Markets & Economy
The Fed's great unwind
August 12, 2013
Catherine Gordon: Hi, I'm Catherine Gordon at Vanguard's headquarters in Pennsylvania. Welcome to today's program where we'll discuss the challenge that the Federal Reserve and other central banks face in stimulating growth without triggering high inflation. Joining us is Joe Davis, Vanguard's chief economist. We'll also hear from Roger Aliaga-Díaz, our economist in Asia, who is in our Melbourne, Australia, office. Joe, thanks for being here today.
Joe Davis: Thank you, Catherine. My pleasure.
Catherine Gordon: So Joe, the U.S. economy appears to be in better shape than most other major economies, is that an accurate perception?
Joe Davis: Sure. Happiness is always relative. Certainly at the beginning of the year, our outlook was an expectation where the United States was going to grow in a more resilient fashion than other parts of the developed world, and I think that's been the case. Nevertheless, it has been an outlook, an expectation, of modest but uneven growth. And we're seeing that even through this summer, where the data has been mixed on the United States front.
We're seeing strength, continued strength in housing and parts of the consumer sector, but then we're seeing weakness given global headwinds in trade as well as the federal government in the sequestration effect.
So it's mixed, but it's still closer to a 2% outlook for growth, for real GDP growth, that we saw at the beginning of the year. And importantly, job growth has remained resilient in the face of some of this recent weakness, and I think that's important because all else equal, the U.S. is closer today than perhaps where we were two years ago in what we would call . . . achieving escape velocity, which means entering a self-sustaining recovery. We're not there yet. To do that, we need to generate growth of 3% or more. I think the odds are more likely that next year, we could generate that, rather than this year.
Catherine Gordon: Looking beyond the United States, we talked recently with Vanguard's economist in Asia, Roger Aliaga-Díaz. He was unable to join us today, but we did get to record his thoughts from Vanguard's office in Melbourne, Australia. We asked Roger how Europe and Japan are doing lately in their efforts to stimulate growth.
Roger Aliaga-Díaz: Well, in terms of Europe, there have been some positive signs in the form of a slower base of contraction, moderating recession, so good news already to what was expected but clearly still a very weak growth environment. We may see some modest positive growth toward the end of the year and next year but not in the periphery. In Japan, on the contrary, the sharp change in direction announced by the recent administration has been well received by the markets. Soft indicators such as business sentiment, consumer confidence, are all at levels not seen for a long time; in that sense there has been some progress. We have yet to see more evidence of hard indicators, hard economic data, as consumer spending and industrial production are picking up at levels that are consistent with the ambitious goals set by this administration.
Catherine Gordon: Joe, if we talk about monetary policies, how would you compare the effectiveness of the monetary policies of the U.S., European, and Japanese central banks?
Joe Davis: Well, I think in many ways for the past several years, our view was that, quite frankly, other central banks were going to follow in the steps of the United States Federal Reserve, and I think we've actually seen that, particularly more recently with the Bank of Japan. I think broadly speaking, there are some positives from the actions the Federal Reserve has taken. But clearly Vanguard as a firm has also had concerns in, quite frankly, Catherine, how potentially successful the influence has been of central bank policy on the financial markets, investors taking on more risk, and so forth. And so I think it's good news that the Federal Reserve is now contemplating the gradual unwind(ing) of their balance sheet, and ultimately, in perhaps two years' time, higher short-term interest rates. But there have been concerns that have come with some of the success of central bank policy.
Catherine Gordon: We also asked Roger about the effectiveness of monetary policies, and here's what he had to say.
Roger Aliaga-Díaz: Well, the case of Japan is a little bit different, they have obviously announced a very aggressive monetary policy that matches the Fed, but they have to basically fight the expectations of deflation. They have been stuck for a long time in a deflationary trap, so clearly their 60-to-70-trillion-dollar yen purchases they have announced are understandable given those challenges. In the case of Europe, that case is interesting, but the European Central Bank as well as the Bank of England have both announced or issued, recently, forward guidance. This is something the Fed has been doing for a time now, and it consists of announcing publicly the plans for how long they are going to keep rates at a certain level. With the recent increase in rates, those central banks in Europe have found understanding that their stands for monetary policy have become too restrictive, so they felt the need to push back on the markets to restore an expectation for low rates at their original levels.
Note: Quantitative easing refers to the monetary policy in which the Federal Reserve purchases securities, including bonds, in an effort to increase the money supply.
Joe Davis: The one thing I would just add, Catherine, is I think there's been a lot of conversation recently about the tapering of quantitative easing, this so-called third round, or QE3, from the Federal Reserve. There's, quite frankly, a great deal of consternation—in the fixed income markets—as to, does that imply quickly thereafter a market rise in short-term interest rates? And I think it's a clear message in our mind that tapering, so to speak, slowing down the rate of purchases of the Federal Reserve, does not equal tightening, right? So tightening could very well, in terms of raising short-term interest rates, be much further out, in our estimation, most likely around the year 2015. So even though they may not continue to add new additional purchases to their balance sheet, it may be still a considerable period before we're talking about higher short-term interest rates.
Catherine Gordon: So Joe, to wrap things up, with so much uncertainty still in the economy and the economic environment, are there any stock or bond markets around the world that investors should avoid at this point?
Joe Davis: I think it's always important just to keep in mind our asset allocation, how we're thinking about longer term, Catherine. Initial conditions matter, and so we talked about the investment outlook for the next several years. At the beginning of the year, we, as a firm, remained positive in terms of the probability or the odds of achieving a decent historical-like equity return in the high single-digit range. In fact, this year it's already been well above that . . . which is not surprising, that you're going to get any one year significant deviations from that long-term outlook. But it's been a positive outlook. So I think it's still . . . I think a good practice or a good baseline . . . to stay globally diversified. There's always going to be pockets of weakness. There's going to be positive aspects, (or) positive surprises. The United States has been one over the past several years. I think with fixed income, we continue to remain consistent in our message of low, muted bond returns with an elevated, although temporary, period of loss, and we've seen that in parts of the fixed income markets, per se.
I think at the end, it's trying to think about looking beyond the headlines and try to be—all of us—to be a voice of reason as well as a voice of caution. So your question was one of caution, Catherine, but I also see areas where perhaps there's perhaps too much pessimism for long-term investors. A great example is the concern now in emerging markets, in the same way that several years ago, the outlook we maintained for U.S. stocks was a formative one, despite the low expected economic growth. In the same way now, in emerging markets, growth expectations continue to come down, and there are headwinds, but nevertheless valuations—or the price paid for future growth—is arguably among the lowest it's been in a decade. So if anything, the outlook for global equity markets and emerging markets has become somewhat brighter.
Catherine Gordon: Joe, thanks for your insights today. And we appreciate hearing from Roger Aliaga-Díaz in Melbourne. And thanks to all of you for watching. We hope that you'll join us again for our next discussion of economic trends around the world.
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Investments in bonds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
Quantitative easing refers to the monetary policy in which the Federal Reserve purchases securities, including bonds, in an effort to increase the money supply.
© 2013 The Vanguard Group, Inc. All rights reserved.
A conversation with Vanguard economists Joe Davis and Roger Aliaga-Díaz
The world's major economies face a common problem—how to build momentum toward sustainable growth even as high debt levels continue to limit increased spending.
Vanguard Chief Economist Joseph H. Davis, Ph.D., and our senior economist in Asia, Roger Aliaga-Díaz, Ph.D., discuss the challenge that the Federal Reserve and other central banks face in stimulating growth without triggering high inflation.
- All investing is subject to risk, including the possible loss of the money you invest.