William RutherfordFear lingers as worry of a double dip fades. What can the Federal Reserve do? The past quarter brought numerous gloomy headlines. The specter of a double-dip recession, a depression or inflation loomed.

Each day seemed to bring more negative news and reason for gloom. Not surprisingly, markets reacted, and after a strong July, equity markets dipped in August to an overall minus number for the year. It did not help that investors withdrew about $34 billion from equity mutual funds for the year and placed $32 billion into international and emerging market funds, or that the “flash crash” of May 6 caused many investors to wonder if they were playing with a stacked deck.

Job losses continued to mount last month with the unemployment rate hitting 9.6 percent. The Obama administration took solace in the fact that the private sector in August added 67,000 jobs – about one fourth of the number needed to provide jobs for new entrants into the workforce.
The question the market seems to be wrestling with is: Are we about to experience a “new normal” for growth in the U.S.?

Historically, on average, the U.S. economy has grown about 3 percent per year – also about the rate of inflation. Bonds have historically returned the rate of inflation plus 3 percent, for a total of 6 percent. Equities have historically returned about 9 percent.

As every investor knows, the last 10 years have been anything but normal, and the U.S. economy seems to be growing less than normal. Is this the “new normal”? Should we expect less than 3 percent growth, or even none? Is the structural growth rate of the U.S. economy lower now than historically? The answer has big implications for investors.

Both the equity and fixed-income markets seem to agree that the new rate of growth will be significantly lower. Based on cash flows, the U.S. equity markets have been significantly cheaper only three times before the present. The markets have concluded that the growth rate going forward is 2 percent or less. But what happens if the markets are wrong? The markets have a tendency to overreact. Are we indeed experiencing a “bond bubble”? What happens if the growth rate for the economy is greater than 2 percent? The bond market will crash and equities will rise. The catalyst for such a “return to the mean” could be the upcoming election.

There is a strong inverse relationship between government spending and economic growth. There are many reasons that support this notion such as more government leading to more regulation of the private sector and government spending providing no internal growth. If the upcoming elections form a Congress able to reduce the rate of government spending, then we might see a redeployment of capital from the fixed-income markets to the equity markets.

In 1994, a big shakeup in Congress led to a significant rally in equity markets. On the other hand, if the current expansion of U.S. government continues, we will likely see stronger bond markets and a repeat of the last two decades in Japan. However, government now provides 30 cents out of every $1 earned in the U.S. today; the prior peak was 28 cents in 1975, so any cutbacks will not come easily. The gloom and doom of the second quarter masked some positive trends in the U.S. economy. Demand growth posted its strongest quarterly rate since the recession began, and it has accelerated faster than the two previous recoveries. Income grew at a 3 percent rate, the fastest pace yet in this recovery, largely due to increased hours worked. Wages rose at a 3 percent rate and small business profits increased twice as fast.

The housing market is in a healing mode. The inventory of new homes has plunged in the last few years from 550,000 units to 200,000. A rough calculation indicates that the U.S. has shed some $50 billion in new home inventories over the past five quarters, with $510 billion remaining today. That suggests that the new housing inventory should settle by fall 2011. Because new homes typically make up about 67 percent of home inventory, with a six-month lead, this would suggest a drop in the inventory of existing homes.

Ben Bernanke describes the outlook for the U.S economy as “unusually uncertain.” With interest rates at .25 percent, what tools for growth does the Federal Reserve have? The Fed has pursued an unusually accommodative interest-rate policy for an extended time; however, the economy is still “uncertain.” Re-enter quantitative easing.

In March 2009, the Fed announced that it would buy long-term treasuries to push down interest rates further; this process was called quantitative easing. The idea is to put more money into circulation, forcing lower interest rates, and putting pressure on banks to lend. The Fed has already begun this process by increasing the money supply. It also has announced that it will use proceeds from repayments on its balance sheet to buy more Treasuries, but it could be more aggressive by simply
printing money, and we believe it will.

Furthermore, the Fed could reduce the amount it pays banks for money on deposit at the Fed to zero. Banks are quite willing to leave their trillions of dollars on deposit with the Fed for 25 basis points. The banks take no risk, but borrowers see no money. Perhaps a rate of zero or even a negative rate, a charge for deposits, would flush out some money.

Things are not as bleak as they seem. The economy is healing slowly. We do not face the threat of inflation. The Fed will move to block deflation. If we can get Washington to get out of the way, we might just see some growth.