Is The Fed Out of Options?

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The Fed's Conundrum

The market outlook remains fragile. High valuations, a choppy economic outlook, record profit margins, and little if any foreseeable earnings growth all combine to suggest that the market is likely to recalibrate lower if a significant black swan should appear.

There are many structural problems around the world yet central banks are left with fewer tools to deal with them. Could a longer, slower-growing U.S. economy push country "x" off the rails? These higher global risks would perhaps result in lower P/E's despite the positive of lower inflation and record-low interest rates as a result of that risk off environment.

It is not surprising, therefore, that the TINA (There Is No Alternative) principle remains in effect—equity valuations vis-à-vis U.S. Treasury yields remain the primary (only, in my opinion) prop to valuations.

I believe all would agree that action was needed during the Financial Crisis. What causes concern is the central bank's actions eight years after the crisis.

The Fed faces several critical questions: Is this framework, as well as the models it uses, useful in our current situation? Has something fundamentally changed that calls for new protocols? Should the inflation target be lifted significantly higher than 2%? Should we change from an inflation target to a targeted nominal GDP growth objective?

Perhaps we are simply stuck until the answers reveal themselves. All of this stems from an acceptance of the neutral Fed Funds rate—a level that neither stimulates nor slows the economy—that has been, and is likely to remain, very low.

Thus, the Fed cannot really raise interest rates by any significant degree for quite some time. This will keep the yield curve flattish and inflation expectations low.

The Fed wants, and perhaps needs, a higher neutral rate because it would allow the central bank to raise rates higher, thus providing more ammunition to fight the next recession. It also means that the Fed's balance sheet does not shrink until the neutral rate rises.

The animal spirits are missing, amid too much uncertainty to take chances, it seems. This lack of risk taking also makes traditional monetary policy less impactful. In fact, some have coined the phrase "stagnation light" as an apt description of the current economic situation in the U.S.

The current situation deepens the conundrum for the Fed in that the risks are asymmetrical. If the Fed tightens too early, it's likely to prove a significant policy error, while tightening too late may not be nearly as consequential. The Fed has many tools with which it can tighten; however, at this point it has too few to ease at its disposal.

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