The Fed has two primary job descriptions. First, keep prices stable. Second, promote an environment of economic growth that provides employment opportunities. Which is more important?
Economic crises at their core typically consist of disruption in financial and currency markets. Once the financial transmission mechanisms fail, hard recessions and unemployment spikes follow. I struggle to identify a crisis scenario where the catalyst was a spike in unemployment that led to a disruption in the financial and currency markets. Therefore, a central bank’s first and highest priority should be maintaining price stability.
Within our own Fed history, we see evidence of this. One of our most revered Federal Reserve Chairmen, Paul Volker, deliberately put the economy into a recession leading to painful and widespread unemployment, in order to regain price stability. In truth, the Fed bears responsibility for most recessions as it raises rates to tamp inflation. Perversely, it is low unemployment toward the end of economic cycles that creates inflation as the employed press their bargaining advantage with their employers. Remember this maxim: healthy economies create jobs, price stability creates healthy economies.
Last week, Ben Bernanke surprised most market participants by not “tapering” the Federal Reserve’s asset purchase program. The market expected a taper because Bernanke laid out a hypothetical roadmap for tapering at their June meeting. Markets took this as a signal of future action applying an expiration date and withdrawal then effected this policy presumption by pressing the yield on the 10-year Treasury and related mortgages over a percentage point higher. No need for the Fed; the marketplace set the policy.
Higher mortgage rates reduced housing activity and higher intermediate term interest rates downshifted growth assumptions and disrupted economic activity within emerging markets. This complex interaction increased deflationary forces already present due to the continuing retrenchment from global deleveraging. Right now, the world is hypersensitive to monetary conditions, and rising rates apply deflationary force.
Today, the core personal consumption expenditures price index (the Fed’s favorite inflation measure) stands at 1.2 percent. The historical low for this reading was .9 percent, reached in 2010. This measure has fallen by .3 percent since the beginning of the year. Stated differently, the Fed’s primary marker of price stability has fallen 22 percent since the beginning of the year. The Fed equates 2 percent inflation with price stability. Price levels are falling, not rising. Why would a prudent chairman tighten monetary conditions in this environment? He wouldn’t and he didn’t. Markets shouldn’t dictate Fed policy. The Fed should dictate Fed policy. Good call Ben.
Cue the All-Time Highs
The primary competitors for investor capital are the stock and bond markets. Using trailing operating earnings on the S&P 500, the stock market has an “earnings yield” of 5.77 percent. The yield on the 10-year Treasury bond stands at 2.75 percent. What justifies the voyage past all-time highs for stocks is this relative advantage. With the Fed on deflation watch, this differential will continue to promote stocks. No, the U.S. stock market isn’t cheap anymore, but it’s still really cheap when compared with bonds.
David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.