Sent: 03-10-2013 09:29:02
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U.S. Fed Keeps Hope Alive
Some potentially important implications of the Fed's decision to maintain its securities buying program have been overwhelmed by politicians threatening to derail the world's most important economic driver.
Against the expectations of market participants, the US Federal Reserve Open Market Committee decided at its September meeting to maintain, at least for the time being, its monthly security buying program at around $85 billion.
In confounding expectations by not cutting back on its asset buying program, the Fed was effectively saying that its view of the US economy was less rosy than the view held by the market at large. This judgement could yet prove to be wrong since even Fed members were split on their interpretation of the data. Nonetheless, the Fed does lead opinion and began to force a rethink at the margin about how robust the US economic recovery is likely to be.
Earnings among U.S. companies had been forecast to increase by 14% over the coming year. However, economy-wide sales growth is stuck in a 3-5% range and insufficient to support the forecast earnings growth, throwing into doubt the resilience of the overall market.
Companies have been notably successful in managing short term expectations down over the past two years while encouraging expectations about future growth. Cost containment efforts have substituted for the missing revenue growth to help bridge what could have been a fatal credibility gap.
Bernanke and his colleagues are signaling implicitly that more of this will be needed to keep the markets aloft, despite the expectations management task being progressively harder to carry off. This could prove unnerving as time goes on.
Secondly, the Fed's actions are counselling against the likelihood that inflation will be a problem. Commentators, including company executives, are prone to talk about the Fed's policy as "printing money". This image is reinforced by television news bulletins showing notes coming off printing presses whenever they report on Fed policies. Printing money also conjures up ideas of Weimar Republic or Zimbabwean hyperinflation. Gold aficionados love this. The bad news for the gold bugs is that the economy is less primed for inflation than they would like to think. Two indicators are worthwhile keeping in mind on this front.
Certainly, the volume of money per unit of output has risen beyond historic norms. On this measure, the money supply has been growing excessively and could be construed as inflationary. However, the turnover in the money supply - its velocity of circulation - has plummeted.
An inflation analysis which assumes that the velocity of circulation has been unchanged is analytically flawed. Any rise in the velocity of circulation would become evident in enough time for the Fed to adjust its policies to prevent an inflation outbreak.
Another indicator of the weak inflation potential of the Fed's policy is the ratio of U.S. employment to its population. There is a chart of this measure going back to 1948 on my daily market commentary page for 9 September (http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm).
Every significant fall in the ratio over more than six decades has coincided with a US recession. With the exception of the last two, each subsequent cyclical recovery has at least restored the prior levels of the ratio. Since the most recent recession, the ratio has been stuck at levels experienced in the early 1980s.
An additional five percentage points on this ratio - the difference between what it is now and what it was in 2007 - would mean an extra 12.3 million jobs. It would take six years at the current rate of employment growth to generate that number by which time the population base would have grown even larger.
Thirdly, the Fed decision again highlighted the nature of the exchange rate risk faced by import competing Australian companies or those with U.S. dollar denominated revenues. Almost universally, corporates are counting on the Australian dollar moving lower. So, too, are Australian governments as they worry about funding their looming deficits. The vast bulk of analysts are encouraging everyone to believe that the currency is going lower. There is a risk in this overwhelming consensus.
Being overly focussed on what is good for Australian business makes it easy to forget that exchange rates are a two way street. If a lower currency is good for both the USA and Australia, only one may get its wish. There is no guarantee that Australia will get its way. The reaction in the aftermath of the Fed decision is another reminder.
Fourthly, Fed asset purchases have helped keep commodity prices higher than otherwise would have been the case. The chart for 17 September in my daily market commentary (see the link above) shows the Fed's holdings of securities over the past 10 years and movements in copper prices. Copper prices experienced a cyclical rise prior to 2007 as a result of significant changes in market balances. After 2009, however, when prices might have normally fallen, the extra liquidity flows created by the Fed went into commodity markets (as they did into all asset markets, including emerging market securities).
Each stage of the policy seems to have had a diminishing impact leaving the bellwether commodity precariously positioned as long as physical market balances imply something lower.
Last week, after the Fed's policy meeting concluded and Chairman Bernanke spoke at his press conference about the reasons for its decision not to reduce its asset buying program, commodity prices and related equities received a boost. The initial reaction stalled quickly, however, highlighting an ongoing risk to this part of the market until the Fed's buying program is unwound and traders can see where prices might settle for the longer haul.
This is not just true of metal commodities like copper, the prices of which have been kept aloft by the infusion of Fed liquidity, but also of financial instruments. Bond yields have also been trying to find new post-Fed levels in anticipation of the Fed's influence being reduced.
Having got the U.S. economy to a point where it looked increasingly likely that progress could be self sustaining, the vandals on Capitol Hill are once again threatening to block budget and debt ceiling legislation.
As usual, the most parochial of the Republicans, having taken the U.S. and world economy to the brink of disaster, will most likely back off and markets will respond positively in relief.
Unfortunately, the impact on economic activity does not disappear because the threat is not exercised. This game of chicken is doubly dangerous because the U.S. economy, however weak it might be by historical standards, remains the single most important glimmer of hope for an acceleration in global economic activity in the immediate future.
Members of the US Congress are becoming global economic saboteurs as others through Asia, Europe and South America tries desperately to build consensus to restore a stronger growth path.
Why can't American leaders be more like Messrs Putin, Assad and Rouhani who have shown themselves open to negotiation to find ways through what should be more intractable problems than those confronting Washington's legislators? There is something amiss when this trio is playing a more constructive world role than those who were supposed to be on the side of good.
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