In the Fed’s Bizzaro World, Whose Economy is Yellen Looking At?

In her testimony before Congress on Wednesday, May 7, Fed Chairwoman Janet Yellen made three points that deserve further scrutiny:

1. There is continued slack in the labor market;
2. There is worrisome weakness in housing;
3. Investors are “reaching for yield,” especially in the High Yield markets.

As a result of the first two points, a continued ultra easy monetary policy is a slam dunk for the foreseeable future.  As far as the third point is concerned, one has to wonder if the Fed chief thinks that the “reaching for yield” is caused by something other than the ZIRP (zero interest rate policy) of the Fed’s past five years.

Labor Market Slack

The Chairwoman is clearly concerned with the falling labor force participation rate.  It is apparent that she believes that the majority of the fall in the participation rate is cyclical and can be reversed by monetary policy.  In a recent missive to subscribers (May 6), David Rosenberg (Gluskin-Sheff) analyzed demographic trends and concluded that “about two-thirds of the decline in the overall participation rate is less due to cyclical factors like discouragement and more the result of well-dictated structural factors – accordingly, the declines in the unemployment rate that we have seen are largely the result of underlying improvements in labour market conditions.”  Monetary policy can’t combat structural issues that result from demographic factors.  In addition, there are over 4 million jobs in the U.S. that continue to go unfilled because of skill mismatches.  Monetary policy can hardly reverse that.

Housing

There are 3 reasons that housing trends have flattened out:

1. Average home prices are up 13% in a year, and up much more over the past 2 or 3 years.  This makes homes less affordable;
2. Interest rates have risen more than 100 basis points over the past year; this makes homes less affordable;
3. The so-called housing recovery was fueled by investor demand, as first-time home buyers have continued to be less than 30% of the market.  Now that prices have risen significantly and mortgage rates are up, that demand has dried up.

New housing accounts for less than 5% of GDP.  So, it seems overkill to use the blunt instruments of monetary policy, which impact 100% of the economy, to impact this 5%.  The original objective of the ultra easy monetary policies of the past 5 years and of all of the QE programs of the Fed was to raise the prices of assets (like housing and equities) to impart a wealth-effect to consumers.  Well – mission accomplished – all those prices are up.  Consumers are more comfortable; the economy is strengthening.  So, what possibly could be the objective now?

Reaching for Yield

The “reaching for yield” in the High Yield market remark by Chair Yellen is the first recognition of the bubble that has formed there.  What she seems to ignore is the fact that this very bubble has been caused by 5 years of the Fed’s policy of ZIRP, and that this very bubble is encouraged by her own statements that ZIRP will continue for a “considerable period” after the end of QE3.  I take little comfort from the fact that she sees this bubble, because she acts like the Fed had nothing to do with it and she doesn’t seem predisposed to change policy to deflate it.  As with all bubbles, this one, too, will burst, whether it be from a future Fed policy change, or the simple recognition that the returns generated are not worth the risks being taken.

Robert Barone, Ph.D.