Is the Fed Painting Itself -- and the Market -- Into a Corner?

The economy is improving faster than the Fed is adjusting its outlook for rates

Jul 4, 2014 at 9:23AM
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Happy 4th of July! The stock market is closed today, but it managed to celebrate early, with the benchmark S&P 500 and the narrower Dow Jones Industrial Average (DJINDICES:^DJI) settling at record highs at the end of yesterday's abbreviated session on a gains of 0.5%. The Dow also managed to break pass millenary milestone, closing above 17,000 for the first (note that there is no particular economic significance to that threshold). Conversely, the CBOE Volatility Index (VOLATILITYINDICES:^VIX), known as the VIX, fell 4.6% to close at 10.32 -- the index's lowest closing value since Feb. 2007, and roughly half its historical average going of 20.06. The VIX is derived from the price of short-dated options on the S&P 500 and reflect investor expectations for stock market volatility over the next 30 days.

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Those phenomena were (at least partially) the product of a June employment report, which was quite a bit stronger than expected, as the following table illustrates:

 

Actual/ Consensus estimate

Consensus range

Increase in nonfarm payrolls

288,000/ 211,000

199,000 to 290,000

Unemployment rate

6.1%/ 6.3%

6.2% to 6.3%

 Source: Bloomberg

On Tuesday, Federal Reserve chairwoman Janet Yellen delivered a spirited defense of the Fed's ultraloose monetary policy in the face of signs of excess in assets markets, stating: "I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns."

I don't disagree with that statement -- after all, price stability and maximum employment are the Fed's twin mandate. The thing is, we're essentially there, yet Fed policymakers show no inclination to adjust their expectations for the path of interest rate rises.

The recovery elephant in the room
As St. Louis president James Bullard told the Fox Business Network last Thursday [my emphasis]:

The Fed is closer to its goals than many people appreciate. ... I think people still are thinking, "It's 2010, we're miles from where we need to be" -- that really isn't the picture. We're really pretty close to normal, I think especially if unemployment goes below 6% later this year and inflation continues to move up, and maybe it's at 2% later this year later this year, and you're basically going to be right at target on both dimensions possibly later this year. That's shocking and I don't think markets -- and I'm not sure policymakers -- have really digested that's where we are.

The bond market appeared to be paying attention to yesterday's employment data, as Robin Harding noted in the Financial Times, "The yield on two-year notes, which are highly sensitive to monetary policy expectations, rose toward 0.53 per cent, just shy of last September's peak." But the stock market wants to have its cake and eat it, too: Mediocre economic data, we'll benefit from low rates until the end of days; strong economic data and earnings growth will take the relay from rates in supporting stretched stock market valuations. It seems to me that something will have to give once expectations fall into line with economic reality. Enjoy the record low volatility while it lasts.

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Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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