Without intending to — and perhaps without even realizing it — the normally cautious Fed head Ben Bernanke may have launched a major tightening policy during his news conference on Wednesday. The de facto policy shift immediately sparked a rout on Wall Street, with stock, bond, and gold prices all plunging. And it’s going to shake up confidence even more, perhaps even slowing the already anemic recovery.
Mr. Bernanke has stumbled into a major policy mistake.
While Wall Street was debating about exactly when the Fed would slow its quantitative-easing bond-buying program, Bernanke set out a plan to completely end the new cash-generating QE in roughly one year or less. Wall Streeters were speculating about a September or fourth-quarter tapering of bond purchases. Then the Fed chair indicated that QE will start winding down later this year, and that it will end when the unemployment rate gets to about 7 percent sometime next spring. And since the chairman also offered a relatively upbeat economic outlook, investors began discounting an even faster end to the Fed bond-buying operation.
The idea of a 7 percent unemployment target to end QE next spring is new information, and it has completely spooked all the financial markets.
After dropping around 200 points the day of the news conference, the Dow plunged 350 points the day after. What a rout. Gold dropped nearly $100, and the 10-year Treasury note jumped to over 2.40 percent. That marks a near 70-basis-point year-to-date increase for the 10-year. But the rate rise has happened fast. It really began in early May, and it picked up steam after Bernanke’s congressional testimony two weeks later. Then, of course, it jumped after Wednesday’s news conference.
I’ve never been a big fan of the Fed’s balance-sheet-ballooning operations. But I have acknowledged in several columns and on the air that I was completely wrong two years ago when I said the Fed’s money-creating program would lead to higher inflation. (See “Another Round Goes to Bernanke.”) In fact, the Fed’s favorite inflation indicator — the personal consumption deflator — is rising only 1 percent year on year. On top of that, bond-market indicators of future inflation are falling. Plus, the gold crash.
You can almost make a case that the Fed is too tight, not loose. Deflation is in the air.
While the Fed’s balance sheet was exploding, bank reserves were not circulating through the economy. So the M2 money supply has been growing around 7 percent, in line with its long-term trend. Meanwhile, the lack of cash circulation has pulled velocity down by about 3 percent. So nominal GDP is growing around 4 percent, which is at least 1 to 2 percent too low in total spending for a real recession recovery.
Real GDP is only growing around 2 percent. Manufacturing over the past three months has declined 2 percent at an annual rate. Core capital-goods investment by businesses — a surefire job creator — has been rising at an anemic 2 percent pace. And while jobs are climbing, the monthly average for the past three months is only 155,000, compared with over 200,000 for the prior three months.
The best part of the story is housing. Existing home sales in May ran 13 percent ahead of the year-ago period, with single-family median home prices rising at 16 percent. And new housing starts have been rising about 7 percent year on year, although the pace has slowed over the past 3 months. Long-term mortgage rates are going to go up now, but probably not much higher than 4 percent. It’s still a cheap rate for a home.
But a mountain of tax and regulatory barriers to job creation is looming over the economy. As Harvard economic historian Niall Ferguson has written, the federal register for regulations has exploded to 78,961 pages, with a price tag of $1.8 trillion. That’s a surtax on the whole economy. And Obamacare is a job-stopper.
Monetary policy cannot solve our fiscal problems. But it can provide a cushion. On the other hand, lower money-supply growth and rising interest rates will not help anything.
Bernanke jumped the gun this week, and markets are in revolt. They’re trying desperately to tell the Fed chair to go slow, not fast — perhaps even to wait for pro-growth tax reform and additional budget restraint out of Washington. As clumsy as the QE process may be, it still looks like the economy requires more money creation. Big Ben made a mistake. The training wheels need to come off slowly.
– Larry Kudlow, NRO’s economics editor, is host of CNBC’s The Kudlow Report and author of the daily web log, Kudlow’s Money Politic$.