Fed Chairman Bernanke used his appearance before the House and Senate finance committees as yet another opportunity to soft-pedal his original ill-conceived effort to explain the eventual winding down of QE. In doing so he emphasised the risks to the economy in the coming period and the FOMC’s intention to keep monetary policy as accommodative as needed. His testimony had the intended effect of boosting the stock market, but was far less successful in talking down the long-term bond rate that is so crucial to keep the still-fragile housing market growing.
Bernanke, while giving a seemingly token nod to what he called “improving” economic conditions, stated that the economy still faces “significant risks”. He said it was too early to tell if the economy had weathered the full impact of tighter fiscal policy “or that the debate concerning other fiscal policy issues, such as the debt ceiling, will evolve in a way that could hamper the recovery.” He added that “with the recovery still proceeding at only a moderate pace, the economy remains vulnerable to unanticipated shocks, including the possibility that global economic growth may be slower than currently anticipated.”
The Chairman took pains to point out that the Fed’s asset purchases were “by no means on a preset course” and could be maintained longer if their economic and inflation forecasts were less favourable than they expected. He even mentioned the possibility of actually increasing the pace of purchases if necessary. To further reassure the markets, he pointed out that even reaching the previously stated goal of a 6.5% unemployment rate would not necessarily result in monetary tightening if it occurred for the wrong reasons, namely a significant additional drop in the labour force participation rate.
In our view, however, reassuring investors was not Bernanke’s only reason for putting such heavy emphasis on the risks to the economy. The Chairman must know that the economic projections the FOMC issued after their last meeting are already obsolete on the high side. The committee finished its meeting on June 18th, meaning that their projection of likely 2013 GDP growth in the range of 2.3%-to-2.6% had to be compiled sometime before. The disappointing first quarter GDP growth of only 1.8% was released on June 26th. Subsequently, below par reports on retail sales, inventories and exports led most economists to reduce second quarter GDP growth to about 1% or even less.
At the time the FOMC made their 2013 GDP forecast, the previously reported GDP growth for the first quarter was 2.4% and consensus second quarter forecasts averaged about 2%. With the first quarter GDP growth now revised down to 1.8% and second quarter estimates marked down to about 1%, the FOMC forecast of fourth quarter 2012 to fourth quarter 2013 growth of even the lower end of the range (2.3%) looks like a real stretch. Doing so would require an average growth rate of about 3.2% in each of the last two quarters of the year, a goal which seems exceedingly difficult to reach.
We believe that the continued tepid growth in the economy means that the Fed will curtail its asset purchase program later rather than sooner. Unlike most observers, however, we think that this will be bearish for stocks. The market is currently cheering continuing monetary accommodation while at the same time looking for a more robust economic recovery and far higher earnings. The problem is that while investors can have one or the other, they can’t have both. A stronger economy means an imminent reduction of QE that the market doesn’t like, while a weaker economy that results in an extension of QE leads to corporate earnings far lower than current forecasts. We therefore think that the current market strength is irrational in the same way as the dot-com boom of the late 1990s and the subprime mortgage boom of 2005-2007, both of which were ignored by investors for lengthy periods
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