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Taper Hits Bonds and Stocks But Growth Accelerates

Irwin M. Stelzer

The bad news is that there is good news. At least, that’s how many skittish investors in shares and bonds see the increasingly cheery view of the Federal Reserve Board’s monetary policy gurus who concluded last week that downside risk to the economy has diminished since the Fall, and guessed that by the middle of next year the unemployment rate will have fallen from its current level of 7.6 percent to 7 percent, and then to between 6.8 percent and 6.5 percent by the end of 2014. If the 7 percent level is reached and the trend is downward by mid-2014, Fed chairman Ben Bernanke might end the $85 billion monthly asset purchases that have tripled the Fed’s balance sheet. Meanwhile, he will “taper” reduce his buying. Those who regularly study the entrails of Fed forecasts fall into three groups.

  • Some Fed-watchers expect the taper to cut monthly buying by about $20 billion, starting in September;
  • Others believe the taper won’t begin until December, after Bernanke sees the third-quarter GDP estimates;
  • And a cautious few point to the chairman’s statement that his decision will depend on incoming data which, if they show a slowdown in the economy, or that tapering is causing a dangerous market upheaval, might prompt him to step up rather than cut back on bond-buying.

The markets are betting on the first of these forecasts, or at least on the second. Even before the chairman confirmed the worst fears of bond holders, investors pulled almost $18 billion from bond funds in just two weeks, foreign private sellers prominent among those headed for the exits, if trends recorded in earlier months persist.

If you are interested in what all of this might mean for the performance of the economy, best to chalk this off to the madness of crowds, the lemming-like behavior of investors, irrational despondency. Not being an expert on short-term movements of stock and bond prices, I can’t say with certainty that the end of the week turmoil was mere sound and fury, signifying nothing. But as an economist I should raise the possibility that the fuss over the huge drop in share prices, and rise in interest rates that followed Bernanke’s reiteration of an oft-stated position concerning tapering, obscures the longer term prospects for the U.S. economy.

It is just possible that economic growth will accelerate, the Bernanke taper notwithstanding. For one thing, the economy has withstood the shock of tighter fiscal policy. The combined effect of tax increases and spending cuts has cut the deficit sharply, yet consumer buying, which accounts for two-thirds of total demand, was up 4.3 percent in May over last year’s level, perhaps buoyed by the rise in household wealth that is now higher than before the recession hit. But as is always the case, not all of the data point in one direction: Americans dipped into savings to pay for their purchases, among them the big-ticket items that go along with the purchase of new homes.

Which they have been buying in large numbers, such large numbers that construction of new homes rose as home builders, more confident than in years, rushed to fill the demand that shrinking inventories of already-built homes cannot satisfy. Over the past twelve months, total housing starts are up 28.6 percent, and single-family starts are up 16.3 percent. Applications for permits to build single-family homes are at their highest level since May 2008, suggesting that new construction is not likely to slow, a guess supported by the fact that small trucks favored by construction workers are flying off the dealers’ lots. Even so, many analysts point out that the recession-induced construction slowdown has left supply seriously lagging demand, so seriously that neither rising prices nor the Fed-induced upcreep in mortgage rates that has hammered builders’ shares is likely to slow demand. Estate agents from Phoenix to Washington, D.C. report selling homes only days after they come on the market, and this when fixed rates on 30-year mortgage have risen at the fastest pace since 2010, taking them from 3.35 percent early last month to above 4 percent now. So much for economic theory that tells us that rising interest rates will dampen the demand for housing. In fact, rising interest rates have been taken by potential home buyers as a signal to buy now to avoid further interest rate increasesmarkets are all about expectations.

In the longer run, reckon Zelman & Associates researchers, population growth will create a need for 14 million new housing units this decade, fewer than six million of which will be built by 2015. So for the rest of this decade there will be a market for two million homes per year, far more than the current rate of completions.

Perhaps even more important to anyone trying to decide whether America’s best days are behind it or lie ahead is the nation’s new-found energy affluence, due to the much reported and, to environmentalists, the much detested fracking process that is releasing large reserves of oil and natural gas from hitherto inaccessible shale formations. A funny thing happened on the way to President Obama’s fossil-fuel-free future. So much oil and gas has been discovered in the United States that crude imports are at a 15-year low, and by the end of the summer we will be producing more oil than we import, reversing a 20-year trend. Fears of running out of oil have been replaced with what is now called a “supply shock,” an almost 50 percent increase in domestic oil production in the past five years. Daniel Yergin, who won a Pulitzer Prize for his book on the oil industry, points out the fracking revolution has already created 1.7 million jobs in America. And likely to create still more as the manufacturing sector is boosted by the availability of cheap natural gas. The onshoring of manufacturing is not on a scale that will restore it to its previous relative position in the economy, not a bad thing given its cyclicality and the tendency of leading manufacturing companies to seek hidden subsidies such as a ban on the export of natural gas. But cheap energy can now be weighed against lower labor costs by corporations wondering where to plan the next round of expansion.

Then there is Silicon Valley, increasingly a generic term for the areas in which creative geniuses tend to congregate in the nation’s cities. These concentrations of talent produce teenage billionaires and a steady stream of innovations. A great intangible asset that countries such as the UK are attempting to emulate and countries such as China are attempting to steal, both with some success.

The recovery has survived the tax increases that conservatives predicted would doom it. It has survived the cuts in government spending that Obama predicted would slow it. It has survived the deficit-reducing austerity that the International Monetary Fundthe once-proud parent of austeritysays is “excessively rapid and ill-designed.” It will survive the tapered return to a more normal bond market.

The Brookings Institution’s George Perry sees no reason that “we cannot today be starting an expansion like that of the 1990s,” which lasted eight years and drove the unemployment rate down from 7.5 percent to 4 percent. That would be a nice capstone to Bernanke’s career as an innovative central banker.

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