Fed's Dilemma: Transparency or Mystery

 | Jun 21, 2013 | 3:00 PM EDT  | Comments
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One way the Fed has done in getting the economy to grow is through the "wealth effect." That is engineering higher prices on not just government bonds along with riskier assets, but on home prices as well. The proceeds of investors selling their bonds to the Fed meant more cash pushing up share prices, while lower mortgage rates bolstered home price gains.

When households feel wealthier, they might consume more, even if their incomes aren't growing. Even if workers don't own an extensive stock portfolio, they may own mutual funds in their 401(k). If the market is going up, they may reduce their 401(k) contributions out of their paycheck and spend the money instead.

This is particularly important because wages and salaries are not growing by much after inflation. Earlier this week, the Bureau of Labor Statistics published its real earnings report, which is the hourly and weekly pay data provided in the non-farm payrolls report, adjusting it for inflation per the Consumer Price Index.

What we see is that real average hourly earnings for all employees fell 0.2% in May, seasonally adjusted. This decrease stems from an unchanged average hourly earnings combined with an increase of 0.1% (with some rounding) in the CPI.

The decrease in real average hourly earnings, coupled with an unchanged average workweek, led to real average weekly earnings that fell 0.1% over the month.

Over the past year, real average hourly earnings rose 0.5%, seasonally adjusted, from May 2012 to May 2013. The increase in real average hourly earnings, combined with a 0.3% increase in the average workweek, resulted in a rather small 0.9% increase in real average weekly earnings over this period.

If consumers based their consumption patterns on just what they earned on the job, it would be hard for the economy to grow. That would be the case unless consumers focused on their net worth instead and lowered their savings rate to increase consumption.

A falling savings rate is what has happened during the recovery. Real wages haven't been growing by much for some time now; households have increased their spending only by saving less. The savings rate has fallen to a low 2.5% from 5.8% three years ago in June 2010. Since then, the stock market has soared and housing prices have surged. That explains why consumer spending gains have been able to be stronger than income growth has been.

The savings rate might not continue to fall, supporting higher spending, if asset prices aren't rising. The eventual end of the Fed's bond purchase programs meant a big selloff in both the stock market and the bond market, which leads to rising interest rates for mortgages as well as other loans.

Higher mortgage rates would mean higher monthly payments, which would make a house that much more expensive in terms of monthly outlays. That could hurt further home price appreciation. While price increases in some markets have been perhaps too strong, the particularly rapid pace of home price gains has been a notable contribution to stronger consumer confidence, and thus spending. People refinancing to cheaper mortgages at lower interest rates also freed up monthly cash flow to spend instead, and this avenue may now be constrained.

If the stock market drops further, or home prices fail to continue to post sizable increases, then consumer spending growth may be limited to puny income gains. And if the savings rate reverts back to levels seen a few years ago, spending could even fall. Bear in mind that the current savings rate of 2.5% compares to a savings rate that had been in the 8% to 10% range in decades past.

By simply announcing economic conditions are improving and that there is less of a need for bond purchases going forward, the Fed may paradoxically have engineered a weaker economic growth scenario. That could mean that the Fed may need to continue its bond purchases for a longer duration or by a larger amount than if it had not announced that the program would be curtailed.

While investors may have appreciated the transparency of the Fed's forecasts, the economy might have been better off with a bit more mystery. Stay tuned!

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