Federal Reserve Board should focus on higher GDP growth to reduce income inequality and poverty

Posted by Shyam Moondra

During the administration of President Barack Obama, we have had a slow-growth economy and lower inflation. However, Obama left a record 40 million Americans under poverty level (defined as income of $30,750 for a family of four) in spite of his significant increase in welfare spending to the tune of $1 trillion (Obama was the first president to spend more on welfare than on defense). The current administration of President Donald J. Trump pushed for higher sustained economic growth via lower taxes, reduced regulations, and more favorable trade deals with global trading partners. In a short period of one-and-half years, the unemployment rate has gone down to 3.7%, the lowest in the last 49 years, and unemployment among African-Americans and Hispanic population has gone down to the lowest level ever. So the key to reducing income inequality and poverty is sustained 3-4% GDP growth and not limiting inflation to an arbitrary 2.5% as currently targeted by the Federal Reserve Board (FRB).

The FRB expeditiously wants to increase the funds rate to a "normalized" level which is somewhat arbitrary because what was "normal" yesterday may not be "normal" today, depending on a multitude of issues related to global trade, regulations, and tax policies. In anticipation of higher inflation caused by growing economy, the FRB has been increasing interest rates that are negating the positive results achieved by Trump’s fiscal and trade policies. Higher interest rates are already slowing down housing and auto industries that are the backbone of the U.S. economy. Also, higher interest rates are making dollar stronger relative to other major currencies, which is exacerbating the trade deficit problem and making it harder for Trump to achieve his goal of cutting trade deficit by half. Therefore, the FRB’s monetary policy designed to keep inflation under control is acting against Trump’s policy of high sustained growth designed to reduce income inequality and poverty in America. If Trump’s policies reinvigorate the manufacturing sector in the U.S. (new 700,000 high-paying manufacturing jobs have already been added since Trump was inaugurated), the average wage level will go up. Therefore, the FRB shouldn’t be exclusively concerned with inflation, so long as wages are increasing at a faster rate. If the FRB is overly aggressive with their interest rate increases, the corporate world would reduce capital investments in anticipation of economic slowdown which would hurt the economy in the long-term. Higher economic growth and capital expansion must go hand-in-hand to achieve higher employment levels while keeping inflation under control. In recent years, Germany has had near zero interest rates for many years and yet it became the most prosperous country in Europe.

Rather than be solely focused on anticipatory inflation and using the outdated Phillips Curve (inflation vs unemployment) as its guiding principle, the FRB needs to find a way to maintain high growth while at the same time keeping inflation in check by aligning monetary policies with fiscal policies to create an environment where businesses feel confident about making new capital investments. The FRB has been creating these artificially manufactured boom-and-bust cycles by adjusting interest rates lower or higher, but these cycles make it impossible to make a dent on poverty which can be reduced only by sustained high economic growth.

To get the optimum results for the country, we need the FRB to come up with a new model which has the funds rate fixed at a nominal rate, say between 1 and 2% (and it should be changed only in emergency situations), while using other tools at its disposal to focus on growing economy at 3-4% a year.  We need a collective monetary and fiscal policy approach to achieve the best possible results for the American people in terms of higher growth, higher wages, lower unemployment, lower trade imbalances, and increased wealth creation. If we can maintain the current GDP growth with low inflation while freezing funds rate at the current level, we should see a significant reduction in income inequality and poverty in the coming years.

Stock market on track to hit 18,000 by early 2014

Posted by Shyam Moondra

In 2011, I predicted that DJIA was headed to 18,000 (“We are in a secular bull market - DJIA headed to 18,000,” The Moondra Post, March 14, 2011) and it looks like we are on track to achieve that record high by early 2014. Given that the current bull market is now more than five years old, many prominent analysts are predicting that a market crash of 10-20% is imminent. However, I believe that the bull run is not yet over.

The following trends favor a continuing up move in the stock market at least through March, 2014:

• The stock valuation is high but the market is definitely not overpriced. The forward PE of 15 for the DJIA, as currently estimated by WSJ, is by no means excessive compared to the high 20’s at the recent market peaks of 2000 and 2007. The market would look pricey if PE were to get close to high-teens, given that we are currently in a low-growth environment compared to the go-go years of the early 2000’s.

• Corporate profits continue to be at record levels, thanks to a superb job done by the corporate world in managing their cost-structure through the great recession in the aftermath of the financial crisis of 2008. Given that economy is currently strengthening (3Q13 GDP growth rate revised upward to 3.6%), further gains in corporate profits are predicted for 2014. Accordingly, there is room for continuing expansion of the PE multiples of the stocks.

• The unemployment rate has steadily come down to 7% from double-digit numbers at the height of recession, which means consumer spending would continue to increase in the foreseeable future. Also, increases in the stock prices and recovery in real estate prices have pushed the household wealth to record levels which would also guarantee increased consumer spending. Since consumer spending accounts for 70% of the economy, the economic activity would continue to be in high gear which would lead to further reduction in the unemployment rate, creating a sustainable upward spiral in GDP.

• Interest rates and inflation continue to be at low levels that always favor the stock market. In the near- to mid-term, we might see a spike in interest rates from the current 2.8% to 3.5% (on 10-year treasuries), but historically we would still be at relatively low levels. Since the corporations have a record cash hoard of the tune of $4 trillion, they may not have a huge need to borrow to support their capital expansion plans and thus the impact of higher interest rates on the economy could be somewhat muted.

• Currently, there is too much cash lying around in money market accounts and the stock market lacks euphoria which is typically seen at the market peaks (that's when stock prices go up sharply with heavy volume). That means the stocks have not yet peaked and that we would see a continued upward move in the stock prices.

• Europe and emerging markets are showing early signs of recovery after unprecedented austerity measures (taken to reduce budget deficits) devastated their economies. The U.S. recovery combined with recovery in Europe and emerging markets would give a further boost to global trade which would increase the U.S. exports and corporate profits.

• Finally, much has been made of the impending Fed tapering of their monetary stimulus program, QE3, in which the Fed buys government securities at a rate of $85 billion a month. The Fed has said that when economy improves and unemployment rate falls to 6.5%, they will phaseout monetary stimulus. The recent GDP growth rate of 3.6% makes it likely that the Fed would start tapering QE3 in 1Q14. Theoretically, QE3 tapering would have some negative impact on the stock market, but there would be some offsetting factors as well. As the interest rates increase in the face of tapering, the bond bubble would finally burst and some of the bond money would end up in stocks. Also, the underlying economy would be stronger and that means corporate profits would remain healthy. Therefore, tapering may not necessarily be a bad news and the fears of market crash are overblown.

Given the above global economic trends, there is a possibility that the DJIA might even surpass the 19,000 mark some time in 2014.

Rapid economic recovery may be the nightmare scenario for Federal Reserve

Posted by Shyam Moondra

On May 22, 2013, in a congressional testimony, Federal Reserve Chairman Ben Bernanke talked about the possibility of winding down Quantitative Easing (QE) in the next few months which caused the stock market to crash by more than 250 points. This flash crash makes the Fed acutely aware that their biggest challenge now is to flawlessly execute on the question of when and how to end QE.

With the congressional gridlock preventing the government from taking effective actions on the fiscal front to stimulate economy, the Federal Reserve came up with the idea of increasing liquidity via the so-called QE program. On December 16, 2008, the Fed announced that it would purchase up to $600 billion worth of mortgage-backed securities (MBS) and agency debt. On March 18, 2009, the Fed expanded the program by additional $750 billion. The idea behind QE was to push the long-term interest rates down to give a boost to the housing recovery and steer the investors towards more risky investments such as stocks that were being shunned by investors in the aftermath of the financial crisis of 2008. The thinking was that if housing prices recovered and stock prices went up, the wealth effect would lead to higher consumer spending. Since consumer spending accounts for 70% of the U.S. economy, it was thought that asset appreciation would increase the pace of economic recovery. When the Fed started its unprecedented QE program, the biggest fear was that significant increase in money supply over a short period of time could fuel inflationary expectations and bring the economic recovery to scratching halt. Since such a daring experiment had never been undertaken before, no one really knew what unintended consequences might result from QE. However, given the gridlock in Washington, DC, the Fed had no other choice but to find a way to infuse large amounts of funds into the monetary system to stimulate economic growth.

After the initial QE, however, the pace of economic recovery continued to be sluggish. The Fed doubled down and initiated QE2, which involved the purchase of long-term Treasuries at the rate of $75 billion a month over the period from November, 2010 to June, 2011. In September, 2011, QE2 was followed by the Operation Twist, which involved the purchase of $400 billion (later expanded by additional $267 billion) worth of bonds with maturities of 6 to 30 years and to sell bonds with maturities of less than 3 years, thereby extending the average maturity of the Fed's own portfolio. This was an attempt to do what QE tried to do, without printing more money and without expanding the Fed's balance sheet, thereby hopefully avoiding the inflationary pressure associated with QE. On September 13, 2012, the Fed announced a third round of quantitative easing, QE3. This new round provided for an open-ended commitment to purchase $40 billion worth of MBS per month until the labor market improved "substantially". The amount was later increased to $85 billion per month ($40 billion worth of MBS and $45 billion worth of Treasuries). Massive infusion of funds by the Fed into the monetary system finally did have the intended effect; the housing industry started to recover and the stock market zoomed up. The economy grew at a rate of just over 2% which helped create new jobs, albeit at a slower pace than desired, and the unemployment rate came down from 10 percent in 2008 to 7.5% in April, 2013. To the surprise of many economists (including some of the hawkish members of the Fed), inflation remained in check in spite of significant increase in money supply. In addition, QE inspired economic expansion, coupled with higher tax rates for the rich agreed to by President Barack Obama and Congressional Republicans, increased the tax receipts beyond what was expected. Higher tax receipts, in return, reduced the budget deficit to $642 billion (or 4% of GDP), about $200 billion lower than what the CBO had projected only three months ago. It is estimated that sequestration (across-the-board spending cuts) and QE could eventually bring down deficit to the level of 2.5% of GDP which is not considered excessive. The unanticipated large reduction in projected budget deficit has completely changed the dynamics of the gridlock in the Congress on the question of deficit/debt. With the sequestration in effect and Fed’s QE improving economy, the pressure is off for doing a quick grand bargain. The Congress might now focus more on its long-term goal of reforming the tax code and entitlement programs.

The biggest challenge for the Fed now is to decide when and how fast to terminate QE. It’s clear that if economy strengthens to the level of 4% GDP growth rate, the continuation of QE at its present level would most likely increase the inflationary pressures and force the Fed to stop QE in a hurry which could trigger rapid increase in interest rates and destabilize the financial markets. On the other hand, if economy continues to expand at the slow pace of 2.5% to 3% (at a cost of sluggish reduction in unemployment rate, of course), the Fed could devise a plan to gradually reduce the QE amount and eventually start selling MBS and Treasuries to bring down its balance sheet to more traditional levels. The QE disengagement has to be done slowly over a period of couple of years to have minimum destabilization effect on the financial markets. Bernanke was right in refusing to give in on the demands by some conservatives in Congress to terminate QE immediately. If economy continues at its present trajectory, the Fed may still have at least six months before beginning the phase-out of QE and completely unwinding QE by the time GDP growth rate hits 4% rate or unemployment rate falls below 6%, whichever happens first.

Bernanke’s second term as the Chairman of Federal Reserve Board expires in January, 2014. I hope he stays on beyond January, 2014 to finish the job and to make sure that QE is phased-out at just the right time and at just the right pace to ensure soft landing.

Outrageous ideas for speeding up economic recovery and job creation

Posted by Shyam Moondra

This Thursday, the Federal Reserve Board (FED) is likely to announce a new Quantitative Easing program (QE3) through which they will infuse liquidity into the monetary system, inducing investors to go after more risky assets rather than park their money in fixed-income instruments that they consider as safe haven in the present uncertain environment. The earlier similar programs (QE1 and QE2) have had some positive effect on economy but they provided only a temporary lift. What if the FED takes a different approach this time?

Here is a recap of where things stand right now:

• The stock prices are historically low with S&P 500 PE hovering at around little over 15. At the last market peak, it was over 30. When the market goes up, the investors feel wealthy and more secured about the future. That leads to their increased spending which fuels the economy.

• The housing prices are improving, but they are still very depressed from their historic averages. Higher housing prices have the same wealth effect as higher stock prices; homeowners start borrowing against home equity which leads to increased spending that boosts the economy.

• The corporations have the best balance sheets in a generation, hoarding cash of the order of $3 trillion. They are ready to invest in capital projects and hire more workers, but two things are holding them back: gridlock in the Congress that creates uncertainty (and corporations hate uncertainty) and tepid consumer spending.

• Having lost tons of money in the 2008-2009 market crash, the investors have parked their cash in government securities that pay almost no interest and corporate bonds that are barely keeping up with inflation. So what we have is a fixed-income bubble that would eventually burst, as all bubbles do.

Given the above facts, this is what we can do to increase the rate of economic recovery and speed up job creation:

• The voters need to take a decisive action in November and give control of all three government entities, the White House, the Senate, and the House of Representatives, to the same party so we can finally get rid of gridlock. Under Obama, we have made progress in terms of job creation from the depth of severe recession left by the former President George W. Bush (4.5 million new jobs created in the last 30 months compared with 2.6 million jobs lost in the final year of the Bush presidency). Obama has demonstrated that he is the absolute champion of the middle-class (that accounts for 70% of consumer spending) and protector of Medicare and Social Security safety-net programs. Therefore, the voters should put Democrats in charge of all three parts of the government. In the past, the voters preferred a divided government to have checks-and-balances and to avoid ideological domination by any single political party. However, in the current circumstances, getting rid of gridlock is much more important than worrying about ideological domination. In the absence of gridlock, the government will be able to swiftly move on tax reforms and adopt a long-term balanced plan to reduce federal budget deficit and debt.

• The FED has been buying treasuries and mortgage-based securities to infuse more liquidity into the system with the hope that investors would go for more risky assets such as equities. The FED actions have had limited success in achieving their goals and these actions have largely benefited the financial sector which is in much better shape today than it was in 2008. Therefore, may be the FED should buy equities instead of treasuries and mortgage-based securities to encourage the investors to move their money from less risky instruments to more risky equities. The previous government investment in equities by the Treasury Department under the bailout program TARP (e.g., in auto companies and financial companies) has produced good returns for the taxpayers; FED’s equity purchases now when the market prices are relatively low should prove to be profitable for the taxpayers as well as beneficial for the overall economy. The FED purchases of equities (they could buy the stocks in various indices such as Dow Jones, S&P 500, NASDAQ) will move the stock market up and create wealth. By the same token, the FED should snap up foreclosed properties (rather than buy mortgage-based securities that benefit only the banks) to reduce supply of homes and thus give a boost to the housing prices, thereby creating the wealth factor on that front as well. The Congress would have to revise the Federal Reserve Act authorizing the FED to buy equities and foreclosed properties and also increase funding for the FED so that it will have the necessary resources to effectively execute the plan of investing in equities and foreclosed properties.

• The FED has stated that it will keep interest rates close to zero at least through 2015. The idea was to nudge investors away from fixed-income securities and towards more risky assets and encourage corporations and consumers to borrow and spend. Unfortunately, the low interest rates are not having an appreciable stimulative effect on economy; corporations don't need to borrow much because of their huge cash pile and consumers are reluctant to borrow because they don't feel secured in the current economic environment with high unemployment rate. Also, the potential home buyers are putting off their real estate purchases thinking that interest rates will remain low for some time so it's better to just wait for lower real estate prices. Therefore, the FED’s low interest rate policy is actually having unintended negative impact on economy. May be the time has come for the FED to try a different tack and start increasing interest rates and force these waiting potential homeowners to start buying homes now which will have a big impact on job growth. Higher interest rates will also increase the spreads for banks that will allow them to make fatter profits and thus become financially more stronger than they are now.

Since the 2008 recession, we have had the slowest recovery on record. It’s time the voters and FED try different approaches to improve economy and create lots of jobs faster.

Obama's poor execution may sink his approval rating

Posted by Shyam Moondra

Since Barrack Obama became the president, he has been saying all the right things. However, Obama's mode of operation has become an obstacle in achieving the desired end-results of his policies. Consequently, Obama's popularity has declined somewhat and is about to crash down unless he improves his execution.

Bill Clinton's presidential campaign strategy was based on "it's the economy, stupid" that led to his astounding victory over George H. W. Bush. After the election, Clinton exclusively focused on economy and he especially avoided making foreign trips. He even resisted getting involved in Kosovo as long as he could. His hands-on approach in formulating and executing economic policies paid off handsomely - he turned the budget deficit into a surplus and the American people enjoyed the longest period of prosperity in the modern history. Now we have a much more serious economic crisis but Obama has been spending way too much time traveling around the globe. When people are losing their jobs and homes at the fastest rate since the depression of the 1930's, it's hard to justify Obama's extensive travel plans. Surely, Obama has improved the image of the U.S. that was battered during the Bush years, but, at the moment, that's not what the American people want him to focus on - they want him to stop the bleeding of our economy.

One of the other operational problems Obama has is his desire to be in front of the cameras at all times. He suffers from overexposure because of his constant interviews, press conferences, speeches, video blogs, etc. The American people would rather see him working at his desk in the oval office and be focused on execution of his economic policies. Obama likes to tell Congress that he wants this or that by so and so date, and then becomes somewhat aloof from the process. The Congress then writes the legislation with the help of lobbyists, who are likely to insert all kinds of loopholes, diluting the reforms that were expected from the legislation. The case in point, the health care legislation - we keep hearing that Obama's original vision has been riddled with all kinds of concessions sought by the lobbyists that raise the question if the proposed legislation will achieve its originally stated goal of significantly reducing costs (in fact, the Congress is talking about imposing new taxes worth $1 trillion to pay for this proposed plan!). During the campaign, Obama promised he would reduce the role of lobbyists in the government, but right now just the opposite is happening. Why not Obama roll up his sleeves and sit down with the Congressional leaders and hammer out legislation rather than let the lobbyists write the laws? The American people want a more hands-on approach from Obama in lieu of his non-stop TV appearances and pronouncements.

Obama has been busy proposing a million different things but in the absence of focus and hands-on approach, nothing much is being accomplished – his emphasis is on quantity of things he proposes as opposed to getting things done right in a timely manner. Congress is not used to working on multiple things that fast, so what will come out would be half-baked goods that will not achieve the reforms that were originally envisioned. May be Obama could get done more by focusing on a fewer things at a time so that he can devote more time in executing things as opposed to proposing things.

Here are some examples of how Obama's poor execution is becoming an obstacle in achieving the desired results:

· In spite of huge stimulus spending, the economy continues to lose jobs and the unemployment rate continues to rise. The loss of jobs means more and more homeowners are joining the ranks of who can't keep up with their mortgage payments. That leads to more foreclosures and lower home prices. The American people would like to know why economy is not getting a lift from increased government expenditures – is it because the stimulus money is not being spent fast enough or the stimulus package was flawed? The proposed budget will sharply increase the national debt, so it is important to properly analyze why increased expenditures are not generating more jobs. Shouldn't Obama be focusing on analyzing the stimulus package and deciding what to do next?

· Foreclosures continue to be at near record levels. Shouldn't Obama take another look at homeowner assistance programs and come up with changes in the approach? Mortgage rates went up in recent weeks shutting down the refinance market - shouldn't Obama do something to bring down the mortgage rates to stimulate the demand for the houses? Economic turn around is contingent upon stabilizing the housing industry first.

· Oil prices have doubled in the last few months. Congress had a lot of hoopla when oil hit $150-a-barrel and it talked about reforming CFTC, limiting investment by speculators in oil and other commodities, eliminating the "Enron loophole" etc but nothing has happened. Why is Obama not doing anything about this? When commodity prices on the futures market go up and down by 100% or more in short periods without any change in the underlying fundamentals, then clearly something is very wrong with the way the markets operate.

· The outlandish executive compensation was a major issue during the campaign, but Goldman Sachs and Morgan Stanley just announced that they would put aside tens of billions of dollars for 2009 bonuses that is 50% more than the amount set aside for 2008 bonuses. Why has Obama not done anything on this issue? We need a law to limit CEO compensation at all publicly held companies, not just TARP companies.

· Everybody knows that investment banks and hedge funds manipulate the stock markets. There have been a lot of talk about twenty-first century regulatory reforms but nothing concrete has yet come out and market volatility continues to be an obstacle in getting the economic house in order. We need to clamp down on computerized day trading by investment banks and hedge funds that are destroying our markets.

· With the huge increase in government spending, the budget deficit is ballooning rapidly that almost guarantees that interest rates will go up in the coming months. Why has Obama not announced concrete plans on how the budget deficit and national debt would be brought down?

If Obama doesn't change his mode of operation and exclusively focus on deteriorating economy, his approval rating will crash in coming weeks and months. Obama has a real opportunity to be a great president but he is blowing it away by not being on the top of things in seeing that the economy rebounds quickly.

FED should buy stocks to stabilize the markets

Posted by Shyam Moondra

It's amazing to see how people have become used to the DJIA declining 500+ points a day. The ramifications are far reaching; the crash of financial and housing markets will inevitably lead to declining living standards and increasing poverty around the world. While people enjoyed the fruits of globalization when things were going great, now they must share the pain when the sky is literally falling down.

The question is what can we do now? The government has many other tools at its disposal that it can use to build up the investor and consumer confidence. One thing the federal government could do is to buy the stocks in the open market which will surely move the market up and improve the investor sentiment. At the current fire-sale stock prices, the tax-payers will eventually reap huge profits in a year or two when the stock markets reflect the true value of the corporations. Those profits could then be used by the new president to invest in education, health care, and infrastructure improvements.

Here is a list of what the government should do:

1. FED and Treasury Department should buy stocks of major blue-chip high quality stocks in the open market at the current outrageously low prices.
2. Extend FDIC insurance to all deposits regardless of the amount.
3. Close-down weaker banks immediately, so that banks can start freely lending money among themselves.
4. FRB should immediately lower funds rate by another 0.5%.
5. FRB should extend credit to corporations and small businesses to avoid layoffs.
6. Implement $700 bi bailout without any delay.
7. Treasury Department should also buy foreclosed houses on sale and sell later when the housing market recovers, as was done during the last depression.
8. President Bush should coordinate actions with EU, Japan, and China, and convince oil-rich countries to use their sovereign funds to invest in American companies.

Should Federal Reserve Board increase the interest rates?

Posted by Shyam Moondra

Economy in deep recession, the unemployment rate zooming up, inflation out of control, corporate profits declining, dollar taking a plunge in the currency markets, and the stock market in a huge downward spiral. No, I am not talking about "today," I am talking about the 1970's.

The 1970's were the troubled years. Huge government expenditures necessitated by the Vietnam War and the oil embargo by OPEC (after the Yom Kippur War in October, 1973, which led to a big spike in oil prices), fueled the inflationary pressures throughout the economy. The people were losing their jobs and everything seemed to be falling apart. If there was such a thing as stagflation, that was it. President Carter had no stomach for the failed Nixonian style wage and price controls of 1971 (free-market economy and massive government intervention are like oil and water, they never mix!). Then in 1979, came to the rescue Paul Volcker, the FRB Chairman, who rapidly increased the interest rates to get some control over the inflationary spiral. The elderly people were in a dreamland earning more than 15% on money market accounts and CDs. The sustained high interest rates broke the back of the inflationary spiral. By 1987, Volcker left an economy that was getting ready for the biggest economic expansion we have seen in the modern history. The 1990's go-go years were the years when we had very low interest rates, low inflation, low unemployment, high house ownership, budget surpluses at federal and state levels, and "irrational exuberance" in the stock market. The people generally felt very prosperous and confident about the future.

What we see today is not much different from what we experienced in the 1970's. We have the Iraq War, which has drained our economy of at least two trillion dollars (and still counting), oil and commodity prices fueling inflationary pressures, joblessness increasing, stock markets in the dumps, and people are generally feeling financially insecured. May be what we need is the Volcker treatment of high interest rates combined with responsible fiscal policies (especially on the side of government spending) to bring back the happy days again. It will surely be a painful period of several years before we are able to put our economic house in order.

At this juncture, high interest rates would have more upside than downside. Higher interest rates will strengthen dollar, which will bring down oil and other commodity prices and thus lower the inflationary expectation. Lower gasoline and food prices would enable consumers to spend more on other things, thereby revitalizing the economy. Surely, higher rates will make it difficult for the housing market to recover, but the housing troubles have more to do with the fact that mortgages were given to unqualified people, who are defaulting on their loan repayments. Overall, higher interest rates will be more beneficial than detrimental to the economy and they might even boost the stock market (which may seem strange, but it did exactly that in the 1970's).