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One top dog at the Federal Reserve issued cautious comments about the bounce in the economy, throwing cold water onto the rising talk of a sustainable recovery and the most overused buzzword of the moment, so called "green shoots."
According to Reuters Federal Reserve Governor Kevin Warsh, in prepared remarks to the Institute of International Bankers annual meeting in New York, told the group" "The panic's hasty retreat should not be confused with robust recovery," adding "The rather indiscriminate bounce off the bottom -- across virtually all assets and geographies -- may be more indicative of a one-time reset, which may or may not be complete."
Mr. Warsh added that 'private demand, the true arbiter of economic performance, "remains weak" even while government spending has surged, and the the jobless rate is likely to peak at a higher rate, and linger longer at those high rates, than in recent recessions," further noting that ""The 'jobless recovery' may prove to be a familiar and vexing refrain," while further noting "I would expect business capital expenditures and consumer spending to continue to disappoint for the next several quarters."
So, as housing starts showed improvement, job losses have slowed, demand for gasoline has risen, traffic on the highways is surging, and corporate earnings are seeming to bottom out, Mr. Warsh thinks that we're in the middle of an unsustainable, oversold bounce, basically.
When you read the speech directly (http://federalreserve.gov/newsevents/speech/warsh20090616a.htm), though, a whole new meaning and context is evident, as Mr. Warsh's negative views are encased within a much larger social context, that of deviancy. The first paragraph sets the stage: "In a seminal essay delivered about 16 years ago, Senator Daniel Patrick Moynihan offered a striking view of the degradation of standards in society.1 He observed that deviancy--measured as increases in crime, broken homes, and mental illness--reached levels unimagined by earlier generations. As a means of coping with the onslaught, society often sought to define the problem away. The definition of customary behavior was expanded. Actions once considered deviant from acceptable standards became, almost immaculately, within bounds."
Warsh then brings his focus to deviancy in the context of the financial crisis, noting 'Given the financial crisis, deep contraction in the real economy, and extraordinary fiscal and monetary responses, I cannot help but wonder what constitutes deviance in economic terms in 2009 and beyond. What level of real economic output and unemployment is expected and, more important, accepted? And what level of volatility constitutes the "new normal"?' and adding "As I will discuss, we must be wary of macroeconomic policies that--in the name of stability-- may have the effect of lowering trend growth and employment rates."
Warsh frames his discussion within the bounds of policy that is meant to foster either growth or stability, pointing out that neither runaway growth or stability are in and of themselves "final," as runaway growth has its downfalls, while stability "stability threatens to displace economic growth as the primary macroeconomic policy objective."
And sounding much more upbeat than the sound bytes and selective quotes of the wire services displayed, Mr. Warsh is actually hopeful, noting "we must recognize that the singular pursuit of stability, however well intentioned, may end up making our economy less productive, less adaptive, and less self-correcting--and in so doing, less able to deliver on its alluring promise. This fate, however, does not have to be ours. The U.S. economy is capable, in my judgment, of delivering more."
Warsh questions the effects of the current policy decisions on the future cautiously noting: "Long after the official recession ends, the choices being made may significantly alter the contour of the U.S. economy. The harder question that remains is whether these changes will prove beneficial."
In fact, Warsh was fairly balanced in his speech, not as bearish as the mainstream media reporting. After describing the period ranging from the mid 1980s to 2007 as one in which "bipartisan, pro-growth policies" led to excellent economic growth, he wisely backed away from overpraising the era, saying "I do not mean to suggest that the period that preceded the crisis was a golden age. It wasn't," and citing the 1990-1991 and 2001 recessions as proof that "Even during this seemingly enviable, secular period of prosperity - cyclical weakness occurs."
His main focus seems to be whether the boom that preceded the bust was abnormal and whether the measures being taken now will lead to a prolongation of a significantly weak period of economic activity. He wonders if the swing of the pendulum away from growth toward stability won't in the end be harmful, noting "stability, in the sense of lower macroeconomic volatility, is a fine objective, but it is not a final one. The conduct of monetary policy, for example, aims to achieve price stability throughout the economic cycle. But central bankers do so because we believe it is the precursor to strong and sustainable growth. If other policies--notably, those for fiscal, regulatory, and trade--treat stability as the ultimate objective, then we might find ourselves with lower growth and diminished economic potential."
Perhaps the most salient line in the speech was this: "The costs of the stability experiment might turn out to be large. Necessarily and hastily crafted when the financial crisis began, the stability experiment is likely to survive far longer than the panic that preceded it. It is surging in popularity and is likely to grow in application, particularly if, as I suspect, the economic picture disappoints."
More sobering is Mr. Warsh's notion that we are in uncharted waters, a fact that he makes in several key points:
- "The panic's hasty retreat should not be confused with robust recovery. For economic performance will turn ultimately on the force of private final demand; and for now, it remains weak."
- "The trauma experienced by businesses and consumers coming out of the panic should not be underestimated."
- " Exceptional fiscal expenditures, by their own terms, are intended to replace shortfalls in aggregate demand. And recent extraordinary monetary policy actions are intended to lower risk-free rates and grow balance sheet capacity to help offset the pullback by private financial intermediaries. But financial markets may extract penalty pricing if fiscal authorities are unable to demonstrate a credible return to sustainable budgets. And they are unlikely to look kindly on monetary authorities unless they decidedly and unambiguously chart their own independent paths. The Federal Reserve should not--and will not--compromise another kind of stability--price stability--to help achieve other government policy objectives."
- "On balance, I would not be surprised if these countervailing forces--unprecedented public support and underwhelming private demand--fight to a draw by the fourth quarter. But the scale of stimulus and the recent blow to the real economy are both lacking precedent, so predicting the victor is tough business."
Conclusion
Mr. Warsh is onto something. He has carefully laid out the history of the most recent boom-bust cycle and has crafted an argument based on deviancy, or the way that policy makers justify their actions and then sell them to society. As Mr. Warsh points out, many of the actions of policy makers are "well intentioned," but clearly have the potential to affect economies for long periods of time.
We have gone from a period where growth was the objective, to one in which stability is the goal. The problem is that policy is an all or none proposition, and that goes against the grain of the way the Universe works, Chaos, where life behaves similarly to a stock chart, moving in channels until a trend line is broken and a search for a new channel begin.
What Mr. Warsh isn't saying is that life is by definition predictably unpredictable. And policy makers are looking for predictability in a world where it is fleeting and only a small part of the normal, Chaotic, swirl of events.
But this is more than academics. This is the start of a fight between the Fed and the politicians. Mr. Warsh, likely under the direction of Mr. Bernanke, is also drawing the line as to what the Fed will do from a political standpoint, noting that the Fed will not be a pawn to politicians. This is particularly interesting since Fed Chief Bernanke will be appearing in front of Congress to argue about his involvement in the Bank of America purchase of Merrill Lynch.
The mainstream media seems to have missed the point in their reporting of Mr. Warsh's speech. Yes, he is cautious about the future. But he is also hopeful, at least conceptually, noting that the Fed has done all that it could and that policy makers, driven by self-interest, ie. seeking re-election or re-appointment, will likely lead us astray by overreaching toward stability.
This is, in our opinion, very predictable behavior on all sides. Congress and the president have an agenda. But so does the Fed. If we were to pick sides, we'd pick the Fed. But in reality, the choices are not great. It's like having to decide whether you invite Lucifer or Beelzebub to dinner.
From an investment standpoint, the potential for a war between the Fed on one side, and the White House and Congress on the other, is not what those looking for a continuation of the rally are hoping for. In other words, we're in for a very tough period of political wrangling, with the potential to roil the markets, especially the dollar and bonds.
The only things missing from this saga are Luke Skywalker and Han Solo.
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