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Are the Fed’s Decisions Already Made?

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By Terry Connelly

A good many economists expect the Federal Reserve Board to begin cutting back its purchases of government and mortgage-backed securities at its September meeting. The cuts may be as much as about 20%, despite the fact that Chairman Ben Bernanke has said that the decision to do so will be driven by the actual incoming data on the jobs and the economy rather than the Fed’s current expectations regarding that data.

That means that a large percentage of economists either don’t take the Chairman at his word, or agree with the Fed’s perception that the economy is coming along better than it looks to the naked eye. The first of these thoughts is not very appealing; the second of these would be sort of a “first” - i.e., economists actually agreeing with the Fed.

Many expect the Fed, in fact, to signal its commitment to cut back on QE in September in the statement released after its upcoming July 30-31. This writer believes any such decision could and should wait until the late October meeting when much more real data will be available, to have any real chance of coming true. This includes the first estimate of 3rd Quarter GDP, which is going to have to have a “3” at the front of it for the Fed’s optimistic economic forecast (the stated reason QE can be cut back this year).

That said, it may be that the 2nd Quarter GDP data will have an even more immediate impact on the Fed’s decision, especially when we (and the Fed) focus on the actual calendar dates when it and other key data will be released as July turns into August.

The great unwinding

Before we go there, why does this all matter, anyway? The big time reason is that the Fed and the economy have never experienced this particular situation before. It’s a tricky business even in the best of hospitals to know when to withdraw the very last life-support systems that have been in place to aid the patient’s recovery.

From the Fed’s point of view, the US economy is long removed from the emergency room of TARP and the initial Obama stimulus package of tax reductions and Federal spending. The economy is also no longer in the “intensive care” period of QE I and QE II, which in fact led to accusations that Dr. Fed had given the economy the adverse side effect of a "fever" of rising commodities prices. True or not, those prices seem to have gone the other way during the QE III period apart from oil, which has been up and down largely on the basis of geopolitical and factors and localized bottlenecks in supply -- not to mention all the oil held in anchored tankers and held off the market by the big US banks’ commodities trading desks. (The banks are clearly in outpatient care.)

QE III was supposed to ensure that the economy could walk out of the hospital on its own and achieve what economists label “escape velocity.” It steadied the “pulse” of longer-term interest rates, like mortgages and loans that drive consumer and business risk appetite, without raising the “blood pressure” of commodities prices. Indeed, the cheap money that the Fed’s Treasury and mortgage security channeled into the marketplace did spur a measurable housing rebound in both sales and prices. It also found its way into the stock market which has risen over 20% since QE II started last September. And job growth stabilized at a decent level around 200,000 per month since the end of last year as well, a level consistent with economic GDP growth of around 2%. Corporate profits, meanwhile, have surged to all-time highs along with the Dow Jones average. All these numbers have been good news for the Fed’s patient.

It's not all good

Normally the patient is not released from the hospital until all “vital signs” are all flashing green. But in this novel case, not all such signs turn out to be in synch. Despite the slow, steady job growth – with states and localities actually returning to hiring after the post-stimulus let-down of 2011-12 – unemployment has only moved about five-tenths of a percentage point down. This movement is barely enough for Bernanke to claim progress towards the Fed’s interim goals of 7% for the end of QE and 6.5% for the “beginning of thinking about” the end of ultra-low short term interest rates. In short, it’s too thin a reed on which to hang the commencement of QE tapering by September.

Moreover, despite the growth in jobs, the stock market indices and business profits, GDP for the three quarters following the inception of QE III looks like it will average about 1%, not 2%. We haven’t had 2% growth in any quarter for a year! And the first look at Q2 GDP might even be less than 1%. The Fed can blame the weak GDP in 2013 on – what else – Washington DC. The President and Congress indeed have contrived to produce first the “fiscal cliff “ drama that paralyzed business investment decisions, then a personal and payroll tax increase to start the year that crimped consumer spending, and then a sequester of Federal spending as a sort of “instant austerity” just when Europe was answering, “How’s that approach workin’ out for ya?” in the negative. So just as the patient has been getting ready to unhook the last of the QE - IV tubes, he gets a distinctly hospital-borne infection – often the deadliest of them all.

So we must say to our economist friends again: look at the calendar, dummies. Q2 GDP will be announced the very morning of the last days of the Fed’s July meeting. Do you honestly think the Federal Reserve will pick the day on which we may well not have ANY digit before the GDP decimal point – or worse – to telegraph to world that QE tapering will really begin in September? Do you think they might hold their fire so they can also absorb the July employment report just two days later, and the same for August? Surely they would not want to turn the promise of September into a need to actually put the patient back on renewed or even expanded QE III just in time for Halloween. Now that would be scary! No way for Bernake to give up the ghost.

Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.