Sunday, November 22, 2015

The Hidden Message of the Fed Minutes (The Federal Reserve is looking for lower interest rates for a long time)

From Barron's 'Up and Down Wall Street' column:
Has nasty, brutish, and short become the real new normal of today’s world? To judge by stock markets around the globe last week, it might seem so.

Not missing a beat after the horrific terrorist attacks by Islamic State operatives that took the lives of 130 people in Paris a week ago Friday, equity markets rallied, with Wall Street actually putting in its best week of the year. 

Was this a manifestation of defiance or denial? The latter might have been the case previously, as when President Obama said the Islamic State had been “contained” in an interview with ABC News the day before the Friday the 13th Paris massacre. That description recalled the similarly unfortunate assessment by former Federal Reserve Chairman Ben Bernanke, who declared the spillover effects from subprime mortgages were “contained” in early 2007—only months before the crisis really began to unfold.

Equity markets do have a record of bouncing back from the initial blow imparted by acts of terror, as Liz Ann Sonders, Charles Schwab’s chief investment strategist, wrote last week in’s Wall Street’s Best Minds. Even after 9/11, the 12% hit when the U.S. stock market reopened was recouped a month later. And after the London underground bombings in July 2005, there was only a 1.4% drop, which was recovered the next day.

But even on Monday, in the very first trading session following the heinous Paris attacks, stock markets not only didn’t buckle but moved higher. To be sure, the U.S. market seemed oversold and due for a bounce. Still, the seeming indifference to the events of the previous Friday suggested that investors had grown a lot more callous in recent years. 

Recall that the Flash Crash on the afternoon of May 6, 2010, which sent the Dow Jones Industrial Average plunging nearly 1,000 points in a matter of minutes, seemingly was precipitated by videos of protests in Athens against austerity measures needed to stay in the euro. I’ve lost track at this point of the number of Grexit crises; they all blur together. And, at the risk of sounding like Spiro Agnew, Richard Nixon’s vice president who resigned in disgrace, when you’ve seen one street demonstration, you’ve seen them all. 

But by week’s end, bourses around the globe had put on sparkling showings in an extension of the advance that started last month—and as if nothing had happened in Paris. Asia, Tokyo, Shanghai, and Hong Kong were up by 1.4% to 1.6%. Closer to the attacks, Germany soared 3.8%, London by 3.5%, and even the Paris bourse was up over 2%. 

And back in the U.S.A, the Standard & Poor’s 500 index put in its best week of 2015, gaining 3.3%. To be sure, that followed one of the worst weeks of the year, in which the benchmark for big U.S. stocks shed 3.6%. Meanwhile, the Nasdaq Composite regained the 5000 mark and wound up 3.6% higher. And the Dow Jones Industrial Average was kicking it, adding 3.4%, with the help of Nike (ticker: NIKE), which jumped 5.5% Friday, on news of a stock split, a dividend hike, and an expanded share-repurchase plan. 

What was especially striking was that the markets seemed to gain steam after Wednesday’s release of minutes of the Federal Open Market Committee’s meeting last month, which gave further confirmation that the U.S. central bank would raise rates at the coming two-day confab on Dec. 15-16. As if much confirmation was needed, especially after the previous report of a bigger-than-expected 271,000 jump in nonfarm payrolls in October. 

So, the long-awaited, and endlessly discussed, initial liftoff in the Federal Reserve’s interest-rate target from the near-zero (0% to 0.25%, to be exact) that’s been in place since the dark days of the financial crisis in December 2008 might finally be at hand. That’s a reason to bid up stocks?

WHAT GOT LESS MEDIA ATTENTION—but didn’t escape that of the market—was that the FOMC minutes strongly implied that even if the initial rise in the federal-funds target rate is imminent, the ascent will be milder and will not reach nearly as high as most forecasts indicate.

Specifically, the minutes discuss the notion of a real—that is, after adjusting for inflation—equilibrium interest rate. That rate would be associated with stable prices, a construct theorized by Swedish economist Knut Wicksell a century ago. Divining that golden mean isn’t obvious, but Thomas Laubach, a staff economist at the Fed’s Board of Governors, and John C. Williams, the president of the San Francisco Fed, have been studying the matter since early last decade.

In a recent paper, they reckon that this equilibrium real rate—which they dub r* from their equations—is about 0%. This is a moving target, but this rate had averaged about 2%—again, over the inflation rate—during the past half-century. Following the financial crisis and the Great Recession, they found, it was about a negative 1.5%. By implication, the 0% to 0.25% fed-funds target was about right....MORE