Financial markets have become increasingly dependent on the Federal Reserve. The Fed is dependent on data (just in case you didn’t know). The data for the next few months will be distorted by the federal government shutdown during the first half of October. So what’s a responsible policy maker or investor to do to get a handle on how the U.S. economy is faring?
Step back, look forward, lean in only if you must. Now is the time to focus on the big picture, not the individual working parts of the economy as reflected in the monthly data releases.
A good place to start -- always, not just during a hiccup in the real-time data -- is with leading economic indicators, the most forward-looking of which involve market prices. Things like the interest-rate spread between the federal funds rate and 10-year Treasury yield, for example, and stock prices, which set a new high this week.
“The forward indicators suggest we should be picking up steam,” says Michael Darda, chief economist at MKM Partners in Stamford, Connecticut.
Yes, they do. The problem is, they have been suggesting that for a long time. Yet solid, sustained economic growth remains elusive, forever consigned to the next quarter.
Does that mean normally prescient leading indicators have lost their edge? No. It just means that monetary and financial conditions have to remain accommodative for longer to achieve any given result.
Economists Carmen Reinhart and Ken Rogoff documented the differences between recoveries from financial crises and ones that adhere to the more typical, post-World War II business-cycle pattern: The Fed tightens to tame inflation, the economy goes into recession, the Fed eases to stimulate demand, the economy recovers, and the cycle begins anew.
The severity of the 2007-2009 financial crisis, recession and subsequent deleveraging changed the relationship between market-price indicators and the expected economic effect. Take the yield curve, for example, which happens to be my favorite leading indicator. (It also happens to be the one with the longest lead time.) A spread of 75 basis points between the overnight rate and long rate is considered to be neutral, all things equal. In simplest terms, a 75-basis-point spread would exert neither an expansionary or a contractionary effect on the economy. The current 225-basis-point spread is wide by historical comparisons, although it’s well shy of extremes witnessed in previous cycles.
The closest parallel for the wider-for-longer theory is the anemic recovery after the savings-and-loan crisis in the early 1990s. The spread topped out at close to 400 basis points in 1992 before banks resumed the business of creating credit.
This is another reason the central bank’s effort to flatten the yield curve has never made any sense. The spread acts as an incentive to lending institutions. For some reason, most economists look at the long-term rate in isolation, not in relationship to the artificially pegged short rate.
OK, I know what you’re thinking. The Fed has distorted market prices so much with three rounds of quantitative easing and one stab at curve-twisting (selling short-term securities and buying longer-term notes and bonds) as to dilute the value of the signal.
I’ve thought about this issue a lot, and each time I come to the same conclusion I did when the yield curve inverted in 2006 amid protests that “this time is different” because of a global savings glut. (Asian central banks were using the dollars they received from selling their own currencies to buy U.S. Treasuries.) Because I tend to repeat myself anyway, I might as well do it accurately. Here’s what I wrote on Oct. 4, 2006: “Many analysts dismiss the yield curve signal -- it’s different this time -- because they claim the why of the inversion is more important than the what.”
It wasn’t different. The what mattered then, and the what matters now. The essence of the yield curve is so simple that most Ph.D’s don’t understand it. Its power comes from the incentive it creates for banks to expand credit: The steeper the curve, the greater the incentive to borrow short, lend long.
Financial crises put lending institutions temporarily on the disabled list. Bank credit, which finally started to expand in mid-2011, peaked in May of this year, drifted lower for four months and started to revive again this month. That’s a good sign if it continues.
“The yield curve is steep, credit spreads have narrowed: It’s a powerful dual signal that is unlikely to be sustained without a pickup in economic activity,” Darda says.
The only questions are how long it will take for growth to accelerate, what the unintended consequences of stimulative monetary policy are, and whether the Fed will be able to unwind its asset purchases without destabilizing markets.
These are the questions that matter. The answers aren’t likely to be contained in the monthly employment report.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist.)
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