Since the global financial crisis, central banks around the world have been forced to take dramatic and unprecedented actions to stabilize markets and shore up faltering economies. As a result, a high degree of global monetary policy accommodation has been part of our economic landscape for years, and likely will remain so for some time.
That said, a wide variety of asset classes are beginning to show signs of disconnect from fundamental valuation underpinnings as a result of these policies, and it's increasingly clear that policy actions are starting to distort fixed-income markets in particular. Moreover, in the U.S., the Federal Reserve is unlikely to achieve its stated labor market goal of 6.5% unemployment any time soon, largely due to structural trends that hamper rapid employment recovery. Therefore, and perhaps ironically, the Fed's policy goals might be better served over the medium term if the central bank were to slowly begin reducing its quantitative easing program and allow interest rate markets to begin a process of normalization.
There is little question that in the aftermath of the financial crisis the Fed's zero-interest-rate policy, its alphabet soup of emergency liquidity programs and its early rounds of quantitative easing combined to help stave off an economic disaster much worse than that experienced. Also, in the absence of fiscal support due to political paralysis in Washington, the Fed's asset purchases have bolstered markets through the eurozone crisis and other troubles.
Nevertheless, we have now arrived at a point in which household debt levels in the U.S. are moving closer to historic norms, nominal gross domestic product is growing, household net worth has dramatically recovered from crisis lows, and corporate earnings and margins are strong. Further, the original site of financial crisis trouble, the housing sector, appears to be staging a legitimate rebound, and indeed median home price affordability has come back to its longer term, or 1981-2000, average. From this standpoint, the Fed's desire for a continued wealth effect might prove counterproductive, as it risks excessively distorting markets through asset price inflation and it hampers true price discovery mechanisms.
Fed policy has had a distorting effect on capital allocation decisions of all kinds at virtually every level of the economy, from corporate treasury departments and pension funds, which have either had to take greater risks to meet their return targets or risk facing negative returns after inflation in purportedly safe assets, to households attempting to save for future liabilities. Beyond capital flow distortions, I have long argued that Fed policy is having a significant impact on bond market supply-and-demand dynamics. This impact is most obvious in sectors such as U.S. agency mortgage-backed securities, where Fed purchasing in recent months has comprised between 40% and 60% of the gross issuance in that segment of the market, but dislocations can also be seen in a variety of other sectors. Generally speaking, demand for fixed-income assets has continued to be strong, but net supply remains relatively low, particularly when accounting for Fed purchases. Moreover, a greater degree of interest-rate risk has crept into commonly tracked bond market benchmarks, adding risks to portfolios in exchange for meager compensation.
Still, what is the ultimate payoff for the price of potentially distorted markets? Will the Fed's stated goal of improving labor market conditions be met as a result of its policies?
Unfortunately, I do not believe current policy will aid in resolving job market struggles more than at the margin. The U.S. labor market recovery suffers not merely from uncertainty, or from lack of sufficient aggregate demand, as contended by many, but rather it faces an array of structural headwinds that are likely to be overcome only in time. For example, most of the payroll gains witnessed since the beginning of the labor market recovery have come in sectors not directly affected by the financial crisis, whereas the sectors of the economy most directly disrupted have struggled to adjust to the new environment. And while the economy grows and labor markets slowly improve, the labor force should also expand at a clip that might keep the unemployment rate unusually high and the Fed accommodative for too long.
Additionally, demographic and educational misalignments also hamper rapid labor market healing. Indeed, since September 2007, the cumulative change in labor force participation rates has dropped by more than 8% for the cohort aged 16 to 24 years, while it has increased by nearly 4% for those aged 55 and older. Thus, younger workers are being crowded out of the labor force, in part due to a mismatch between the skills they offer and those the labor markets require. Further, while higher levels of education are certainly vital for improving employment prospects, there is a degree of inefficiency to the process of retraining workers, which often takes years. Finally, due to factors such as technological advancement and globalization, U.S. companies are operating much more efficiently today than in the past, limiting the need for workers. We have thus witnessed a breakdown in the correlation between corporate profits and private employment that holds major implications for labor market recovery.
As a result, the Fed might be more effective in advancing its labor market goals by slowly reducing its quantitative-easing purchases, initially to around half the current level of roughly $85 billion a month, which would create more normalcy in markets, the currency and, ultimately, in economic conditions. A statement that assured markets that the larger amounts of stimulus would be resumed, if weaker economic conditions became more apparent, would dampen any tangible market concerns of the Fed's clear commitment to long-term growth and full employment.
I don't believe that QE should be removed in a manner that is likely to destabilize markets, particularly since inflation concerns have not materialized to force the Fed's hand and policy rate levels will likely remain low for years. Still, moving in this direction is important, since as Ben S. Bernanke, chairman of the Federal Reserve board of governors, himself conceded in his December Federal Open Market Committee news conference, further QE purchasing could in fact increase the risks to financial system stability, and we believe the investment stresses and excesses that are beginning to manifest themselves are testimony to that conclusion.
Rick Rieder is chief investment strategist for fundamental fixed income and co-head of Americas fixed income at BlackRock, New York.
