Equity markets struggled to gain traction last week and finally lost ground registering their first weekly decline in month. It finally looks as though markets are succumbing to the inevitable; the realisation that the recovery is going to be a rocky ride but neither will it be rapid or aggressive. Markets look as though they have just about run out of fuel and after registering major relief that the global economy was not falling into an endless whole and that financial markets were not going to implode, the equity rally has finally come to a point where it will need more than just news about “green shoots” to keep it going.
One question that has been raised in particular in bond markets and in interest rate futures pricing is whether these “green shoots” have accelerated the timing of the end of quantitative easing and/or higher interest rates. Although the markets have retraced some of the tightening expectations that had built in following the May US jobs report there will be a lot of attention on whether the Fed will attempt to allay market concerns that current policy settings will result in inflation running out of control and necessitate a hike in interest rates.
The Fed’s job shouldn’t be too difficult. In usual circumstances the expansion of the money supply undertaken by the Fed would have had major implications for inflation. However, the circulation of money (money multiplier) in the economy has collapsed during the recession as consumers have been increasingly reluctant to borrow and lenders have become increasingly reluctant to lend. The end result has been to blunt the impact of Fed policy. Of course, once the multiplier picks up the Fed will need to be quick to remove its massive policy accommodation without fuelling a rise in inflation. If it didn’t it would be bad both for long term interest rates as well as the dollar.
Although the current policy of quantitative easing is untested and therefore has a strong element of risk attached to it the reality is that the Fed is unlikely to have too much of a problem on its hands. The explanation for this is that there will be plenty of slack in the economy for months if not years to come. The labour market continues to loosen and as the US unemployment rate increases most probably well in excess of 10%, wage pressures will continue to be driven down.
In addition there is plenty of excess capacity in the manufacturing sector and as the May industrial production report revealed the capacity utilisation rate dropped to 68.3%, a hefty 12.6% below its average for 1972-2008. Inflation data continues to remain subdued as revealed by last week’s release core inflation remains comfortable at a 1.8% annual rate. Weaker corporate pricing power suggests that core inflation will remain subdued over coming months and will even fall further, so there will be little threat to Fed policy.
The output gap (difference between real GDP and potential GDP) remains wide and according to CBO estimates of potential GDP the economy will end the year growing at around 8% below its full capacity. Even if the economy grows above potential for the next few years it may only just close the output gap and subsequently begin fuelling inflation pressures. The bigger risk is that the economy grows slowly over coming years and takes several years to close the output gap.
Taking a perspective of past Fed rate hikes following the last two recessions, interest rate markets should take some solace. In 2001 the Fed begin to hike rates until around 2 ½ years after the end of the recession whilst in the 1990-91 recession rates did not go up until close to 3 years following the end of recession. Arguably this recession is worse in terms of depth and breadth suggesting that it will take a long time before the Fed even contemplates reversing policy.