the increases in liquidity have been responsible in keeping the economy from slipping into a secondary recession. Currently, with most economic indicators showing signs of weakness, it is clear that the Federal Reserve is currently experiencing a diminishing rate of return from their monetary policies.”
From this standpoint it was shocking to see someone, particularly Larry Summers, actually discuss this issue during a recent CNBC interview stating his case on why it is wrong to rely on monetary policy as the main driver of the economy.
The important point is that, for the first time that I am aware of, someone has verbally stated that we are indeed caught within a liquidity trap. This has been a point that has been vigorously opposed by supporters of the Federal Reserve actions.
Of course, the lack of transmission of the current monetary interventions into the real economy has remained a conundrum for the Federal Reserve as the gap between improving economic statistics and the real underlying economic fabric continues to widen. As Larry states, we are indeed in uncharted territory. With the direct manipulation of interest rates near impossible, it leaves only verbal (forward guidance) and liquidity (increases of excess reserves) policy tools available. The problem is that these tools have never been used to such a massive extent before in history. While analysts and economist continue to suggest, with each passing year, that stronger economic growth is coming; it has yet to be the case. As discussed previously, this is a tell-tale sign of a liquidity trap.
My belief all along has been and remains that a well thought out combination of both fiscal and monetary policy is the correct remedy for what ails the U.S. economy currently. However, up to this point, the Fed has been the “only game in town” to quote the famous words of Senator Chuck Schumer. I have to admit that I was pleasantly surprised by Larry Summers view point as I believe that it is the correct one at this late stage of the current economic recovery cycle.