The Fed Fires Another Blank

Today's readers of the Fed tea leaves were not impressed, as the market decline continued into day two. To paraphrase the press release code, the recovery is underwhelming. Macquarie Asia economist Richard Jerran, quoted in the Wall Street Journal, cites a very interesting paper by Hiroshi Ugai, "Effects of the Quantitative Easing Policy," which draws eerie parallels between the actions of the Bank of Japan (BOJ) in the aftermath of the late 1990's crisis and the current actions of the Fed.


From March of 2001 through March of 2006, the BOJ substantially increased the monetary base by increasing the current account balances (CAB) held by member banks with the BOJ through increasingly massive monthly purchases of securities. Incidentally, JP Morgan estimates that the Fed will account for 15% of Treasury demand as a result of the latest policy guidelines.

At the same time, BOJ made a decisive commitment to a zero interest rate policy (ZIRP) until the day that the CPI stopped declining. Although the Japanese economy showed several, short-lived recovery episodes, prices declined continuously from 1998 until the autumn of 2005.


Instead, Ugai concludes that the real benefit from the BOJ policy was not due to quantitative easing at all, but to the ZIRP, or commitment to keeping interest rates low indefinitely. We know that the Fed has studied the Great Depression, but perhaps the better analogy now would be the Japanese experience.


It was troubling to read in the Fed press release that lending by banks "has continued to contract."

Looking at corporate results from Cisco, which exceeded earnings expectations, we see that revenue was below Street expectations. This in spite of the fact that economic statistics, though reported with a lag, show double-digit year-over-year spending increases for equipment and software.

CIO's Michael Cembalest and Hans Olsen of JP Morgan's private banking group make a very telling point about what's driving the current profit recovery. They note that corporate profits have beaten expectations for the past five quarters. At this stage in the recovery, a 5% growth rate would reflect nominal GDP growth in excess of rising unit labor costs. However, the current profit rebound comes from declining labor costs, low real wage growth and sustained high labor productivity. The JP Morgan team believes that this kind of engine for recovery should not command a very high P/E multiple because it is not sustainable. The latest readings on productivity, the slowing of export growth, and weakness in Britain and Germany all reinforce the notion of a lower market multiple.

The JP Morgan team point out that macroeconomic trends are unusually important in evaluating investments in the current world economic cycle, and we agree.