The Fog That’s Yet to Lift

QE Must End, But Bernanke's Plan May Be Too Hasty

By William H. Gross

June Gloom, the fog and clouds that often linger here over the Southern California coast this time of year, appears to have spread to the Federal Reserve. At his press conference last week, Fed Chairman Ben Bernanke said the central bank may begin to let up on the gas pedal of monetary stimulus by tapering its asset purchases later this year and ending them in 2014. 

We agree that QE must end. It has distorted incentives and inflated asset prices to artificial levels. But we think the Fed’s plan may be too hasty.

Fog may be obscuring the Fed’s view of the economy – in particular, the structural impediments that will inhibit its ability to achieve higher growth and inflation. Mr. Bernanke said the Fed expects the unemployment rate to fall to about 7% by the middle of next year. However, we think this is a long shot.

Mr. Bernanke’s remarks indicated that the Fed is taking a cyclical view of the economy. He blamed lower growth on fiscal austerity, for example, suggesting that should it be removed from the equation the economy would suddenly be growing at 3%. He similarly attributed rising housing prices to homeowners who simply like or anticipate higher home prices, as opposed to emphasizing the mortgage rate, which is really what provided the lift in the first place. 

Our view of the economy places greater emphasis on structural factors. Wages continue to be dampened by globalization. Demographic trends, notably the aging of our society and the retirement of the Baby Boomers, will lead to a lower level of consumer demand. And then there’s the race against the machine; technology continues to eliminate jobs as opposed to provide them. 

Mr. Bernanke made no mention of these factors, which we think are significant forces that will prevent unemployment from reaching the 7% threshold during the next year. Falling below “NAIRU” (the non-accelerating inflation rate of unemployment – usually estimated between 5% and 6%) is an even more distant goal.

Indeed, the Fed’s views on inflation may be the foggiest of all. Mr. Bernanke said the Fed sees inflation progressing toward its 2% objective “over time.” At the moment, we’re nowhere near that. 

The Fed’s plan strikes us as a bit ironic, in fact, because Mr. Bernanke has long-standing and deep concerns about deflation. We’ve witnessed this in speeches going back five or 10 years – the “helicopter speech,” the references not only to the Depression but to the lost decades in Japan. He badly wants to avoid the mistake of premature tightening, as occurred disastrously in the 1930s. Indeed, on several occasions during his press conference, Mr. Bernanke conditioned his expectations of tapering on inflation moving back toward the Fed’s 2% objective. 

The Chairman, of course, may be equally concerned about the market effects of tapering and determined to signal its moves early. However, as the spike in interest rates shows, this path is fraught with danger, too.

We’re in a highly levered economy where households can’t afford to pay much more in interest expense. Monthly payments for a 30-year mortgage have jumped 20% to 25% since January. Mortgage originations have plummeted by 39% since early May.

High levels of leverage, both here and abroad, have made the global economy far more sensitive to interest rates. Whereas a decade or two ago the Fed could raise the fed funds rate by 500 basis points and expect the economy to slow, today if the Fed were to hike rates or taper suddenly, the economy couldn’t handle it. 

All this suggests that investors who are selling Treasuries in anticipation that the Fed will ease out of the market might be disappointed. If inflation meanders back and forth around the 1% level, Mr. Bernanke may guide the Committee towards achieving not only an unemployment rate but also a higher inflation target.

It’s reasonable, of course, for Mr. Bernanke to try to prepare markets for the inevitable and necessary wind down of QE. But if he has to wave a white flag three months from now and say, “Sorry, we miscalculated,” the trust of markets and dampened volatility that has driven markets over the past two or three years could probably never be fully regained. It would take even longer for the fog over the economy to lift.