The economic stats continue to reflect an economy that is doing OK, though of course we'd like to see it stronger. But regardless of how strong the economy is or isn't, it's hard to see why the Fed needs to continue its extraordinary QE measures if almost all measures of economic activity are positive. I've argued for years that the real purpose of QE is not to stimulate the economy (monetary policy is a poor tool for manipulating growth) but to satisfy the world's demand for short-term, safe assets (e.g., bank reserves, which are effectively substitutes for T-bills). Is the demand for safe assets still so strong—because confidence is still so weak and risk aversion is still so prevalent—that the Fed must continue to buy bonds in exchange for bank reserves? That is the key question, but I worry that the Fed is not thinking in these terms. Instead, they are thinking about the need to stimulate the economy and avoid the risk of deflation. If they persist in misdiagnosing the economy's problem, we all risk the unintended consequences of a too-easy-for-too-long Fed, which would be higher inflation.
The now Yellen-led Fed continues to worry about the health of the economy and continues to believe that more QE is necessary to avoid a slowdown and to avoid deflation risk. I don't see any signs of a serious slowdown in growth, and although reported inflation is relatively low, portents of deflation are very hard to find. The last time the U.S. economy flirted with deflation was in the early 2000s.
Leading up to that period, the dollar rose significantly, gold and commodity prices declined significantly, and monetary policy was very tight (real interest rates were unusually high and the yield curve was flat or inverted). Today, those same conditions are the exact opposite.
The dollar is relatively weak (see above chart),
commodity prices are relatively strong,
real interest rates are negative, and the yield curve is positively sloped.
As for the economy, the ISM manufacturing index for October was stronger than expected (56.4 vs. 55) and is at a level that suggests that economic growth is picking up speed in the current quarter.
The export orders component of the ISM index increased, and at this level it confirms that global activity has improved, beginning earlier this year in Europe and now, apparently spreading to Asia.
The employment subindex remains at a modest level, confirming what we already know: businesses lack the confidence and/or the willingness to significantly expand hiring.
The Eurozone economy has improved, but it is not exactly off to the races. The PMI index of Eurozone manufacturing activity suggests that growth is still quite modest. But it is significant that the Eurozone economy is no longer plagued by recession.
Even modest growth has been enough to boost Eurozone equities. The Euro Stoxx index is up almost 22% since June, almost double the 12% gain in the S&P 500 over the same period. The Eurozone was mired in a recession for two years, and now it's growing modestly. It's not that the Eurozone economy is suddenly very strong, it's that things are better than they were expected to be. Weak growth is much better than negative growth.
Lots of things are doing OK. In the past year, housing has improved dramatically; auto sales have experienced a huge recovery; retail sales in general continue to rise; companies keep creating new jobs; incomes continue to rise; the equity market is hitting new all-time highs; money and liquidity have become abundant; and borrowing costs (real interest rates) are low.
There are really only two things the Fed can point to in order to supposedly justify continued QE: the labor market—where unemployment remains relatively high and the labor force participation rate is dismal—and capital spending, which shows business investment is still meager despite record profits. (Come to think of it, slack business investment and slow hiring go hand in hand.) But it's difficult to see how more QE bond purchases are going to change people's minds about hiring and/or deciding whether to work or not. The Fed has been buying bonds by the bushel for over four years and it hasn't seemed to make much of a difference. One suspects that QE may have hurt more than helped. "QE forever" makes it seem that the Fed is worried, and that doesn't bolster confidence. Meanwhile, the increasing uncertainty surrounding the eventual unwinding of so much QE saps confidence.
Although confidence in the economy seems to be lacking these days, the bond market is not worried at all about deflation. Inflation expectations—according to the Fed's preferred indicator, the 5-yr, 5-yr forward expected inflation rate embedded in TIPS and Treasury prices—have been averaging about 2.5% for the past several years and are 2.6% at the time of this writing. If anything, that tells us that the bond market expects inflation to rise from its current level (the CPI is up 1.2% in the past year). That seems reasonable to me, and it's not unreasonable to worry that inflation might be even higher.
What we are learning with the Obamacare nightmare is that government is not very smart when it comes to big, complex things. Bureaucrats, and especially politicians, invariably ignore the unintended consequences of their policy actions. With the Fed seemingly intent on vanquishing the presumed onset of "dangerous deflation" (to quote a media pundit I read somewhere), it wouldn't be surprising to find, a few years from now, that the real threat is just the opposite: rising inflation.
This is not meant as a clarion call for selling the dollar and buying gold, since I think the market has already done that in spades. The dollar is weak and gold is still very strong because the market has worried for years that things would work out badly. Gold is down over the past two years because the market's worst fears have not come to pass. Gold is arguably still priced to a significant rise in inflation that has yet to occur.