Tuesday, December 14, 2010
Today's FOMC statement was unsurprising, and the decision to leave policy unchanged was as expected. The statement reiterated the view that the economy was growing at a disappointing rate, and that "measures of underlying inflation have continued to trend downward."
But the most important part of the statement was what wasn't said. Nowhere was there any mention of the fact that 10-yr Treasury yields have jumped over 100 bps in the past two months (see above chart), while 80% of that rise is due to an increase in the real yield on 10-yr TIPS—a sign that the rise in yields is mostly due to an increase in real growth expectations. Plus, there was not a single reference to the stock market, which is now up almost 12% year to date, and up almost 20% since the Fed first floated the idea of QE2 (see chart below of the S&P 500). The rise in bond yields and the rise in equity prices are classic indicators of a big increase in the market's expectation for future growth. Why couldn't the Fed at least acknowledge this?
Another glaring omission was the failure to mention the fact that the dollar is very weak from an historical and inflation-adjusted perspective (see chart below). The dollar's historical weakness is reflected, not surprisingly, in gold prices which are now at historical highs. A very weak dollar is almost proof-positive that there is an over-supply of dollars in the world. And we still need more quantitative easing?
If the Fed persists in ignoring the market's signals, they will end up making another mistake. It's very unfortunate, since past mistakes (e.g., tightening too much in the late 1990s, then easing too much in the early 2000s) have given us a roller-coaster stock market, huge gyrations in interest rates, and a massive housing boom and bust. Monetary mistakes coupled with fiscal policy mistakes (e.g., last year's $1 trillion of "stimulus" that turned out not to be stimulative at all) have been the bane of the U.S. economy for over a decade now, and it's high time our policymakers learned how to pay attention to the market and how to understand what makes the economy tick.
I'm amazed that the FOMC has managed to ignore the market-based indicators for so long. But I find it hard to believe that this state of affairs can continue for much longer. The bond market vigilantes have only just begun to raise the alarm, and sooner or later the Fed will be forced to take note. The Tea Partiers have already beat our politicians over the head, and that's begun to bring positive change to Washington. Despite the miserable state of affairs, there is still room for optimism.
Posted by Scott Grannis at 1:46 PM