Federal Reserve Meeting: January 2015

The United States Federal Open Market Committee concluded its first meeting of 2015 this past Wednesday, releasing a statement that was highly analyzed and scrutinized given the anticipation over the Fed raising interest rates. While there was no clear indication of the Fed's future moves, analysis of the statement and some of the key points can bring a more solid understanding of the Fed's actions going forward.

One of the most interesting analytic tools available to understand the FOMC's statements is the Statement Tracker Tool provided by the Wall Street Journal. This tool takes a direct comparison of two statements, using red highlights and strike-throughs to indicate verbiage that has been removed and green highlights to indicate points that were added. For this most recent statement, I analyzed the change between the January statement and the directly preceding it (December 2014). One of the most prominent changes between the two statements occurs in the third paragraph:

The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time...especially if projected inflation continues to run below the Committee's 2 percent longer run goal, and provided that longer term inflation expectations remain well anchored.

As indicated by the red highlight and the strike-through, the FOMC had chosen to omit this portion of the December 2014 statement in their statement released this past Wednesday. This change is important on two levels: first, it takes away the "considerable time" clause from the Fed's statement. This clause was cited by Federal Reserve officials as showing a commitment to near zero short term rates for an extended period of time. With the removal of this clause, it gives a pretty clear indication that the Fed will adjust the target range within the coming months. The second piece of information that is taken away from the Fed's statement is concerning keeping the target rate low given lower inflation. This, I feel, is a more striking development, as it more explicitly states that these rate hikes will in fact happen, even if inflation remains under their 2% target. The removal of this key policy point shows that changes will be made, and they will be made (almost) regardless of what the data shows.

Upon analyzing the Fed statement, the Wall Street Journal published an article entitled 7 Takeaways From the January Fed Statement: 'The Committee Judges That It Can Be Patient'. In this article, several WSJ writers analyze seven of the key points that can be taken away from the January statement. For his analysis, Pedro Nicolaci da Costa analyzed the meaning behind one added word in the third paragraph:

The Fed added a single word to its policy statement which may actually have a lot of meaning. In a sentence saying it was monitoring inflation and market trends, the Fed now notes it is monitoring "international developments." That's about as close as Fed officials will ever get to hinting that movements in the dollar, which has been rallying steady, may affect their thinking.

The addition of another policy variable, "international developments", is an interesting shift from the FOMC. This shift takes into account the rapid appreciation of the dollar as compared to numerous currencies, especially the Euro. While the Fed will never directly state that it makes policy decisions based on movements in the market, the addition shows that the Fed is cognizant of the headwinds that the US economy could face given international instability: namely, decreasing amounts of exports.

ECB Decision in the Details

This past Thursday, the European Central Bank made a historical decision in announcing its first ever quantitative easing program. This decision to undertake a QE program was highly expected by the markets, but the pace and size of this program, €60 Billion per month for a total size of €1 Trillion, sent stock markets across the globe rallying. While the headline numbers were often the most discussed, much of the important features of this bond purchase program comes from the details buried further down the page.

One of the most important details of this program comes from the loss sharing provision, or the small size of it, that is in the QE program. In an article posted to Medium in the Bull Market page, Karl Whelan breaks down exactly how and how the risk will not be shared:

As flagged, any risk from the "additional asset purchases" will not be shared apart from the 12% of purchases used to buy debt issued by European institutions. The ECB will also be making 8% of the purchases under the program and it is jointly owned by the NCBs, so effectively this means 20% of the purchases will feature risk sharing. However, the vast majority of the purchases-national sovereign bonds bought by NCBs-will not have risk shared. Thus, if a national government defaults, the NCB that purchased its debt will not be compensated by the other central banks.

This feature of the QE program was critical for the larger countries, such as Germany and France, to agree to this deal. While 20% of the program will be risk shared, these countries whom have significantly safer debt ratings will not have to be overly concerned about the increased risks associated with the more risky countries in the Euro Zone. In addition, making each NCB responsible for holding their sovereign debt removes most of the possibility for moral hazard, as it does not incentivize governments to default if their loss sharing would have been shared equally.

An additional detail of the ECB's decision to begin a QE program was the handling of Greece. As the results of this weekend's election, the controlling party in Greece is now one of anti-austerity philosophies. This brings a complication to the QE program, which was described by Nektaria Stamouli and Selios Bouras in their WSJ article Greek Austerity Review Needs To Be Completed for ECB QE:

The review of cutbacks and reforms in Greece must be completed to receive the next installment of international aid...Greece needs to stick to the terms of its bailout, footed by the European Commission, the European Central Bank and the International Monetary Fund, to be included in the ECB's bond-buying program.

As the outcome of the election is now clear, we can see that the anti-austerity party could cause a double hex to be placed on the Greek economy. First, as promised in their campaign, the Syriza party will push to end austerity measures as imposed as part of their bailout. With this push, they could compromise the continuation of receiving their bailout funds, leading to an eventual default and negatively impact their economy. Second, the ECB's decision to include Greece in the bond buying program is dependent on their continued bailout; again being involved with this program, which can aid in pulling down bond yields, is at risk with the Syriza party in power.

2014: A Year in (Economic) Review

2014 was an interesting and transformational year for the United States economy. Now that the year has come to a close, it is important to take a look back on the past twelve months to keep track of our economic progress. 2014 saw a brief economic contraction in the first quarter, the end of the Federal Reserve's third quantitative easing program, and a changing of the guard at the head of the Federal Reserve. Taking a comparative look at the reaction to the first quarter's GDP report and the anticipated fourth quarter GDP report can show the metamorphic story of the US economy last year.

When Chair Yellen took office in the beginning of 2014, the economy was in the midst of only the second economic contraction since the end of the Great Recession. A CNBC article and accompanying video highlight the reaction to the first estimate of US Gross Domestic Product in the first quarter. While the final estimate of Real GDP growth was only revised downward (twice) to -2.9% from the 0.1% growth initially reported, the reaction to the weak data nevertheless holds. In the video, CNBC reporter Rick Santelli offers his reaction: "so to summarize: weak. Let me summarize again: weak." The article goes on to further discuss the "weak" initial report saying:

While the harsh weather could partially explain the weakness in growth, the magnitude of the slowdown could complicate the U.S. central bank's message as it is set to announce a further reduction in the amount of money it is pumping into the economy through monthly bond purchases.

The added backdrop to this initial reaction is that, as I said before, the final number came in significantly worse than what was originally reported. If this number had been reported to begin with, I would have been curious to see if there would have been greater questioning within the Fed about the speed of their tapering plan. I would have expected that Chair Yellen, who is considered to be an monetary "dove", may have pushed for an ease of the tapering plan.

The first quarter GDP report stands in stark contrast to how the United States economy finished the year. Third estimate of the third quarter Real GDP growth currently stands at 5.0% growth, and this strong growth is expected to continue at a slightly slower pace in the fourth quarter and into 2015. In a recent publication by the International Monetary Fund, the United States economy's growth rate was revised upwards while most other developed areas were revised downwards. The IMF explains:

For 2015, the U.S. economic growth has been revised up to 3.6 percent, largely due to more robust private domestic demand. Cheaper oil is boosting real incomes and consumer sentiment, and there is continued support from accommodative monetary policy, despite the projected gradual rise in interest rates.

This report of expected healthy economic growth for the United States stands in direct contrast with the beginning of 2014. An economy that could only be described by the word "weak" now appears to be one of the healthiest economies in the developed world. It now appears the Fed was correct to continue its course of tapering, and are now even expected to begin to normalize their monetary policy.

America: A State of Political Roadblocks

I will preface this blog post by saying that, while I consider myself a Democrat (mostly due to my Keynesian view of economics), I generally abstain from promoting one political thought over another. It is my guiding political view that, during troubled economic times such as these, the country should look for proper leadership, regardless of political lines.

As the State of the Union was last night, I thought it would be proper to discuss some of the economic issues that were debated and examined by both political parties. One particularly hot bed issue that came up Tuesday night was the debate over taxes and tax reform. In the multitude of articles that came out before and after the address, two things became immediately clear: Republicans and Democrats disagree on what to do about taxes (shocker) and there seems to be almost no hope of getting a tax deal done.

The address, like this debate, will start on the Democratic side. In a front page article by the Wall Street Journal, Carol E. Lee, John D. McKinnon, and Kristina Peterson outline the President's initial proposal for tax changes. The authors highlight the talking points of the proposal, starting with a $320 billion tax hike over the next 10 years centered on high-income Americans, which would then go to pay for a $235 billion tax break for "mostly moderate-income workers". They then followed the talking points with a quote from an administration official:

"If Republicans, who now speak of poverty and income inequality with some regularity, want to defend a tax loophole of trust funds of the wealthiest of Americans, then we look forward to hearing that argument," a senior administration official said, referring to the proposal to tax additional inherited assets. "We're going to make the counter on Tuesday night. We are calling it middle-class economics."

Before the Republican Party even had a chance to respond, it seems as though the political strategy game is already being played. This official, and potentially other Democrats, seem to be salivating over the prospect of having trapped Republicans into this political corner.

On the Republican side, most of the ideas that were pushed for by President Obama were largely dismissed. Scott Neuman gathered statements and quotes in response to the address in his article Republican Leaders Dismiss Obama's Tax Proposal As 'Not Serious'. Neuman sites a spokesman for former Republican Vice Presidential candidate Paul Ryan:

"This is not a serious proposal," said Ryan spokesman Brendan Buck in a public statement. "We lift families up and grow the economy with a simpler, flatter tax code, not big tax increases to pay for more Washington spending."

While it is still early to determine what this "simpler, flatter tax code" will exactly entail, previous tax proposals have indicated that Republicans often advocate for tax breaks and a cutback in spending, which stands directly opposed to the President's plan.

Not even a day after the President's address and we are already starting to see a roadblock form on the tax issue. Economically speaking both plans have merit. Increasing taxes on those who are seen as able to "afford" it to fuel spending programs creates expansionary fiscal policy. On the other hand, continuation of tax breaks and a simpler tax code will likely stimulate consumption of goods, again expansionary. What is clearly not expansionary (or in any way economically helpful) is the political bickering that will likely last well down the road.

And while my ideals will typically agree with the President's tax plan, I am willing to advocate for a Republican plan for the sake of economic advancement. If the debate rages too long into the year, the US may miss an opportunity to take important economic steps toward recovery and, worse yet, deepen the political gridlock that exists in Congress. I concede my economic ideals to being in the minority in Congress, as both houses were recently voted into Republican control by the American public. However, that is not to say that the President should be bullied into accepting a plan that he does not believe in (as he too was elected via a public vote). It is to say that strong leadership from both the President and Republican Congress should make sure that a tax deal, albeit strongly right leaning, gets done.

MLK Day: Lack of Progress

My second post over Martin Luther King Jr. weekend once again focuses on the economic principles preached by Dr. King.  Dr. King was often known for his speeches and activism in social and political spheres, but his work toward equality for all extended to economic issues as well.  As MLK Day offers an excellent time to reflect on how far we as a society have come, it also gives us an opportunity to see just how much further we have to go.

Each year at Princeton University, there is a Martin Luther King Jr. Day celebration held where leaders of the school reflect on the life and teachings of Dr. King.  This year, Cecilia Rouse, the dean of Woodrow Wilson School of Public and International Affairs spoke about the progress, and more poignantly, the lack of progress the United States has made towards King's economic goals.  In a story released by Michael Hotchkiss in Princeton's Office of Communications, Rouse outlines the lack of changes within African American's economic standing within society since the launch of "The Poor People's Campaign" in the late 1960s.  Rouse cites the following economic facts:

In 1966, about 15 percent of Americans lived below the poverty line, Rouse said.  Today, the percentage is about the same.  "That means that today about 45 million people in the United States live on less than $24,000 for a family of four," Rouse said.  For African Americans, the poverty rate is down from 42 percent in 1966 to 27 percent today.  Still, that is twice the poverty rates of whites, she said.

The message that Rouse is sending is clear: while there has been progress toward economic equality, there still remains substantial progress for a substantial part of the population.  It is important to note that Rouse does not simply speak toward one disadvantaged group, but instead tries to focus on all of the underrepresented economic groups.  This flows directly from the teachings of Dr. King, as his teachings were based on equality; every impoverished group should be able to seek assistance and economic promotion.

In the Wall Street Journal, Robert Litan also made use of MLK Day to reflect on the continued economic gap that appears between demographic groups.  In his article Martin Luther King, Race, and the Wealth Gap, Litan focuses his discussion around two charts published by the Pew Research Center in December 2014.  The graph (below) prominently shows the significant gaps that exist between median net worth for white families and median net worth of African American and Hispanic families.

http://www.pewresearch.org/files/2014/12/FT_14.12.11_wealthGap2.png

What is most compelling to note between both of these two graphs are the aftermath of the most recent recession.  In both graphs the ratio of white family net worth to African Americans and Hispanics immediately preceding the financial crisis were approximately 10 times and 8 times, respectively.  However, in the most recent reading, which includes the conclusion of the Great Recession and a partial recovery, the ratios have increased to 13 times and 10 times, respectively.  It is very clear that this recession and subsequent recovery has disproportionately affected minorities, potentially undoing the economic equality gains that had been amassed over the proceeding decades since Martin Luther King Jr.'s passing.

MLK Day: 'Kingonomics'

With this being MLK weekend, I have found it as good of time as ever to reflect on the teachings and principals pushed forward by Martin Luther King, Jr.  As such, this and my next blog posts will try to uncover the modern adaptations of MLK's work.

To start, we can look at the concept of "Kingonomics".  This idea was first introduced to me when I purchased a book by the same title by Rodney Sampson just last year.  Unfortunately for me, school work, job recruiting, and investment banking hours have gotten in the way of my being able to pull it off of the bookshelf.

Fortunately for me, Devin Thorpe of Forbes was able to provide an excellent synopsis in his recent article 'Kingonomics' Embody The Spirit of Social Entrepreneurship.  In this article, Thorpe outlines the twelve "economic and entrepreneurial principles" as Sampson has interpreted from King's teachings and outlined in the book.  While you are able to click through to the article and read through all twelve, I will highlight and discuss two below:

1. Service: More than customer service, Sampson advocates service to mankind, "Many of us are discovering that selfishness, the currency of greed, is not all it was cracked up to be in business school," he says.

I have chosen this message in particular because, as a business school student, I take particular offense to being labeled "selfish".  For me, it is easy to see where this label comes from: in all of our finance classes we are motivated to find accounting gains and losses, add them all up, discount them for time value, and make a yes/no decision based on expected profits.  Very robotic-like.  However, professors and students are increasingly pushing for analysis outside of the balance sheet and income statement to make decisions.  It is now just as important for decision makers to consider environmental, sustainability, and consumer interests as it is for them to consider gains and losses on paper.

The second teaching of Dr. King that I will highlight is related to the first:

5. Personal Responsibility: King, himself, embodied Gandhi's counsel to "be the change you wish to see in the world."  Sampson argues that "followers must lead by the choices they make every day; then the leaders will follow."

In the modern age where the difference between a person and a corporation is being blurred (see: Citizens United), the idea of personal responsibility goes beyond just the "person".  Again, the teachings of business schools across America are promoting the goodness of "Corporate Social Responsibility", "Being Green", and "Sustainability".  However, I am of the mind that corporations who throw out this jargon are just using them as buzz words: they have little, if any, meaning.  That is to say, if they are not following the teaching as promoted by Dr. King.

In this sense, I am reminded of a business school case that my Strategy class analyzed last semester.  The company was Patagonia, who is not only known for its high-quality (and expensive) outdoor clothing, but also for their renewable and environmentally friendly practices.  What sets this company apart in their efforts is exactly what Sampson argued of King's work: employees of the company promote sustainable practices which are then reinforced by the leaders of the company who help facilitate these practices.

While there are many examples of successful, socially responsible corporations, there is a large black mark across the banking industry from the recent financial crisis.  James Sterngold took a look at 2014 in review for banking fines in his article For Banks, 2014 Was a Year of Big Penalties.  Sterngold goes through a laundry list of accusations, including fixing foreign-exchange and interest rate benchmarks, packaging and selling flawed mortgages, and money laundering.  These crimes amounted to "nearly $65 billion in penalties and fines, about 40% greater than 2013, the previous high, according to the Boston Consulting Group."

To me, the banking industry has largely ignored the economic teachings put forth by Kingonomics.  Outside of teachings 2 (Connectivity), 7 (Diversity), and 9 (Dreaming), which really have no relation to the crimes committed, the banking industry has violated all of the other twelve philosophies given by King and Sampson.  As such, not only are they feeling the accounting pain of fines and litigation costs, but they are also feeling social pressure as consumers continue to push blame onto them for creating and causing the financial crisis.

Falling Oil Prices and Why It's Everyone's Problem

As a college student living [relatively] on campus and thus walking to approximately 99% of wherever I am going, I find it easy to ignore the day-to-day movements in gas prices.  I have a habit of filling up when I am on campus about once every semester, so my intimate knowledge of the ebbs and flows of pain at the pump may not be as robust as someone who commutes to work every day.  However, I do take great notice when, for the first time since I first started driving six long years ago, that I can fill my tank for $20.

This dramatic fall in gas prices between my fill-ups was not all that much of a shock to a student of financial markets such as myself, who have been tracking the 57% decline in oil prices over the past six months.  Although myself, and more importantly, my commuting comrades have been jumping for joy over these cheap oil prices, there are an increasing number of economists who have been rumbling over the problems of cheap gas.

Common thought says that as consumers have to spend less and less on filling up their tanks, they are free to spend more on other goods.  Money that would have gone into the gas tank and out the exhaust pipe is now able to find its way into the hands of the discretionary economy.  Families can now afford to go out to dinner.  Travel is now suddenly more affordable.  Extra gas cost savings can be squared away for larger purchases: a new grill, a new car, possibly even a new house.

Isn't this all good?  Those economists are probably just off their rockers, they cannot possibly think that this is bad?  Can they?

Well it turns out that they can.

In a recent fourth quarter earnings preview for the Wall Street Journal, WSJ Markets Reporters Dan Strumpf, Saumya Vaishampayan, and Alexandra Scaggs discuss the impact that sliding oil prices are expected to have on earnings reports.  The article Oil to Put Chill on U.S. Earning Season begins with the potentially ominous opening:

As fourth-quarter earnings season gets under way, investors are bracing for the softest U.S. profit growth in years, pinched by collapsing oil prices and a strong dollar.  That double whammy, coupled with the highest valuations for stocks since the financial crisis, will test the market's ability to prolong its extended bull run and will likely make for continued bumpy trading in the weeks ahead.

The group goes on to explain that much of the weakness in earnings can be attributed to the rapid fall in oil prices, which has pushed oil companies expected earnings down by 19.1% during the fourth quarter.

As much as it is common thought that consumer discretionary spending spike as the result of less gas expenses is a good thing, it is just as agreed that a stock market collapse is just as bad, if not worse.  It is important to point out that these are earnings expectations, which can easily surprise to the up side.  But they are just as easily able to surprise to the downside, which may come to fruition as the severely rapid losses in oil companies might outweigh the gains from companies which count gas and oil as major cost drivers.  With valuations and volatility at recent highs, and investors looking to jump ship at the soonest sign of smoke, a soft earnings season could be the tipping point that starts sending shareholders overboard.

In addition to potentially weakening investment portfolios, the U.S. economy faces the possibility of upwards of trillions of dollar's worth of failed investments.  As reported by Sara Sjolin at MarketWatch, analysts at Goldman Sachs are concerned over continued low oil prices.  According to Sjolin:

Goldman Sachs found in its Top 400 analysis of the world's largest new oil-and-gas fields, that pre-sanctioned projects will be "uneconomic" at $70 a barrell...In dollar terms, this means that around $2 trillion worth of future investments are at risk...This also includes shale developments, where investments for $930 billion are in jeopardy, according to the report.

While I do not have access to the Goldman Sachs report and cannot further breakdown the source of the $2 trillion of future investments (be they world wide or domestic), much of the US production of oil comes from shale fields.  If these numbers are substantially attributable to the US, these discontinued and failed investments can be a large hit to the US economy as a whole (which for comparison purposes is approximately $17.6 trillion).

Beyond the Headline: Weak Wages

The Facts

Since the Friday morning release of the December Employment Situation by the Bureau of Labor Statistics, economists have generally come to the same conclusion: hiring continues to remain strong but wage growth data continues to be a reason for concern.  Non-farm payrolls increased by 252,000 in the month of December and, along with upward revisions in the October and November reports, was a major factor in the 0.2% fall of the U3 unemployment rate to 5.6%.  However, what is now troubling economists goes beyond the headline number as they are beginning to increasingly rumble about anemic wage growth, which in fact contracted by $0.05/hour or 0.2% in December.

The Fed

Tim Duy, a frequent contributor to University of Oregon Professor Mark Thoma's economics blog Economist's View, discussed the jobs report within the context of expectations of future Federal Reserve actions.  Duy utilizes multiple graphs depicting select economic indicators that paint a picture of the current labor market, including eight indicators which have been noted by Federal Reserve Chair Janet Yellen.  While almost all of the indicators show a clearly improving labor situation, in his last graph (below) he notes that wage growth "nosedived during the month".  He goes on to explain:

Bottom Line: Generally a very solid report.  But the wage numbers present a dilemma for the Fed.  Simply put, no wage growth means the Fed can't be particularly confident that inflation will trend toward target.

As economists and participants in financial markets from all over the world attempt to look into their crystal ball and predict the future of Federal Reserve policy, Duy believes that the Fed's plan might become more murky if wages continue to stay stagnant.

The Reasons

But what has caused these stagnant wages?  In the article Hiring Booms, but Soft Wages Linger, Jeffrey Sparshott gives multiple reasons for the tepid wage gains.  First: underemployed and discouraged workers.  Sparshott identifies the falling labor force participation rate, which currently stands at 62.7%, and an elevated U6 unemployment rate, which takes into account part-time and marginally attached workers.  Both of these indicators show that there may not be enough competition within the labor force to drive up wages across the board, contrary to what the strong headline U3 unemployment rate might suggest.  Employers are able to access this "shadow" labor supply in greater numbers than in previous hiring cycles, which will continue to keep wages low despite the falling unemployment rate.

The second explanation that Sparshott offers for sluggish wage growth comes from the distribution of jobs that were created since the recession.  He analyzes the mix further:

Lower-paying positions in the retail, temporary-help and leisure and hospitality sectors have seen some of the strongest job growth, while better paying construction and manufacturing sectors have been slower to make gains.

One of the worst hit areas of the economy during the downturn was housing, which lead to a large contraction of the labor demand in the overall construction market.  As Sparshott points out, this labor market continues to show only slow gains, and the simple shifting proportions of high to low paying jobs has caused the average as a whole to remain immobile.

The Solutions

Both of the issues that Sparshott raises have simple solutions.  To the first issue, the solution is one word: time.  As long as hiring continues to be strong, this "shadow" labor supply will eventually fully acclimated back into the labor force, cutting off employers relatively cheap source of labor.  The passage of time will allow the supply and demand to clear within the labor market and return to wage pressures that are considered "normal" within the context of near natural rate unemployment.

The second issue also be solved by time, but with the additional requirement of economic growth and stability.  In my opinion, one of the main reasons why the construction and manufacturing sectors have yet to show strong rebounds in hiring is due to the relatively slow and shaky economic recovery that the United States has experienced.  While we have reached five and a half years since the end of the recession, there has remained a constant threat that a shock could push the economy back into a contractionary mode.  Now, however, the economy seems to have re-gained its foothold.  With consumer confidence at recent highs, continued strong hiring numbers, and solid recent GDP reports, it suggests that the US Economy can withstand external shocks going forward.  As this strength continues, employers within the construction and manufacturing sector should have the confidence to make the investments and commitments necessary to ramp up business, and most importantly, hiring.