Minutes of the June 22/23, 2010 Federal Open Market Committee

the June OMC meeting

The minutes of the Federal Reserve Open Market Committee meeting of June 22-23 were released on July 14th.

To my mind, the truly striking development in this report is not the economic numbers themselves.  It’s the fact that for the first time since world stock markets bottomed in March of last year, the forecasts of the country’s near-term economic prospects by the 17 members of the OMC (5 governors + the 12 presidents of the regional Federal Reserve banks) have stopped going up.  In fact, they’ve gone–at least temporarily–into reverse.

The Fed now thinks real GDP growth in 2010, at 3.3%, will be .25% less than it thought in April.  The unemployment rate is expected to remain about .2% higher than previously estimated, at 9.4% this year and 8.5% next.

What’s changed?

To be clear, the Fed believes that the US economy is in the process of a moderate, but self-sustaining economic recovery, where “inventory adjustments and fiscal stimulus were no longer the main factors supporting economic expansion.”  But it also thinks that several factors, most of them external, have recently emerged that put a firm upper limit on how fast the economy can advance.

They are:

–financial troubles in Europe

–the rise in the dollar, and

–weakness in stock prices (even with the recent rally from just about 1000 on the S&P 500, Wall Street remains 10% below the high water mark achieved earlier in the year).

They add to business and consumer uncertainties, real estate weakness and reluctance of banks to lend, as sources of the headwinds the domestic economy is facing.

The good news, then, is that the US is on an upward course.  The bad news is that what we see now is as good as it gets.

the US economy:  plusses and minuses

–industrial production gains are “strong and widespread,” with IT investment growing rapidly,

but capacity utilization remains low enough that companies aren’t going to invest in plant and equipment for expansion (vs. replacement or upgrade) for some time to come.

–labor demand continues to firm,

but the proportion of workers jobless for more than half a year, already unusually high, continues to rise.

–bank credit, “which had been contracting for some time, was showing some tentative signs of stabilizing,”

but commercial real estate is weak, with no bottom in sight,

and consumer credit keeps on contracting.

–inflation remains unusually low, with deflation a risk,

but the current lack of inflation has not yet caused Americans to adjust their inflation expectations down, thus raising the deflation risk.

the bottom line

Economic growth will remain muted, and unemployment will therefore  remain unusually high for an extended period of time, with most OMC members expecting “the convergence process (to normal unemployment levels) to take no more than five to six years (emphasis added).”

In consequence, inflation will remain unusually low for a similar extended period, gradually rising to around 2%.

long-run projections

change in real GDP      2.4%-3.0%

unemployment rate     5.0%-6.3%

CPE inflation     1.5%-2.0%

investment implications

Wall Street has always been able to draw a clear distinction between sectors it thinks will perform well and those it thinks will perform badly.  And it has usually been able to separate that judgment from one about whether the overall market will go up or down.

Foreign stock markets have routinely been able to draw a similar kind of high-level distinction between the prospects for the home-country economy and those for international regions.  They have usually been able to vary their holdings between domestic- and foreign-oriented companies, and to disconnect that decision from one about whether the market will go up or down.

Right now, the US economy overall, and consumer-oriented sectors in particular, seem to me to be relegated to the laggard column for some time to come. It also seems to me that the overall market is cheap.  Or, as the Fed put it in its minutes, “The spread between the staff’s estimate of the expected real return on equities…and…the expected return on a 10-year Treasury note…increased from its already elevated level.”

American investors have clearly been able to make the inter-sector judgment without difficulty.  If the market can do the same for the foreign-domestic judgment–and that remains to be seen–IT and international-trade related firms should have smooth sailing in the year ahead.

two other thoughts

The notion that the economy won’t be back to normal for the next half-decade is shocking, but given the enormous amount of damage done by the financial crisis (the Washington-Wall Street complex) it’s not that surprising.  The realization of this fact is probably the cause of the large amount of public outrage directed at politicians and investment/commercial bankers.

Although the negative news about GDP growth and extended high unemployment have been widely reported, the Fed projections have barely made a ripple in the stock market.  Presumably, this means that investors have already discounted most of this n stock prices already.

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