What If the Fed's Economic Recovery Plan Is Just Plain Wrong?

One worry is that a combined heat-up in the economy will combine with inflation to force the Federal Reserve to raise rates before it would like.

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Yellen
Charles Dharapak/APFederal Reserve Chairman Janet Yellen
By Jeff Cox

At the core of the Federal Reserve's credibility is its insistence that it can hold interest rates low enough for long enough to ensure a complete economic recovery. The reality may prove quite a bit different, particularly if current trends hold up.

Those low yields are critical for both the public and private sector -- financing upwards of a trillion dollars a year in corporate borrowing as well as helping to contain financing costs for the government's $17.5 trillion debt. But after nearly five months of a decline in yields that caught market participants almost completely off guard, talk is increasing that inflationary pressures are building and that yields may begin to rise in a way that could put the Fed behind the curve of market forces.

That could help undermine the position of a central bank that badly needs the market's confidence if it is to have any chance to unwind a nearly $4.4 trillion balance sheet and a historically lengthy time period of basement-level interest rates.

"It's not that I don't have faith in the Fed or think these are not some of the smartest economists out there. This is unprecedented territory," said Lindsey M. Piegza, chief economist at Sterne Agee. "It's going to be very difficult to understand those unintended consequences on the back end of these policies. ... That confusion of how to unwind these unprecedented policies says to me there's going to be a lot of volatility, a lot of missteps."

Others in the market share the sentiment that while the Fed may not be driving blind, it doesn't have a particularly clear road map, either. One worry is that a combined heat-up in the economy will combine with inflation to force the Fed to raise rates before it would like.

An Earlier Increase in the Neutral Rate?

Goldman Sachs in particular released a paper Thursday suggesting that the "neutral" rate often discussed by Fed officials -- or the Fed funds rate that would be appropriate to ensure normal economic growth -- is wrong. Central bank governors expect this rate to remain low for some time, reasoning that the economy continues to heal slowly from the financial crisis of 2008 and 2009.
Goldman economists, though, contend that the Fed is actually too pessimistic about growth prospects.

"Our results suggest that the neutral rate might well normalize relatively quickly as the headwinds fade and the economic recovery begins to firm," Sven Jari Stehn wrote in a report for clients. "The latter would appear at odds with the [Federal Open Market Committee's] view that the neutral funds rate will remain depressed for years to come despite a healthy economic recovery."

The view is an interesting one in that the Fed for years has badly miscalculated economic growth -- but on the optimistic side. It projected as recently as 2011, for instance, that gross domestic product growth in 2013 would be in the 3.7 percent o 4.6 percent range, when the actual print was 1.9 percent. Similar trends have continued throughout the recovery from the recession that ended in 2009. The Fed's most recent projections are for GDP to grow in the 3 percent range for the next few years, yet it sees a need to keep its funds rate around zero.

A Panic About Inflation?

Despite the Fed's hopes of continued low rates, the reality could see market structure get away from the Fed's actions. Jim Paulsen, chief market strategist at Wells Capital Management, said he envisions the 10-year Treasury yield in the 3.5 percent range or higher before year's end, which would be a full percentage point and maybe then some above current levels.

"I'm already seeing some evidence where good news could become bad news," Paulsen said in a CNBC interview. "If wage inflation goes up just a little bit, all of the sudden we could have a little panic about inflation. That could feed into bond yields."

Indeed, there's plenty to watch on the inflation front. The April consumer price index rise to 2 percent gets it closer to the Fed's target of 2.5 percent, while there also have been noticeable spikes in producer prices, rents and auto prices.

"Some of the survey evidence has indicated that price rises are becoming more prevalent." Capital Economics said in a note to clients, referring to studies by the National Federation of Independent Business and others. "The increase in the selling prices balance of the NFIB small firms survey, for example, suggests that core (personal consumption expenditure) inflation will climb to 2 percent within six months. That would be a quicker rebound than either the Fed or the markets are expecting."

Market participants are getting nervous about where that would leave the Fed, evidenced by some of the churns this week. "We have to be ready for some bumps and volatility," said Piegza. "The Fed's going to do the best job it can, but it's unlikely that it's going to be the perfect, smooth transition."

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moonmur1

The Fed doesn't care about inflation. Inflation helps those who are in debt and hurts those who have cash. Who does the Democrat party represent?

May 27 2014 at 5:54 PM Report abuse rate up rate down Reply
syhersch

Look at the Japanese experience with low rates for the last 30 years.....why does anyone doubt that we can't have the same scenario? Low rates drive the stock market to higher and higher levels WITHOUT any demonstative higher corporate performance. The real problem is not higher or lower rates. It is the inequality of application of those rates. Large corporations get fabulous bond rates, the governmental entities continue to carelessly and corruptly operate on those low rates and now someone thinks higher rates are going to be helpful?.....REALLY?

May 27 2014 at 4:45 PM Report abuse rate up rate down Reply
telepole

OK, all you yahoos. You know what didn't happen? No wall street crook has fone to jail for the credit swap debacle, and the collapse of our economy. These are now the ame people running things today. Remeber, this happened under Bush. The feds rates are almost non existant. Yet the banks are charging 15, 16 up to 24 % on credit cards.
The crooks still are in charge. Yo common sense, I guess you must be a banker. Democrats huh. Most the BIg Bankers are Republican crooks.

May 27 2014 at 9:51 AM Report abuse rate up rate down Reply
COMMON SENSE

Here is what happened on January 1st 2014:

Top Income tax bracket went from 35% to 39.6 %
Top Income payroll tax went from 37.4% to 52.2 %
Capital Gains tax went from 15% to 28 %
Dividends tax went from 15% to 39.6 %
Estate tax went from 0% to 55 %
Remember this fact: if you have any money, the democrats want it. These taxes were all passed only with democrat votes, no republicans voted for these taxes.

May 27 2014 at 8:25 AM Report abuse rate up rate down Reply
1 reply to COMMON SENSE's comment
clark8642

Any idea where federal income tax rates were on January 1, 2013 when the temporary tax cuts had expired?

May 27 2014 at 12:45 PM Report abuse rate up rate down Reply
COMMON SENSE

Just remember that your government is trying to impose a whopping carbon tax on you, on the basis of the bogus 'human-caused' climate-change scenario.
Isn’t it interesting how they don’t mention 'Global Warming' anymore, but just 'Climate Change' - you know why? It’s because the planet has COOLED by 0.7 degrees in the past few years and these global warming bull artists got caught lieing again..
And, just keep in mind that you might yet have an Emissions Trading Scheme - that whopping new tax - imposed on you that will achieve absolutely nothing except make you poorer. It won’t stop any volcanoes from erupting, that’s for sure.

May 27 2014 at 8:24 AM Report abuse rate up rate down Reply
1 reply to COMMON SENSE's comment
clark8642

A carbon tax may or may not be a good idea. Do you have a better idea for lowering the amount of carbon dioxide in the atmosphere which registered over 400 ppm last month?

May 27 2014 at 12:49 PM Report abuse rate up rate down Reply
jim.lapt

I love Obama, he's my Idol.

May 26 2014 at 7:29 PM Report abuse rate up rate down Reply
jim.lapt

Okay all you cons, I have to go get sleep because I have to fly my RC plane

May 26 2014 at 7:28 PM Report abuse rate up rate down Reply
1 reply to jim.lapt's comment
clark8642

Do you really think anyone believes you are liberal or even a typical conservative?

May 26 2014 at 7:30 PM Report abuse rate up rate down Reply
jim.lapt

You Republican Scum!

May 26 2014 at 7:22 PM Report abuse rate up rate down Reply
jim.lapt

Lick on my nuttsack all you conservatives.

May 26 2014 at 7:21 PM Report abuse -1 rate up rate down Reply
jim.lapt

I'M Gay and my savior Obama approves gay marriage.

May 26 2014 at 7:16 PM Report abuse -1 rate up rate down Reply