The Federal Reserve 2015: Looking For The Goldilocks Solution

DecisionQuantitative Easing (“QE”) & Tapering.  QE is a process whereby the Fed purchases large quantities of long-term securities held by big banks. The Fed prints money to make these asset purchases.  By reducing the supply of these securities for other investors, the price goes up.  When the price of the bonds goes up, their yield goes down.  This means that for large companies and municipalities who depend upon the sale of bonds for the financing of projects, their borrower costs go down.  Since mortgage interest rates track the long term T-Bill rates, as QE keeps these rates low, it also keeps mortgage interest rates low.  The goal of QE was to keep long term interest rates low and release more money into the marketplace, thereby increasing economic activity for households and businesses.[1]

The Federal Reserve first began QE shortly after the credit markets crashed following the Bear Stearns collapse and the Lehman bankruptcy in the fall of 2008.  QE2 occurred in 2010; QE3 was initiated in 2011. In its third iteration, QE3, the Fed was buying $45 billion in treasury bills (“T-Bills”) and $40 billion of mortgage-backed securities a month.

When interest rates went down – which they did – the hope was that the construction and housing industries would rebound, businesses would increase capital investment, employment would increase, and household balance sheets would improve.  The Fed’s mantra at the time was that QE and low interest rates would continue until unemployment, which exceeded 10% at the time, came down to seven percent.[2]  However, after three shots at QE, there is no broad consensus that it worked.[3]

In October 2013, the Fed began slowly taking its foot off the QE pedal – a process called “tapering.”  Here’s how it was explained in a recent Bloomberg article [“Tapering to the End of a Giant Stimulus”]:

It was the biggest emergency economic stimulus in history and now it’s over. The U.S. Federal Reserve’s once-in-a-lifetime program to buy immense piles of bonds, month after month, in an extraordinary effort to restart a recession-deadened economy came to an end in October after adding more than $3.5 trillion to the Fed’s balance sheet – an amount roughly equal to the size of the German economy. The bond-buying program, called quantitative easing or QE, had been controversial since its start in 2009, as had the Fed’s decision in 2013 to gradually reduce the monthly economic boost, a plan that became known as the taper. Whether the Fed tapered too soon, given global economic weakness, or too late, given signs of bubbles in some markets, was hotly debated. But even after the taper’s end the Fed continued to pump support into the economy the old-fashioned way, by holding its interest rates near zero.  

The Disconnect.  Although the idea behind QE was that pumping money into the economy would stimulate investment, employment, and housing, it didn’t really happen.  The recession has been deeper and longer than anyone anticipated; recovery has been slower. We’ll never know if the U.S. economy would have been any worse without QE.  So as we close out 2014 and five years of QE, what can be said for certain?  Here is my take:

  • Although it may have produced some incremental benefits, on the whole, it has been underwhelming[4];
  • Even though the benefits of QE were intended to trickle down to workers and consumers, the real beneficiaries of QE were the big banks; ironically, thanks to Dodd-Frank, with increased regulatory pressure to deleverage [i.e. cut debt and risk] big banks have built up huge capital reserves – rather than using the funds to increasing lending;
  • The double-whammy of Dodd-Frank has also been that many potential home purchasers now find that tighter lender underwriting has now locked them out of the marketplace for an affordable loan;
  • Lacking confidence in the long-term economy, large national and international corporations have been hesitant to increase production and hire more employees;
  • One of the biggest indirect beneficiaries of QE has been the U.S. stock market, which has been flooded with investors in their search for higher yields. On October 10, 2008, as Fannie and Freddie were being taken over, and Bear Sterns and Lehman were on the ropes, the market dropped nearly 2,000 points from a week earlier (10,325.38 to 8,451.19). As of December 28, 2014, the Dow closed at 18,053.71. For investors who stayed in the market, QE has been a very good run;
  • For the past two months without QE, since the Fed continues to keep interest rates low, the stock market is still improving. When interest rates do begin to climb, we can expect there may be a corresponding drop in the equities market;
  • Lastly, some of the tragic losers from QE were retirees on fixed incomes, with only limited savings held in banks or certificates of deposit. With interest rates next to zero for the past five years, their yield on savings were only marginally better than putting cash under the mattress.

Interest Rates and Inflation.  Now that QE is officially over, the new topic du jour is interest rates – when will the Fed begin returning them to normal levels?  The conventional wisdom based upon prior statements going back to Ben Bernanke, and now with Janet Yellen, the new Fed Chair, has been that rates will not likely begin to rise before mid-year in 2015.

The Fed’s concern that starting too soon, with a still fragile economy, could backfire.  The fear is that inflation, which the Fed wants to see at 2.00%, has remained stubbornly low.

For most folks, the idea of inflation in any amount sounds bad, since it erodes one’s purchasing power. But the worry is that if inflation gets too low, i.e. close to zero, we could lapse into “deflation,” where prices fall.  When that happens, economic theory holds that people reduce spending, as they wait for prices to fall further.  Essentially this did happen with real estate circa 2007 – 2012.  While there were many other reasons for the falling home prices, it was a buyer’s market back then, and many potential purchasers remained on the sidelines waiting for values to hit bottom.

The school of thought that some inflation is good is based upon the idea that with more employment, workers can move up and demand higher wages.  That then is reflected in the cost of goods, which tick up.[5]

The Fourth Quarter of 2014.  October – December 2014 has been the most interesting quarter of 2014, and it’s given some folks at the Fed reason to raise rates sooner rather than later.  Here are some of the highlights of 4Q 2014: 

  • Notwithstanding the voices of doom and gloom which predicted that interest rates would spike when tapering ended, QE is over and interest rates have actually continued to drop a bit. [See Bankrate table here.]  
  • The Wall Street Journal reported here that the December 5, 2014 jobs report issued by the Bureau of Labor Statistics showed that “…U.S. employers added 321,000 jobs last month—the best monthly gain in almost three years–while the unemployment rate held steady at 5.8%….”
  • In addition, as virtually everyone who drives a car knows [with the possible exception of Tesla owners], the oil market has tanked…pardon the pun.  This is due in large part to the oil glut resulting from the fracking revolution going on in the U.S.[6]  Prices at the pump and for home heating oil have plummeted. This has translated into increased consumer spending – all good news to everyone but Iran, OPEC, Venezuela, and Mr. Putin. On the other hand, lower prices hold down inflation, which is already lower than the Fed’s 2.0% goal.  This fact supports keeping the status quo until inflation gets closer to 2.0%.
  • Then there is the issue of the strong U.S. dollar.  While it enables us to buy imports more cheaply, it makes exports more expensive, as it costs other countries more to purchase our goods.  This directly affects U.S. manufacturing, employment and GDP.[7]  To some, a strong U.S. dollar puts a damper on GDP and is a bad thing; to others, it is a reflection of international confidence in our country, and therefore a good thing.
  • However, on October 30, 2014, the Commerce Department reported a 3.5% growth in GDP for 3Q 2014.  As reported by Bloomberg here: “Gross domestic product grew at a 3.5 percent annualized rate in the three months ended September after a 4.6 percent gain in the second quarter, Commerce Department figures showed today in Washington. It marked the strongest back-to-back readings since the last six months of 2003.” [Italics mine.]
  • Even though interest rates remain at historically low levels, sales of pre-owned homes were better in 2013 than 2014 by approximately 1.7% according to Forbes magazine, using statistics provided by the National Association of REALTORS®.
  • Despite predictions and reports to the contrary, in some parts of the country – including Oregon – there is still a glut of foreclosures, displacing families, and keeping available housing off the market for resale.[8]
  • And lastly, but equally significant, in the November 4 mid-term elections, the American voters roundly rejected the overbearing and oppressive regulatory regime [some might say “nanny state”] of the Democratic Party and White House.   The effect, which we will undoubtedly see beginning  on January 1, 2015, will likely be a gradual unwinding of many of the laws which have acted to constrain our economy for the past five years.[9]  The very thought that the country will no longer be at the mercy of Messrs. Obama and Reid, serves as a vote of confidence that the economy will finally be headed in the right direction, as opposed to the doldrums of indecision.

The Goldilocks Principle.  Generally, this principle, ala Goldilocks and the Three Bears, is the quest for a solution that falls within certain given parameters in order to be “just right.”  When setting interest rates, the Federal Reserve has many parameters; employment, inflation, deflation, new hiring, GDP, housing, etc., etc.

The policy-makers at the Federal Reserve are roughly divided into hawks and doves; the hawks want to see an increase sooner, the doves later.  There is no consensus about what is “just right.” Currently, there are more doves than hawks.  In its last meeting of the year, on December 17, 2014, the doves carried the day.  The Committee report[10] stated that:

Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to ¼ percent target range for the federal funds rate[11] for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer–term inflation expectations remain well anchored.  However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.  [Highlights mine.]

Voting in favor of the Fed Committee report were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Loretta J.  Mester; Jerome H. Powell; and Daniel K. Tarullo.  Four Fed officials dissented.  According to the report:

Voting against the action were Richard W. Fisher, who believed that, while the Committee should be patient in beginning to normalize monetary policy, improvement in the U.S. economic performance since October has moved forward, further than the majority of the Committee envisions, the date when it will likely be appropriate to increase the federal funds rate; Narayana Kocherlakota, who believed that the Committee’s decision, in the context of ongoing low inflation and falling market-based measures of longer-term inflation expectations, created undue downside risk to the credibility of the 2 percent inflation target; and Charles I. Plosser, who believed that the statement should not stress the importance of the passage of time as a key element of its forward guidance and, given the improvement in economic conditions, should not emphasize the consistency of the current forward guidance with previous statements. [Bold highlights of names are mine.]

PCQ Observation:  In its prior reports, the FOMC had previously stated that it intended to retain the low fed funds rate for a “considerable time” following the end of QE. My guess that the reason for this language was due to the May 2013 misstatement by Fed Chair Ben Brenecke which implied that interest rates could go up in the near future. The result was that the stock market plunged and interest rates surged nearly a point.

Mindful of this misstep, the Fed likely wanted to telegraph its determination to keep rates low for a “considerable time.”  This language had been interpreted by observers as meaning at least until mid-2015.  What changed in its latest December 17, 2014 report was that it stated an intent to remain “patient” before increasing interest rates.  But did this really add any clarity, especially when combined with the subsequent hedge that normalization could be sooner or later depending on employment and inflation numbers?  

Parsing the FOMC’s wording has become a fixation for some and an irritant for others.  Here is a link to a mark-up of each new and old words used between October 29 and December 18, 2013 FOMC meetings according to the WSJ’s Fed Statement Tracker.  Adding in its latest report an intent to remain “patient” caused consternation to some.  Here is one irate comment in the WSJ’s Real Time Economics:

What was the point! The last FOMC meeting of 2014 was not just a disappointment, the outcome was plainly bizarre, if not outright confusing.  For a Fed that seeks to introduce more clarity and transparency of its views, they have in fact done the opposite. The tortuous, semantic-conscious language of the statement is really an exercise in obfuscation, one that harkens back to the days of Alan Greenspan. In stark contrast to this now stale Fed note is the fact the U.S. economy is unambiguously stronger and more dynamic than anytime we have seen in at least a decade. Frankly, I think the FOMC has done the institution some harm. By retaining the ‘considerable time’ phrase, we begin to worry whether the Fed is now falling behind the economic cycle.Slipping in the term ‘patient’ changes really nothing. –Bernard Baumohl, The Economic Outlook Group

It appears to me that Janet Yellen, aka Goldilocks, and the six doves, actually did intend to send a stronger message by adding that they intended to remain patient. To them, saying a “considerable time” too frequently dilutes its own meaning with the passage of time.  But following the events leading up to its December 17 report, many of the parameters were, in fact, changing; some possibly for the good: The November midterms bode well for a more business friendly environment; the jobs reports and GDP were improving significantly.

Conversely, oil prices, while temporarily benefiting consumers, could be mildly deflationary; the 2% inflation goal has still not been met; new construction and pre-existing housing numbers have been disappointing, and although unemployed has dropped below 6.0%, there is still a sense that for many Americans displaced by the Great Recession, they are not faring any better five years later.

The Take-Away.  So by including a statement of intent to remain “patient,” it is my belief the Fed’s doves are, in fact, saying that they are not going to rely upon on a few short months’ good news, and immediately resume normalization of interest rates, say in 2Q 2015. In other words, they are still looking to mid-year 2015 before changing policy.

Lastly, there is one more factor that – though unstated in the FOMC report – has to be on Ms. Yellen’s mind: Five years of cheap money, even though it hasn’t been the boon to housing it should have been, can spoil anyone.  There are young people just now thinking of entering the housing marketplace; there are empty nesters thinking about selling, and perhaps downsizing.  After half a decade of historically low interest rates, there has to be a concern by policy makers that increasing the cost of money could be a deal killer, depressing new construction and housing sales even more than it is.  The last thing Goldilocks would want is a bear market.

[1] For a good discussion of whether it worked, see link from the BBC here.

[2] For details, see MoneyNews article here.

[3] For a cynical, but very funny explanation of Quantitative Easing, see cartoon here.

[4] See October 29, 2014 N.Y. Times article here.

[5] For a simplified discussion of the  pros and  cons of inflation, see link here. For a contrary view, see Fortune link here.

[6] How long this will continue is a matter of some debate, however.

[7] Investopedia defines GDP as follows: The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country’s economy. It represents the total dollar value of all goods and services produced over a specific time period – you can think of it as the size of the economy.

[8] Foreclosures actually increased in 2014 over 2013.

[9] Actually, it already has borne fruit, though not to the liking of the White House.  In the spending bill recently passed, the big banks – yes the Vampire Squids of Wall Street – were able to strip a provision from Dodd-Frank that would have forced them to move their derivative trading accounts out of FDIC insured banks, because of the fear that these arcane and risky investments could cause the lender to fail and end up costing the American taxpayers.  I’m no fan of the Big Banks, but the enemy of my enemy is my friend.

[10] The Federal Open Market Committee (FOMC) consists of twelve members.  They include the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.

[11] Investopedia defines the fed funds rate as: The interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. The federal funds rate is generally only applicable to the most creditworthy institutions when they borrow and lend overnight funds to each other. The federal funds rate is one of the most influential interest rates in the U.S. economy, since it affects monetary and financial conditions, which in turn have a bearing on key aspects of the broad economy including employment, growth and inflation. The Federal Open Market Committee (FOMC), which is the Federal Reserve’s primary monetary policymaking body, telegraphs its desired target for the federal funds rate through open market operations. Also known as the “fed funds rate”.