The Fed’s Unemployed Logic

One of the biggest question marks surrounding the government shutdown was finally answered Tuesday: The Bureau of Labor Statistics released the long-delayed September Employment Situation Report. No more uncertainty over labor markets! We have data! (Never mind that we already had it.) Not that the numbers themselves were terribly thrilling. Payrolls rose by 148,000, below expectations. The unemployment rate declined a smidge from 7.3% to 7.2%, but the labor force participation rate didn’t budge from recent lows. Mere months ago, investors would have fretted the news, believing it signals a sluggish economy. This time, however, headlines shifted to the bad-news-is-good-news camp, as investors now view tepid job growth as a sign the Fed will keep its quantitative easing (QE) program in place a while longer. It’s the latest in a long line of backward QE views—and a big sign the program’s end has big positive surprise power.

Despite what the headlines say, September’s unemployment results offer few clues on Fed strategy. Officially, Ben Bernanke said they’d start “tapering” monthly asset purchases once unemployment drops to 7%. The unemployment rate is inching toward this target, but other factors might give the Fed pause. For instance, the low labor force participation rate leads many to believe unemployment has fallen primarily because folks have given up their job search and left the workforce. If these “discouraged” people were officially counted as unemployed, the headline unemployment rate would be higher—and more “stimulus” necessary. Sure, perhaps the Fed will look a tad deeper and see the total labor force is a hair away from all-time highs and total payrolls are 6.5 million higher than in September 2009. Better still, perhaps they see that number would be even higher without 1.1 million public-sector job cuts since May 2010—hardly evidence of a sluggish economy. Then again, these are the same folks who seem to think flattening the yield curve gooses growth, ignoring decades of evidence otherwise.

Of course, attempting to predict what the Fed will likely do—based on any one data point, many data points, forward guidance or the length of Bernanke’s beard—is fraught with peril. Not just because the September jobs report was likely influenced by the government shutdown and all those federal workers filing for unemployment, though that certainly doesn’t help matters (speaking of which, perhaps we shouldn’t get too jazzed if November’s report looks spectacular—all those furloughed folks going back to work probably muddies the waters). Rather, it’s because Fed decisions aren’t gameable market functions. This would be true of any Fed—how a 12-person committee will interpret and choose to act on economic data is anyone’s guess. But it’s even more true of this Fed. To assume one can divine their next move from forward guidance and economic data is to assume their decisions follow logic. To date, they haven’t. Why would they start now?

Ideally, the Fed would put the kibosh on QE at next week’s meeting—even if they believe the economy needs more stimulus, ending QE is the perfect way to give it a shot in the arm. QE isn’t stimulus—it’s a sedative. By purchasing well over $1.5 trillion in long-dated Treasurys and agency mortgage-backed securities, the Fed reduced long-term interest rates. This sounds great—cheaper loans for you and us! Except for banks, it isn’t—and banks control loan growth. Because short rates are pegged near zero, lower long rates flattens the yield spread—and since banks borrow at short-term rates and lend at long-term rates, skinnier spreads mean skinnier profit margins. A disincentive. Hence why loan growth is the weakest of the past five expansions and broad money supply growth lackluster even though the monetary base has risen over 250% since QE began in October 2008.

Similarly, the end of QE should be a boon to the economy. Without Fed pressure, long-term interest rates likely increase, steepening the yield curve and incentivizing banks to lend more enthusiastically. Then, finally, a bit more of the massive excess reserves created through QE should start leaking out—though, lest you fret runaway inflation, we wouldn’t expect banks draw down all of their excess reserves. Not when they need them to meet Basel III’s higher regulatory capital requirements.

Whether the Fed tapers sooner or later, though, stocks have plenty of fuel. Leading Economic Indexes in the US and globally are high and rising, sentiment is very guarded, and political gridlock is firmly in place—the chance market-roiling extreme legislation passes is practically nil. Sure, employment data don’t look rosy, but those are backward-looking—job gains are a function of past growth. They say nothing about the future. More forward-looking, fundamentals suggest the bull market likely has further to run.