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Slaughter & Rees Report - One Foot on the Brake and One on the Gas

December 23, 2013 --

Nobel laureate Robert Solow once quipped that, “Monetary policy is like driving a car along a winding road, when the car responds to the steering wheel with a lag that can range from 10 seconds to a minute or so.” This metaphor came to mind last week with the announcement by the Federal Reserve Open Market Committee that the Fed plans to slow its monthly bond purchases starting in January—from $85 billion to $75 billion, with subsequent reductions contingent on continued economic improvement. Thus will the Fed tap its monetary brakes, hoping to slow the Fed balance-sheet car without triggering a tailspin—or something worse—that hurts passersby including the U.S. labor market, the overall U.S. economy, and global capital markets.

The Fed justified its taper on the basis of “cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions.” But the economic road ahead remains quite foggy. U.S. unemployment has dropped to 7 percent, down from 7.9 percent in January, though a substantial portion of this decline came from discouraged people exiting the labor force and thus not counting in the unemployment statistics. Persistently weak features of the labor market like this help explain why the Fed now expects to keep interest rates low “well past the time” unemployment falls under 6.5 percent. This policy, coupled with the reduced bond buying, is akin to driving with one foot on the brake and one on the gas.

Similar to the healing-but-still-weak labor market is the overall U.S. economy. Annual growth in U.S. gross domestic product has averaged 2.3 percent since the recession ended in mid-2009; the average post-recession growth rate in the first four years of recessions since World War II has been 4.1 percent. For a bit more fog over the road, don’t forget that old bugaboo: inflation. The Fed’s preferred measure grew by just 0.7 percent in the 12 months through October—well below its stated target of about 2 percent, and a source of puzzlement and worry to some.

Adding to the uncertainty up ahead has been the continued strong rise in equity prices. The S&P 500 is, as we write this, up 27 percent for the year (and last Wednesday with the Fed’s announcement it rose nearly 1.7 percent, reaching a record closing high). Only 45 stocks in the index were in negative territory through last week. There has been only one other year since 1980 that the index had more companies recording market gains. “It’s hard to pick a loser,” one S&P analyst recently concluded.

Hard to pick a loser? Is the United States in the throes of what Alan Greenspan famously called “irrational exuberance”? The S&P traded at 28 times prior-year earnings at its peak in 2000; its current price/earnings ratio is 17. The Nasdaq Composite's ratio was 142 at its peak; it is 22 now. Surveying this landscape, last month one market-watcher commented, “Stock prices have risen pretty robustly,” while cautioning that a review of several valuation measures, such as equity-risk premiums, indicated that, “you would not see stock prices in territory that suggest…bubble-like conditions.”

That market-watcher was Janet Yellen, on track to replace Ben Bernanke as the Federal Reserve Chair on Feb. 1. But as we (with different metaphors) and others have observed, the road ahead will test even the most seasoned central banker. No central banker has ever unwound monetary expansion like what the Fed has undertaken—expansion that, as Chairman Bernanke said last week, has been “unprecedented in both scale and scope.”

Today actually marks the 100th anniversary of the Fed’s creation. In this season of glad tidings, hopes, and wish lists, we wish the Fed—its talented leaders and highly-capable staff—a very happy birthday. And, we hope that soon-to-be Chair Yellen proves a capable driver.

(The Slaughter & Rees Report wishes all our readers a restful holiday season and new year. In this spirit, we are on vacation next week and will resume publication in early January.)

Articles © 2013 Matthew Slaughter and Matthew Rees. All rights reserved.
Publication © 2013 Trustees of Dartmouth College. All rights reserved.

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