MONEY The Economy

Think the Fed Should Raise Rates Quickly? Ask Sweden How That Worked Out

Raising interest rates brought the Swedish economy toward deflation Ewa Ahlin—Corbis

Some investors are impatient for the Fed to raise interest rates. They may want to be a little more patient after hearing what happened to Sweden.

If you’re a saver, or if bonds make up a sizable portion of your portfolio, chances are you’re not the biggest fan of the Federal Reserve these days.

That’s because ever since the financial crisis, the nation’s central bank has kept short-term interest rates at practically zero, meaning your savings accounts and bonds are yielding next to nothing. The Fed has also added trillions of dollars to its balance sheet by buying up longer-term bonds and other assets in an effort to lower long-term interest rates.

Thanks to some positive economic news — like the recent jobs report — lots of people (investors, not workers) think the Fed has done enough to get the economy on its feet and worry inflation could spike if monetary policy stays “loose,” as Dallas Fed President Richard Fisher recently put it.

If you want to know why the argument Fisher and other inflation hawks are pushing hasn’t carried the day, you may want to look to Sweden.

Like most developed nations, Sweden fell into a recession in the global financial crisis. But unlike its counterparts, it rebounded rather quickly. Or at least, that’s how it looked.

As Neil Irwin wrote in the Washington Post back in 2011, “unlike other countries, (Sweden) is bouncing back. Its 5.5 percent growth rate last year trounces the 2.8 percent expansion in the United States and was stronger than any other developed nation in Europe.”

Even though the Swedish economy showed few signs of inflation and still suffered from relatively high unemployment, central bankers in Stockholm worried that low interest rates over time would lead to a real estate bubble. So board members of the Riksbank, Sweden’s central bank, decided to raise interest rates (from 0.25% to eventually 2%) believing that the threat posed by asset bubbles (housing) inflated by easy money outweighed the negative side effects caused by tightening the spigot in a depressed economy.

What happened? Well…

Per Nobel Prize-winning economist Paul Krugman in the New York Times:

“Swedish unemployment stopped falling soon after the rate hikes began. Deflation took a little longer, but it eventually arrived. The rock star of the recovery has turned itself into Japan.”

And deflation is a particularly nasty sort of business. When deflation hits, the real amount of money that you owe increases since the value of that debt is now larger than it was when you incurred it.

It also takes time to wring deflation out of the economy. Indeed, Swedish prices have floated around 0% for a while now, despite the Riksbank’s inflation goal of 2%. Plus, as former Riksbank board member Lars E. O. Svensson notes, “Lower inflation than anticipated in wage negotiations leads to higher real wages than anticipated. This in turns leads to many people without safe jobs losing their jobs and becoming unemployed.” Svensson, it should be noted, opposed the rate hike.

image (8)

Moreover, economic growth has stagnated. After growing so strongly in 2010, Sweden’s gross domestic product began expanding more slowly in recent years and contracted in the first quarter of 2014 by 0.1% thanks in large part to falling exports.

As a result, Sweden reversed policy at the end of 2011 and started to pare its interest rate. The central bank recently cut the so-called “repo” rate by half a percentage point to 0.25%, more than analysts estimated. The hope is that out-and-out deflation will be avoided.

So the next time you’re inclined to ask the heavens why rates in America are still so low, remember Sweden and the scourge of deflation. Ask yourself if you want to take the risk that your debts (think mortgage) will become even more onerous.

MONEY The Economy

A Key Fed Official Says the Job Market is Just Fine. But is He Right?

Richard Fisher, president and CEO of the Federal Reserve Bank of Dallas
Richard Fisher, president of the Federal Reserve Bank of Dallas. Jose Luis Magana—Reuters/Corbis

With a little help from Jonathan Swift, Shakespeare, and World War II, Dallas Fed President Richard Fisher makes the case for why interest rates need to rise soon.

In between references to Shakespeare, beer goggles and Wild Turkey, Dallas Federal Reserve Bank President Richard Fisher— a member of the Federal Open Market Committee that sets the nation’s interest-rate policy— expressed concern Wednesday about the risks caused by the Fed’s ongoing stimulative policies.

Thanks to a dramatically improving jobs picture, according to Fisher, the Fed should not only cut off its bond-purchasing program (known as “QE3″) by October, but the central bank should also shrink its portfolio of assets and begin raising interest rates early next year or sooner.

Whether or not the economy can withstand monetary tightening — fewer jobs means fewer people able to buy stuff — is open for debate. The real question, though, is if the jobs picture is really that strong?

First some context.

In his colorful speech, Fisher, one of the Fed’s leading “inflation hawks,” reiterated his belief that the Fed’s rapidly escalating balance sheet (now at approximately $4.4 trillion) in combination with a near-zero federal funds rate has led to investors having “beer goggles.” (As Fisher explains it, “this phenomenon occurs when alcohol renders alluring what might otherwise appear less clever or attractive.”) This is what he says is happening with stocks and bonds, which are both relatively expensive.

To make his point Fischer quoted Shakespeare’s Portia in Merchant of Venice: “O love be moderate, allay thy ecstasy. In measure rain thy joy. Scant this excess. I feel too much thy blessing. Make it less. For fear I surfeit.”

Portia’s adjectives (joy, ecstasy and excess) describe “the current status of the credit, equity and other trading markets that have felt the blessing of near-zero cost of funds and the abundant rain of money made possible by the Fed and other central banks that have followed in our footsteps,” Fisher said.

Of course, the Federal Reserve hasn’t bought trillions of dollars of debt, and cut the main interest rate to nothing, for no reason. There was something called, you know, the Great Recession — the once-in-a-lifetime cataclysmic economic event from which the country is still recovering.

But, said Fisher, things are improving, especially in the labor market. Not only did businesses add almost 300,000 employees last month, but there are more job openings, workers are quitting more often and wages are rising. Is he right?

Let’s check out some graphs:

Job openings:


Fisher is right that job openings “are trending sharply higher.” This time last year, there were a little less than 3.9 million job openings. Right now there are more than 4.6 million – an 18% increase.



The healthier an economy, the higher the number of employees who quit their job to either find another or start a new business. Therefore a higher so-called quits rate, means a healthier labor market.

Like job openings, the number of quits has been rising since bottoming out during the recession. The major difference though is that the number of job openings has almost reached pre-recession levels, while quits has not.


wage growth

Fisher admits that wages aren’t growing “dramatically.” Nevertheless, he cites the Current Population Survey and the most recent National Federation of Independent Business survey to show that wages are on the rise.

However, wage data from the Bureau of Labor Statistics shows that Americans in the private sector are earning $24.45 an hour, only up 1.9% from last year.

But these three metrics aren’t the only metrics to gauge the health of the labor market.

Long-Term Unemployed:

l-t unemployment

Before the recession, about 1.3 million workers were without a job for longer than 27 weeks. Today, that number is slightly more than 3 million. While that’s significantly better than the post-recession high of 6.8 million in August 2010, there are still a lot of workers who’ve been without a job for a long time.

“Long-term unemployment is still a significant source of slack in the economy and is accounting for a historically large share of the total unemployment rate,” says Wells Fargo Securities economist Sarah House.

Broader unemployment:


And while the unemployment rate may signify the economy is moving closer to full employment, the picture is less sanguine if you look at a broader unemployment rate that takes into account the underemployed (part-time workers who want to work full-time) and discouraged workers. Before the recession that number hovered a little over 8%. It’s now 12.1%. And while it’s trending down, it’s not coming down fast enough. At least according to recent testimony by Federal Reserve Chair Janet Yellen.

Conventional wisdom says inflation will come when wages really start to rise. Some, like Fisher, think we’re getting really close to that point. But if you take into account wage data from the BLS and look at the millions of Americans who aren’t working to their full capacity, it’s not hard to see how tightening monetary policy might make life harder on lots of workers.

MONEY The Economy

The Shrinking Role of Wages

Senior woman looking at Social Security check
A social security check arrives in the mail Donald Higgs—Getty Images

As the population ages and workers get displaced, a smaller portion of income is derived from actual work.

For Americans, work is becoming less and less important.

Today, wages and salaries make up only 50.5% of overall personal income, according to a new Wells Fargo Securities report. That’s down from almost 60% in 1980.

You can blame some of this on changing demographics, including the aging of the population and government programs that direct transfer payments to certain groups.

Take Medicare and Social Security. In the beginning of 2007, 80% of people between the prime working ages of 25 to 54 was employed. Today that number is down to 76%.

image (1)
Source: St. Louis Federal Reserve and the Labor Department

While the Great Recession lowered demand for workers, “the aging of the baby boomers and longer life expectancies have pushed the share of the population age 65 and older to a record high,” writes Wells Fargo economists John Silvia and Sarah House.

Almost one in seven Americans is 65, according to the U.S. Census, compared to 12.4% in 2000. More Americans over the age of 65 means more Americans receiving Social Security and Medicare.

Then there’s help for the disabled and poor. “Increased eligibility and use of social insurance programs such as disability insurance and food stamps have also prompted the rise in transfer payments,” note Silvia and House.

Right now there are more than 14 million Americans who are deemed disabled by the Social Security Administration.

Consider this from NPR’s Planet Money’s excellent series on disability:

Part of the rise in the number of people on disability is simply driven by the fact that the workforce is getting older, and older people tend to have more health problems.

But disability has also become a de facto welfare program for people without a lot of education or job skills. But it wasn’t supposed to serve this purpose; it’s not a retraining program designed to get people back onto their feet. Once people go onto disability, they almost never go back to work. Fewer than 1 percent of those who were on the federal program for disabled workers at the beginning of 2011 have returned to the workforce since then, one economist told me.

Or take food stamps. Since 1969, the number of people on food stamps has increased by a factor of 16.

The share of income derived from transfers has increased from 12.5% in 2000 to 17.3% today, according to Wells Fargo Securities.

A lousy job market in the aftermath of the recession has left millions without work — 36% of today’s unemployed have been without a job for over 27 weeks, compared to 12.1% in 2000. And that abundance of available labor, writes Silvia and House, “has kept wage growth muted, restraining labor income even as hiring has improved.”

image (2)
Sources: St. Louis Federal Reserve and the Labor Department

For the overall economy, “the general diversification of income sources adds to the stability of consumer spending over time,” House says. “In particular, transfer payments have becoming an increasingly important share of income and have helped to smooth income/spending throughout the business cycle and Americans’ life cycle.”

MONEY The Economy

The Return of the Most Interesting Man on Wall Street

Paul McCulley
I don't always call for stimulus, but when I do it's monetary AND fiscal. Lori Shepler—Reuters

Paul McCulley returns to PIMCO as chief economist. Here's how he explains the mysteries of the Fed and ultra-low interest rates.

Pimco, manager of nearly $2 trillion in assets and home to Bill Gross and his massive $230 billion Pimco Total Return bond fund PIMCO FDS PAC INVT TOTAL RETURN A PTTAX 0.0914% , annouced last week that it has brought back Paul McCulley. McCulley, who made his name at the firm with his sharp commentaries on the Federal Reserve, will be Pimco’s chief economist. For 100 days per year.

The return of McCulley is attracting attention in part because of recent management turmoil at Pimco, which saw former co-CEO Mohamed El-Erian clash with Gross and leave unexpectedly. Reports also mention McCulley’s imaginary Q-and-A with his pet rabbit and recent unusual hair. (He’s since cut it. The photo here is from 2011.)

But McCulley is also a man with unusual ideas for a Wall Streeter* (*West Coast Division—Pimco is based in Orange County). Those ideas will certainly be of interest to investors in Earth’s biggest bond fund. But they also point to a different way of thinking about what the ever-mysterious Federal Reserve has been up to.

In his time away from Pimco, McCulley was chair of fellows at a group called the Global Interdependence Center, where he co-wrote a pair of unorthodox papers on the future direction of both the Fed’s interest-rate setting (monetary policy, in the jargon) and government spending (fiscal policy.)

Here’s the conventional wisdom on what the Fed has been doing: By holding interest rates very low, by buying up massive amounts of bonds in operations called “quantitative easing,” and by communicating that it is really, really, super serious about keeping rates low until inflation runs at at least 2% and unemployment falls under 6.5%, it is sending a message to the markets. This will encourage people to buy stocks, to borrow, to invest in businesses, and to spend.

McCulley’s argument (at least in early 2013 when he wrote the most recent paper) is that this is only half the game. When the private sector is still trying to climb out of a debt hole and the Fed has already cut rates near zero, the economy needs the public sector to pick up some slack. “Fiscal ‘irresponsibility’ (running large deficits despite large deficits as far as the eye can see) may in fact be far more important at the zero bound than monetary irresponsibility,” McCulley and coauthor Zoltan Pozsar write. In their language, “irresponsibility,” or unorthodoxy, is a good thing under the circumstances.

They say what the Fed has really been doing (or maybe should have been doing—it’s not clear) with its extraordinary actions is to send a message to Congress and the White House: “Please, go spend some money! Even if it triggers some inflation and blows up the deficit, we won’t get in your way.” In fact, McCulley and Pozsar write, the central bank should have gone further, making clear it would essentially fund deficits by keeping up QE.

If that was ever the message, it was not received. In fact, the deficit has been falling, and recent battles between Congressional Republicans and the President over the debt ceiling have put an end to any talk of fiscal stimulus.

In Europe, the other big engine of the global economy, policymakers are if anything even more austerity minded.

So instead of worrying that the Fed has gone too far with QE and is about to ignite inflation, a McCulley-ish view of the world has central banks basically pushing on a string. If you believe that, you’d think the Fed’s going to be keeping rates low for some time to come. And you’d probably be inclined to ignore the constant refrain that Treasury bonds, with their super low yields, are a bubble just waiting to burst.

Beyond the stock and bond markets, you’d expect sluggish growth ahead. Unemployment has dipped to 6.3%. But some worry that too much of this is due to fewer people looking for jobs.

Pimco’s latest market outlook has been for a “new neutral”—that is, a world where growth and inflation never really take off in a big way, but then neither do interest rates, and investors can expect modest returns. Sounds like they’ve been keeping tabs on McCulley’s writing and thinking. Does that mean the funds will stay bullish on bonds for a while? Maaaaybe. What a firm like Pimco says in public is one thing. They make their money by timing the turns from the status quo to the next big move. They probably won’t tell you about it first. (Pimco has had a mixed—at best—record of getting interest rate and inflation moves right in recent years.)

Pimco has told its investors that a lot of the “new neutral” story is built into today’s high asset prices and low bond yields. So even at face value, this isn’t so much a bullish case as an argument that risks aren’t as high as some people worry they are. In other words, the Pimco view is that we are not yet set up for a repeat of the 2007-2008 “Minsky moment”—a term McCulley coined for the tipping point when complacent investors discover that they took to much risk. (He’s also been credited with the term “shadow banking.” Like I said, interesting guy.)

Beyond what it means for Pimco’s shareholders it should be interesting to see how McCulley, whose new role all but guarantees him a guest seat on CNBC and the ear of every financial reporter, affects public debate about fiscal and monetary policy. Imagine Paul Krugman sitting besides a $2 trillion portfolio.

MONEY The Economy

5 Reasons the Economy is Not Headed for Recession

Growth will soon resurface. Cultura RM/Liam Norris—Getty Images

Despite disappointing GDP numbers, the economy is firmly headed higher.

The economy may have slipped out of gear, but it’s not in reverse.

True, a government report released late last week showed that the U.S. economy did actually contract at an annual rate of 1% at the start of the year, which was much worse than consensus forecasts for a 0.5% decline. That marked the first time gross domestic product had actually shrunk since the first quarter of 2011.

This would explain why market interest rates have been falling so much lately — yields on 10-year Treasuries have sunk from 3% to 2.53% this year. In periods of slow or no growth, investors routinely favor fixed income over equities, which pushes bond prices up and yields down.

Before you start bandying about the “R” word, though, let’s keep things in perspective.

A recession is loosely defined by two consecutive quarters of GDP contraction (actually, it’s officially determined by a group of economists at the National Bureau of Economic Research). The economic data released last week represent just one quarter of activity. Plus a survey of 42 economic forecasters by the Federal Reserve Bank of Philadelphia found strong expectations that the economy snapped back in the second quarter. In fact, the economy is thought to have expanded 3.3% in the spring.

What’s more, forecasts for GDP growth for the remainder of the year are on the rise. In the third quarter, the economy is now expected to expand 2.9%, not 2.8% as was previously thought, according to the Philly Fed survey. And fourth-quarter GDP is expected to rise 3.2%, up from earlier forecasts of 2.7%.

Also, there are at least five economic indicators that would confirm the economy is on much surer footing than either the first-quarter GDP report or bond yields would indicate. Among them:

1) The manufacturing economy is improving.
If the economy were on the verge of reversing course, you would at least start seeing the nation’s industrial sector flatten out. Yet as you can see below, that’s not happening.

US Industrial Production Index Chart

US Industrial Production Index data by YCharts

Nor do investors expect it to, which explains why Wall Street continues to bid up shares of economically sensitive sectors like industrials and basic materials faster than the broad market.

^SPX Chart

^SPX data by YCharts

2) Consumers are getting stronger, not weaker.
If consumer spending represent two thirds of the nation’s GDP, then it would be difficult for the economy to slip into recession if households are loosening up their purse strings. Well, retail sales for discretionary purchases (things you don’t really need) with cash has been growing 2%. Meanwhile, discretionary spending on items requiring financing is up much more—5.6%. “Consumers are flexing their muscles again,” says Jack Ablin, chief investment officer for BMO Private Bank.

3) Small business confidence is growing.
One sign the economy is not in dire shape is that “corporate confidence—even among smaller companies—is improving,” says Liz Ann Sonders, chief investment strategist at Charles Schwab. Small companies are often the canaries in the coal mine of a lousy economy. A year before the economy crashed into recession in December 2007, the NFIB Small Business Optimism was already in decline (in fact, it had been falling gradually since the end of 2005). So far this year, the index has climbed, from a reading of 91 in February to 95.

4) Big business is also gaining confidence.
Not only can you see that in booming merger & acquisition activity, but corporations are slowly but surely adding to their payrolls.

US Change in Nonfarm Payrolls Chart

US Change in Nonfarm Payrolls data by YCharts

5) Economic signs that normally offer clues about future activity are running positive, not negative.
The Conference Board’s index of leading economic indicators “has climbed for the twelfth time in 13 months to yet another new cyclical high,” notes Ed Yardeni, president and chief investment strategist at Yardeni Research.

By contrast, in the 12 months leading up to the start of the 2007-2009 recession, the leading economic indicators index had been precipitously falling.

So buck up.

MONEY stocks

Profit Growth Is Slipping and That’s Not Good for Stocks

As corporate earnings growth slows, stock valuations are climbing well above historic standards.

The fact that companies have been consistently generating record profits in recent years has certainly been a boon to the S&P 500 S&P 500 INDEX SPX 0.5016% .

Unfortunately, there will come a time when corporate earnings growth will inevitably slow — and that time may be now.

A government report released in late May found that overall corporate profits actually slumped in the sluggish first quarter, when a brutal winter weighed on business activity. The Bureau of Economic Analysis says that a key measure of corporate earnings fell 3% in the first quarter, compared to the fourth quarter of 2013. Versus the same period last year, profits slumped much more — 9.8%. This is true for both financial and non-financial companies.

Now, there are a variety of ways to measure the health of profits. In the private sector, economists often look at overall earnings growth for companies in the S&P 500.

By this measure, profits are still climbing, but the rate of that growth is slowing noticeably. In fact, expectations for both first quarter and second quarter earnings have been cut in half in less than a year.

Falling earnings chart
Source: S&P Capital IQ

A big reason why is that the economy is not rebounding as strongly as was thought, and overall corporate revenues are growing only modestly.

Sales Dwindling
Source: Thomson Reuters

Yet stock prices have been surging faster lately than the rate of both earnings and revenue growth. “Over the past few years multiple expansion has been the key factor lifting equity market levels higher,” notes Tom Stringfellow, chief investment officer for Frost Investment Advisors.

Forward PE ratios
Note: P/E based on forecasted profits over next 12 months. Source: Bloomberg

Indeed, virtually every part of the stock market is now trading at higher price/earnings ratios — based on forecast profits over the next 12 months — then they have historically. And that’s never a good sign.

MONEY Macroeconomic trends

Momentum Strategy: Skip Stocks, Go for Sectors

A momentum strategy can boost returns without too much risk. Just don't be too greedy. Illustration: Taylor Callery

You’ve no doubt been warned more than once that chasing last year’s winners is a fool’s game that increases your trading costs, tax liability, and investment risk.

That’s especially true if you are constantly moving in and out of individual securities, which is the classic momentum strategy. Yet a decent body of research suggests that entire asset classes that shine in one year have a better-than-average chance of outperforming in the next.

“Momentum is persistent, pervasive, and well documented in virtually every investment and in every country,” says Gregg Fisher, chief investment officer with the asset-management firm Gerstein Fisher.

So how do you take advantage of momentum wisely? As with many things in life, moderation is key.

Lessen the bounce

Sam Stovall, chief equity strategist with S&P Capital IQ, points out that any added gains from buying what’s been going up “don’t come free.” History shows that momentum investors have to assume greater fluctuations in their returns.

But there’s a neat twist to the numbers. Researchers at the asset-management firm Leuthold Group divvied up the investment universe into seven major asset classes: blue-chip U.S. stocks, small-company shares, foreign equities, government bonds, commodities, gold, and real estate investment trusts.

Over the past four decades, a portfolio entirely made up of the prior year’s absolute top asset class beat the S&P 500 by more than three percentage points a year, but it was also two-thirds choppier.

A “bridesmaid” portfolio composed of the previous year’s second-highest performer, however, was only slightly more volatile than the index, and it returned five percentage points more. (For the record, last year’s runner-up asset class was blue-chip U.S. stocks. Small U.S. stocks were the absolute winner.)

Be only a little greedy

Of course, no sane investor would keep such an undiversified portfolio; there are years it would kill you.

In 1997, for instance, you would have lost more than 14% holding a basket of commodities while the S&P 500 returned more than 33%. And turning over sizable chunks of your holdings would indeed cost you in fees and taxes, eating into your gains. So momentum strategies should be applied with a good bit of caution.

Fisher suggests that you think about leaning slightly toward what’s hot — say, by moving up to 10% of your portfolio to a momentum-driven approach — rather than committing huge chunks of your capital.

“Our view is that investors are well served by tilting toward momentum,” Fisher says. “But they’re even better served by doing so in the context of a well-diversified portfolio.”

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