On Tuesday, Federal Reserve Chairman Ben Bernanke delivered his semiannual monetary policy testimony to the Senate Banking Committee. Washington and Wall Street were eagerly anticipating the introduction of QE3, but Bernanke chose to hold back.
Following the testimony, Senator Chuck Schumer urged Bernanke to “get to work.” Schumer, like many Senators, seems to believe that Bernanke has the power to revive the economy. However, that time has passed.
Jim Paulsen, chief market strategist at Wells Capital Management in Minneapolis, expressed his doubts post-testimony: “Is he [Bernanke] hesitating to announce another program because the Fed is questioning its potential impact? Or do they think that, looking at the data, the situation isn’t so dire?” He speculated, “Maybe it’s a bit of both. But does anyone really need more excess bank reserves?”
Clearly, Paulsen’s question highlighted the fact that banks already have ample credit at their disposal. The issue lies in their inability to find worthwhile ventures to fund. When banks scan the economic environment, they see little worth extending credit for—especially when it’s easier to borrow from the Fed at nearly zero percent and then lend it back to the government by purchasing 10-Year Treasury notes that yield just 1.5 percent.
This situation implies that the financial system is currently devoid of demand for the Fed’s most essential offering—bank credit.
Price Distortions
Banks are wary about lending to businesses, fearing it won’t be profitable. As a result, the Fed’s ability to stimulate the economy through cheap money has diminished. Similar to how too much fertilizer can spoil a garden, repeated rounds of quantitative easing have reached a point of diminishing returns.
Nevertheless, Schumer, along with others from Wall Street and Washington, continues to press Bernanke for further action. At Economic Prism, we believe Bernanke has already done more than enough. With the federal funds rate hovering near zero, banks inundated with credit, and the Fed’s balance sheet swelling to nearly $3 trillion, the economy still crawls along like an old car on a bumpy country road.
At this juncture, the Fed’s monetary strategies are unlikely to benefit the economy. An additional trillion dollars on the balance sheet won’t stimulate business activity; it will merely inflate asset prices.
Despite this, the S&P 500 is inching toward 1,400, oil prices have surpassed $90 per barrel, and gold is attempting to reach $1,600 per ounce. Currently, asset prices are excessively inflated due to Fed influence, detached from the reality of the broader economy.
The Fed understands that some air must be let out of these inflated assets before they can resume any form of monetary easing. Taking action now could lead to skyrocketing prices, including consumer costs, all while the economy cools. This scenario would evoke the worst of both worlds: a stagnating economy alongside rising inflation.
Such a situation recalls the “stagflation” era of the 1970s. Schumer may overlook the lessons of stagflation and the misery index, but Bernanke is acutely aware; he has dedicated his career to understanding these phenomena. Compounding matters, while the economy may already be slowing, it is nearing a fiscal cliff without proper oversight.
Prepare for a Significant Stock Market Selloff
Starting January 2013, substantial tax hikes and erratic government spending cuts will take effect. From our perspective, Congress seems unable and unwilling to steer the economy away from the impending fiscal cliff, caught in a standoff with no resolution in sight.
If nothing changes before year-end, taxes could increase by nearly $3,800 per taxpayer—over $300 a month, roughly equivalent to a car payment or preschool tuition. The sweeping tax hikes will affect income tax, the alternative minimum tax, estate tax, payroll taxes, and a new healthcare tax for Medicare. Concurrently, government spending cuts will impact defense, unemployment benefits, and payments to Medicare physicians.
According to estimates from Goldman Sachs, Citigroup, Merrill Lynch, and Morgan Stanley, the fiscal cliff could result in a GDP contraction of 4 to 5 percent. Given that GDP is currently growing at just 1.9 percent, this shift is likely to push the economy into recession. The Congressional Budget Office has substantiated these findings and believes heading over the fiscal cliff will indeed trigger a recession, yet Congress has chosen to take a one-month vacation.
Here on the ground, signs that all is not well continue to mount like hay bales in a field. Recent data from the National Association of Realtors revealed that sales of previously owned homes plummeted by 5.4 percent in June. Additionally, the Labor Department reported a 34,000 increase in Americans applying for unemployment benefits, bringing the total to a seasonally adjusted 386,000. The Conference Board also indicated a 0.3 percent decline in its leading economic indicators for June.
The stock market may be sluggish, but we have every confidence it will soon catch on to the unfolding reality. With no Fed support, an economy teetering on the edge of recession (if it’s not already there), and a Congressional stalemate, the signs are all pointing toward a substantial stock market selloff.
In conclusion, we suggest you brace yourself; the impending selloff is inevitable, and there’s a palpable sense of it in the air.
Sincerely,
MN Gordon
for Economic Prism
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