The Paradox of The Fed’s Forecast

Written by Stephen Kaczmarek and Gene D. Balas

By making an upbeat economic forecast, the Fed may have paradoxically engineered precisely the opposite outcome. The Fed stated its expectation that growth will continue with diminished downside risks and inflation will rise to the Fed’s 2% target. As a result, the Fed indicated that bond purchases could be reduced later this year and halted altogether mid next year. The dreaded “tapering” is now firmly on the horizon, and with it, the possible demise of the wealth effect that had driven household consumption.

The stock market sold off as the end of the Fed’s bond purchase programs means less cash flowing into the financial markets that had provided buying power for stocks. If the stock market falls, household wealth would be reduced. Workers would then need to make bigger 401(k) contributions in order to build retirement savings, as the stock market may no longer do that for them. If the savings rate goes up from its very low 2.5%, household spending would go down in tandem. Hardly a way to expand GDP.

The bond market sold off as the Fed announced potentially fewer bond purchases in coming months and signaled rate hikes may be sooner than we had thought. Interest rates spiked, affecting both business and consumer loans, especially mortgages. Aside from impeding borrowing by businesses to expand, grow and hire, higher rates may restrain new auto financing. Home price appreciation may be limited as higher mortgage rates make the same house more expensive in terms of monthly payments.

As home price momentum slows, households feel less wealthy and spend less, especially if fewer homeowners become less underwater. The particularly rapid pace of home price increases was a notable contribution to consumer confidence. A slowdown in home price appreciation may cause homebuilders to start new projects less aggressively. That would lead to less employment growth in that sector as well as weaker demand for basic materials and the industries supporting residential construction. So, in one simple act, the wealth effect and employment picture may have changed.

Higher interest rates means commercial real estate (especially apartments) becomes more expensive for tenants through higher rents to offset the increased interest expense. That would reduce funds available to be spent elsewhere in the economy from that group of renters. The same goes with higher mortgage rates causing new homebuyers to have higher monthly payments. And existing homeowners might not be able to refinance to reduce monthly payments. Previously, mortgage refinancing freed up cash for consumers to spend.

Meanwhile, an assessment of higher growth and inflation flies in the face of industrial metals prices that have fallen significantly, partly as demand from China has slowed. China’s slow growth, in turn, is due in part to slower export orders from around the globe. Falling metals prices indicate weak demand globally for finished products, whether they are toasters or tractors. It also means lower inflation pressures – opposite of the Fed’s goals.

Commodity prices do not signal an inflationary horizon, and wage gains are still nowhere to be found. So, James Bullard, President of the St. Louis Fed, who dissented at this week’s meeting because he was concerned that the Fed was too sanguine about low inflation, may prove to be right. Continued too-low inflation may mean the Fed needs to do more, not less. And a strong dollar resulting from the Fed’s decision may further depress inflation, and importantly, it puts U.S. manufacturers at a disadvantage, curbing exports.

Combined, lower inflation numbers, softer consumer spending growth, tempered home price gains, weaker residential construction and lower (or at least slowing) exports, may mean that the Fed could well end up having to delay its tapering program. Instead, the Fed may need to increase the pace of bond purchases to keep the economy from slowing, in a pattern we have seen repeatedly during this recovery. Time will tell.