The Fed is about to have its last meeting this quarter, and the February CES jobs report has made this upcoming March meeting much easier. Total non-farm employment was up another 227K, with 233 coming from the private sector. This is a tad lower than the revised January numbers, but still very positive, and represents over a year of steady monthly private sector job growth without a single negative month. The only real negatives this past month were in construction and retail trade, the latter after five months of increases. Government continues to be the consistent negative, despite the rhetoric on the need to support job creation. A lot has been written dissecting this new report, so little is to be gained by repeating what others have done. However, the key is what the report might mean for Fed actions, which are dependent upon the unemployment rate, job momentum, unit labor costs, productivity, and capacity utilization. Here the evidence is mixed and provides a yin and yang to the Fed’s pursuit of its dual mandate.
The labor market has clearly picked up as the private sectors creates more jobs, but the unemployment rate, which had dropped surprisingly last month, held steady at 8.3%. This is clearly higher than where the Fed thinks it should be. Productivity slowed to 0.3% on a year-over-year basis, and capacity utilization is extremely low at 77%, but unit labor costs jumped at the annual rate of 2.8%. Low capacity utilization implies slack in the economy and a reduced inflation threat, but the jump in unit labor costs, combined with the slowdown in productivity increases, suggests that profits will be squeezed and increases the incentives for businesses to raise prices. Then there are the contagion risks due to possible fall-out from the continuing saga in Greece. To this one needs to add the two-sided risks to the run-up in oil and gasoline prices. Pundits have emphasized the risks that energy prices pose to the recovery and especially consumer spending. Additionally, should higher prices persist, there is the risk that they will show up in increased inflation. So the current situation implies remaining downside risks to growth but upside risks to inflation. In this world, the safest action for the time being may be to just stand pat, and this is justified by reference to the fact that inflation expectations are still very low and appear to still be “well anchored.” Little is to be gained by taking more action at this time, despite the enthusiasm of some for more quantitative easing in one form or another.
This brings us to the recent trial balloon about a new, modified form of quantitative easing being considered that would involve more purchases of mortgage-backed securities, offset with short-term asset sales with agreement to repurchase them (known as reverse repos) to sterilize the transaction. Bob Brusca, in his recent commentary “New Fed Policy? Same Old Fed Policy?,” correctly points out that this is just another form of Operation Twist. Moreover, the Fed has continually engaged in such transactions, which were at the heart of how operations were conducted between August 2007 and September 2008, during the so-called liquidity phase of the financial crisis. The Fed provided subsidized liquidity to the primary dealers while simultaneously selling Treasuries from its portfolio (for a graphic presentation see http://www.cumber.com/default.aspx). There are two other features of this proposal that seem odd.
First, given the large amount of excess reserves already in the system that are simply sitting idle earning 25 basis points, there is no need to engage in sterilization. The point of sterilization is to keep institutions from expanding the money supply through increased lending. But isn’t it the intent of current policy to encourage lending? If there is concern about expansion of the money supply and increased inflation potential, then why is there not more discussion of increasing reserve requirements? That would appear to be the most effective tool to implement at the current time, and at zero cost except for the lost interest rate of 25 basis points, due to the conversion of excess reserves into required reserves. But that would also serve to stimulate lending, since the opportunity cost of holding excess reserves would suddenly become greater than expanding lending. Increasing required reserves would be the functional equivalent of paying zero interest on a portion of what had been excess reserves, which is similar to what some have recently advocated. Additionally, as the economy began to expand, reserve requirements could be relaxed in lock step with the run-off of the Fed’s maturing MBS and Treasury securities in a way that would facilitate a low-risk exit strategy.
Second, what is odd about this recent trial balloon is its seemingly poor fit with the Fed’s communication policy and, as Brusca points out, how it runs counter to the tone of Chairman Bernanke’s most recent congressional testimony implying reluctance to do more at this time. Why even raise this possibility now, other than to suggest that the Fed hasn’t run out of unconventional tools to try to stimulate the economy? Don’t look for the Fed to invoke this “new” strategy any time soon.
What does all this mean for investors? With interest rates low and likely to remain low, at least through 2013, there is the temptation to look to alternatives. On the margin, equities are likely to be somewhat more attractive at this time, if one can stand the roller-coaster ride that is likely to go with equities. Reaching for return in fixed-income investments implies taking more credit risk, unless there are simply mispriced opportunities in the market. At Cumberland we believe that such mispricing exists and, with the help of some duration-based hedging strategies, have designed ways to manage those risks.