Why The Fed Is Too Bullish And Tapering Fears Are Overdone

From private sector forecasts to the IMF, the Fed sees a rosier economy than most which could mean that tapering fears are overdone and that stimulative policies are going nowhere anytime soon.

Markets have plunged in the face of the Federal Reserve's latest statement, in which the Federal Open Market Committee appeared more hawkish, or afraid of inflation, than at any time in recent past. However, tapering fears may actually be overdone despite market fears and the recent collapse of risk markets globally could be the much-needed healthy correction for which many have been calling.

Competing Growth Forecasts

The FOMC updated its economic forecasts on Wednesday as it does at the end of every quarter. The policy setting committee lowered its "central tendency" forecast for real GDP growth to between 2.3 percent and 2.6 percent for 2013. In March, the FOMC had predicted GDP growth of between 2.3 and 2.8 percent, meaning that they a slightly more bearish upside in the base case for the economy.

For example, FedEx FDX, the global shipping and logistics company, this week noted that it sees GDP growth for 2013 in the U.S. at 2.3 percent, the lower end of the Fed's range. FedEx operates across the country and across the world and has a keen eye on the health of the global economy. Before the global economy began to slow in 2007, they noted that they saw negative signals int he global economy and were some of the first to feel its effects.

Further, the International Monetary Fund in April's World Economic Outlook that it expects the U.S. economy to grow a mere 1.9 percent in 2013, well below both the FOMC and FedEx's forecasts. In recent years, the IMF has been more bearish than central banks or governments only to see the central banks and governments revise forecasts lower.

Meanwhile, a poll of Wall Street economists by Bloomberg revealed recently that the consensus forecast for 2013 GDP growth on Wall Street is 1.9 percent, in line with the IMF's "bearish" forecast and below the FOMC. Therefore, who is right? How much will the economy grow? What does this mean for the stock market?

Inflation the Difference?

The difference in these forecasts could boil down to inflation. Although the Fed forecasts a different measure of inflation compared to the IMF and to Wall Street forecasts, the differences between the Fed's inflation metric, the PCE, and the more familiar CPI are small although the CPI does tend to show slightly higher levels of inflation than the PCE, but only marginally so over long periods of time.

By adding the real GDP forecast and the inflation forecast, one can extrapolate the nominal GDP forecast for each of three groups and potentially see the differences in the forecasts. The forecasts are as follows:

• Federal Reserve: Real GDP of 2.45 percent (middle of range) + inflation of 1.0 percent (again, middle of range) = 3.45 percent nominal GDP growth.


• IMF: Real GDP growth of 1.9 percent + inflation of 1.8 percent = 3.7 percent nominal GDP growth.


• Wall Street: Real GDP growth of 1.9 percent + inflation of 1.5 percent = 3.4 percent.

The forecasts thus reveal that the Fed and Wall Street see nominal GDP roughly at the same level, around 3.4 percent, however the IMF sees nominal GDP growth higher at 3.7 percent. This difference is due to the inflation forecasts: if the IMF's inflation forecast were more in line with Wall Street, then so would its nominal GDP forecast. Therefore, the IMF's inflation forecast may actually be too high and could be revised lower in the October update to the WEO (the report is only issued twice a year).

Low Inflation Is Positive For Stocks

For a while, stock market junkies were selling the idea that low inflation was bad for stocks and that higher inflation would mean that people would invest in stocks as an inflation hedge. This idea has actually been refuted by numerous studies, including one done by Credit Suisse last summer which showed that equities only benefit from inflation in "normal" inflation scenarios of between about 1.5-3.5 percent when companies can still operate without margins being squeezed.

However, low levels of inflation mean that there is slack in the economy. Slack in the economy, as defined by the aggregate demand/aggregate supply model, means that there is room for the economy to grow with low levels of inflation. However, modern theories also imply that inflation is partially a psychological phenomenon where low inflation expectations lead to low inflation leading to lower inflation expectations and so on. This is the exact type of phenomenon that Bernanke tried to avoid in his three rounds of QE, learning from examples including the Great Depression and the Japanese asset bubble collapse.

If the Fed's real GDP growth forecast ends up more in line with Wall Street forecasts, the question will be if it is due to inflation rising or underlying growth slowing. If its the latter, and inflation stays low, forget tapering.

More QE?

Inflation expectations priced into the market have declined noticeably in recent weeks. As the chart below shows, the market expectation of inflation over the next 12 months has plunged in recent weeks. The market now only predicts about 0.55 percent inflation over the next 12 months, as measured by the breakeven rate (the nominal bond yield less the inflation adjusted bond yield). Therefore, there may be further downside to inflation; and if this is the case, the Fed may HAVE TO DO MORE, NOT LESS.

That's right. Remember, the Fed said, "The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives."

Tapering is contingent on an improvement in growth and employment OR an uptick in inflation. Should inflation slow, a phenomenon known as disinflation, then the Fed has said it will do more. Purchases could increase rather than see the Fed taper.