FOMC Report

Yesterday was no surprise as far as the FOMC and the careful parsing of the Federal Reserve statement. It was a really dead treasury market after the announcement, and I didn’t make a trade. Looking ahead, everyone wants to know when the Fed moves off 0% interest. As Raghu Rajan said, there is an opportunity cost to 0% interest rates, especially for an extended period of time. The cost of money shouldn’t be free.

They left interest rates unchanged, and will finish the controversial QE2 policy.  Every Fed governor voted unanimously to leave rates alone.

No surprise that there are headwinds to the recovery.  At the beginning of this year, most people expected GDP to be a minimum of 3%, possibly as high as 3.5%.  But, with the high price of oil the rule of thumb says GDP should be shaved by at least .5%.  The earthquake in Japan will also be a headwind, and so is the strife in the Middle East. We are probably looking at GDP of 2%-3%.  That’s not enough to get us going.

That means the Fed won’t be raising interest rates anytime soon.  2012 maybe, but 2012 is an election year.  If unemployment persists at a high rate, there will be political pressure on the Fed to keep rates low.

Some nuggets from the statement.  The Fed believes that the commodity price inflation is “transitory”.  They don’t see it as something that will persist or affect the long term inflation expectations.  I found this interesting because public opinion has been building against the Fed over the past several months culminating in the statement to Fed Reserve President William Dudley yesterday, “I can’t eat an iPad.”

It is right for the Fed to ignore short term fluctuations in the marketplace.  But, I hope they pay very close attention to the weather this spring and summer.  For food prices to abate a little, we are going to have to produce a bumper crop of grain. The weather is the sole determinant of success or failure.

The other big determinant of US economic health is housing.  Housing employs a lot of people all the way through the supply chain.  Housing still has a gigantic overhang in the US.  There is a lot of supply to work through.

However, according to a speech from Chicago Booth economist Erik Hurst, on a macro level we have probably seen the bottom on prices for housing.  But that doesn’t mean prices will rise, or demand is going to increase.  In this recovery, consumption hasn’t increased as much as consumption in other big recoveries.  The American consumer (and business) is not taking on leverage like they did in the past. Savings rates are up because everyone is trying to rebuild their stock of assets.

The housing boom that started in 1997 re-allocated both white and blue collar workers into housing workers.  These workers need to re-tool and find another industry.  That is going to take a lot of time.   For example, Nevada has a high unemployment rate.  35% come from the housing industry.  Unemployment rates should be high going forward.  Hurst expects the malaise of today to persist for quite some time, possibly as long as ten years.  As he said, “It took us a decade to get in, it’s going to take a long time to get out.”

Governments make choices. In this case, they can grow or inflate.  Housing workers need to be retrained and absorbed by other industries.  The Federal Reserve via QE2 has inflated the value of assets.  Americans feel wealthier, but the value of the dollar has declined so in reality they aren’t any wealthier.  Their purchasing power isn’t greater than it was.

Government policy also affects outcomes.  For example, our government’s policy on ethanol subsidies is one of the most price distorting policies that we have.  Row crop prices have significantly higher prices than they normally would, just because of ethanol.  This also filters into land prices.  They become inflated.  These distortions distort the behavior of the people affected by them.  Each individual decision that a person makes adds up to a supply or demand curve on a chart.

Growth is hard.  Government policy isn’t set up for growth right now.  As a matter of fact, in many cases tax and regulatory policy is set up to be a disincentive for growth.  The Lugar-Kerry Start Up Visa Act is a tepid start in the right direction. But it’s nowhere near enough.  The path to explosive growth is low tax rates, limited spending, and low levels of regulation.  Lower levels of regulation doesn’t mean that corporations will run roughshod over the rights of Americans.  If the regulation is written correctly, that’s not going to be a problem.  To the millions that are jobless (16-17% of America), a decent chance at a job is probably more important than a government bureaucrat protecting turf.

The Fed is still on hold.  Inflation will be ignited with a bad growing season.  The Fed should be in the market to hire meteorologists and not economists for the near term.

UPDATE

On the back of this post, Housing Starts were released at down 22.5%, and PPI was up 1.6%.  Weather probably affected the housing number, and strife in the middle east combined with QE2 affected prices.

  • Anon

    “Governments make choices. In this case, they can grow or inflate”

    Can you elaborate on this? Obviously you are not saying that governments have to choose between growth and inflation.

    • But, they do. They can inflate their currency by devaluing it or monetizing their debt. Or, they can create economic incentives to grow their GDP to grow their way out of their deficit.

      99.9% of the time governments choose to inflate. It’s a lot easier path than creating incentives for growth.

      • Anon

        Currently our government is not monetizing it’s debt. In order to do that the fed would have to buy treasuries directly from the treasury itself. The fed is buying from the banks. This is just swapping one asset (t-bill) for another (cash). But that is a separate discussion.

        I interpreted your sentence to mean that if there was inflation there could be no growth. I see now that what you meant to say was that a government has to choose between inflation or growth to meet it’s obligations. That’s a little extreme. I’m sure we will see a combination of the two

      • Anon

        Currently our government is not monetizing it’s debt. In order to do that the fed would have to buy treasuries directly from the treasury itself. The fed is buying from the banks. This is just swapping one asset (t-bill) for another (cash). But that is a separate discussion.

        I interpreted your sentence to mean that if there was inflation there could be no growth. I see now that what you meant to say was that a government has to choose between inflation or growth to meet it’s obligations. That’s a little extreme. I’m sure we will see a combination of the two

        • There is certainly growth during inflationary periods. The question becomes can the GDP of the economy grow faster than the rate of inflation. For example, the Fed targets inflation of slightly under 2%, and growth slightly above 3%.

          John Cochrane of ChicagoBooth in a panel discussion excoriated the stimulus, Fed policy, and Treasury policy. He summed it up by saying govt chooses inflation or growth. When asked if the US should default on its debt, he said, “one time”.

          Economists I have spoken with said in theory that actually works, provided that the government never runs a deficit again. Problem is, they always do.