The Fed’s Being Unnecessarily Gloomy About The Recovery

Is the recovery going to fade out?

At some point, yes, obviously, the recovery is going to fade. No economy is going to support the 30% (annualised) likely growth of the quarter just finished forever. So, clearly the recovery will fade. The question that is rather more pertinent is when, at what level?

If the recovery fades at the current level of GDP, some 8 to 10% down on February’s level, then that’s a problem for current stock indices and price levels. For they’re currently indicating that we’re going to bounce back better than that.

I think it’s obvious that the recovery is going to fade out at some level before we get to February’s level though. Social distancing, the acceleration of other already extant processes (online shopping for example), is going to mean that there will have to be some recalculation of the economy, not just a return to exactly where we were. That sort of exploration of the new production space simply does take more time.

The Federal Reserve’s view

(Federal Reserve balance sheet from Moody’s Analytics)

(We’re not going to see much change in policy about this balance sheet, nor interest rates)

Jerome Powell has been pretty vocal in his view that he thinks the economy requires more fiscal policy. More stimulus that is. Others on the Fed are assuming further such action as well:

The minutes showed that many officials have additional fiscal stimulus penciled into their baseline forecast, but the prospects of this occurring before the election continue to ebb and flow.

Or if we want to go to the source:

With the reopening of many businesses and factories and fewer people withdrawing from social interactions, household spending looks to have recovered about three-quarters of its earlier decline. Nonetheless, spending on services that typically require people to gather closely, including travel and hospitality, is still quite weak.

OK, we’ve bounced back a lot but not entirely.

The recovery has progressed more quickly than generally expected, and forecasts from FOMC participants for economic growth this year have been revised up since our June Summary of Economic Projections. Even so, overall activity remains well below its level before the pandemic and the path ahead remains highly uncertain.

Exactly so, it’s what happens next that matters and that’s what we don;t know.

Looking ahead, FOMC participants project the unemployment rate to continue to decline; the median projection is 7.6 percent at the end of this year, 5.5 percent next year, and 4 percent by 2023.

This is where we start to differ. By one count of unemployment we’re already better than that unemployment rate at 7.3%. Yes, it matters which survey we use, which measure of unemployment (U-3 or another), whether we include the PUA numbers or not, all that. But thinking that unemployment – without assuming a further closedown that is – will be a 7.6% in December looks to me to be excessively gloomy as an estimate.

We can go on with such details but the base case being made by the Fed is that the bounceback is going to leave us substantially below February’s level and thus more stimulus is required.

There is another case

It’s also possible to think of this in a slightly different manner. As I did here. OK, perhaps overly self-referential but the case is simple enough. Yep, bounce back. But some parts of the economy are never coming back and nor do we want them to. Instead we want to find new ways of doing those old things, or new things to do with those old assets. That takes time – it’s akin to the normal process of economic growth and works at some few percent per year more normally, not the 30% per quarter of the bounceback.

In this reading more stimulus is contraindicated because that preserves those old ways rather then encourages the exploration of the new.

The truth being that both stories are true up to a point. There’s a need to stimulate up to some point, there’s a need to explore and build anew at some point. The controversy is over what is the switching point?

This being where my difference lies. Or, perhaps, the difference between the Fed’s and my views.

So, who’s right?

Well, clearly we need to think that the Fed has something going for them. They are there, in the Fed, after all. And yet looking at the numbers out there it’s not obvious that they are right.

Unemployment continues to fall, by one count already better than the Fed thinks for the end of the year. There are plenty of jobs out there, separations are falling. The short term indicators for the immediate future are strongly positive. Inflation is rising and the savings rate is falling – both signals of consumer confidence.

OK, The Moody’s/CNN back to normal index is flatlining but that’s the oddity in our empirical evidence. And market prices doen’t seem to buy the sagging recovery line either.

Contrary to the prevailing view, U.S. business activity has yet to incur a worrisome deterioration. If activity was slumping badly, stock prices would be sinking, and corporate bond yield spreads would be ballooning. Much to the contrary, equities have been rallying and corporate credit spreads have been narrowing.

Well, who is right? The markets, the numbers, or the Fed?

My view

I run with the markets myself. Partly because I just do trust the collective view of the market more than that of any smaller group. Partly because all the other evidence we’ve got seems to support that market view. Thus I run with sure, the bounceback is going to fade out at some point but it’s going to be close to February’s level when it does. After that we’re back to working out how to gain 2 to 4% GDP growth a year in the normal manner.

The investor view

Well, here it’s a matter of who you believe. If you think the recovery is near out of steam then you’ll think markets are too high. If it is near out of steam then more stimulus is required and it’s most unlikely we will get it in this election period. So, plan on a market index fall.

If you look at the more detailed numbers it’s possible to disagree with the Fed. At which point the markets look about correctly priced and that we’ll not gain more stimulus doesn’t matter – in fact is a good idea.

This is one of those times when your prediction of the market level depend upon which reading of the macroeconomic evidence you believe. I’m with the things are doing fine one but your position is up to your reading of it.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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