The Economy Cannot Live on the Fed Alone
Allianz Global Investors
By Kristina Hooper
June 11, 2012
Stocks rebounded from recent losses as the Fed’s pledge to take action and China’s surprise rate cut helped ease anxiety over Europe and unemployment. But the path to economic recovery cannot be paved by monetary policy alone—it must be accompanied by greater access to credit.
It was a “risk-on” environment last week with the Dow Jones Industrial Average and the S&P 500 both gaining more than 3.5%. Small-cap and tech stocks fared even better, with the Russell 2000 and the Nasdaq Composite increasing more than 4%, respectively. Investors moved off the ledge a bit, enabling the yield on the 10-year Treasury to rise to 1.640%.
However, investors’ willingness to embrace risk was not so much based on fundamentals but instead on hopes of intervention, particularly by central banks. In testimony before Congress this week, Federal Reserve Chairman Ben Bernanke expressed his concerns about downside risks to the economy but fueled optimism with his intimation that the Fed stands ready to intervene.
But hopes for intervention were not limited to just the United States. Stocks got a boost from news that Spain would receive a significant bailout from the euro zone—once the extent of the country’s liabilities are better understood. The $125 billion rescue package should help alleviate uncertainty created by the lack of transparency on bad loans in Spain’s banking sector. To gain visibility on the issue, Spain hired independent management consultants, Oliver Wyman and Ronald Berger, which will release their initial stress test results on June 21.
The stock market also got a shot in the arm from the People’s Bank of China, which cut interest rates by 25 basis points. The surprise move was widely viewed as a pro-markets gesture. Interestingly, investors ignored the implications that a surprise rate cut could signal that Chinese policymakers are more concerned about the country’s economic slowdown than previously acknowledged. Still, China’s economic data for May showed a continuation in the easing of inflationary pressures. Industrial production and retail sales disappointed, while the only real positive sign was the rebound in exports.
It’s a (Liquidity) Trap
But while some economists are calling for the Fed to use more monetary tools such as an extension of Operation Twist, monetary policy is only part of the formula. Rates can be kept low for years, but without looser credit standards they cannot be truly potent and stimulative. Of course, monetary policy is not just impacted by the lack of availability of credit, but also by the lack of demand for credit due to uncertainty on economic growth. For example, consumer credit in April grew at a much slower pace, largely attributed to the job market and slow income growth. However, in the U.S., the problem seems to be more of a credit-supply issue than a lack of demand.
In fact, in his testimony last week, Chairman Bernanke signaled the need for more flexible credit standards: “Lending terms and standards have generally become less restrictive in recent quarters, although some borrowers, such as small businesses and…potential homebuyers with less-than-perfect credit, still report difficulties in obtaining loans.”
In many respects, small businesses hold the key to a cyclical rebound in U.S. economic activity. A combination of looser credit standards for these borrowers and their willingness to borrow, would be an unequivocally positive indication for risk assets. At the same time, consumers would also receive an enormous boost: If homeowners with “underwater” mortgages and mediocre credit scores were able to avail themselves of lower interest rates and refinance, then it could jumpstart the economy.
It seems that banks will need to do their part for monetary policy to be effective. In particular, their emphasis on offering capital to a larger number of small businesses and enabling more homeowners to refinance their mortgages—or even purchase new homes—is a key ingredient of economic growth efforts that will help keep us out of a liquidity trap.
Kristina Hooper, CFP®, CIMA®, is head of portfolio strategies at Allianz Global Investors Distributors LLC.
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