For all the excitement earlier this week about the Federal Reserve’s response to deteriorating economic conditions, investors finally seem to have come around to a more realistic view of the Fed’s powers – that the central bank has a limited effect next to the awesome force of a global economic slowdown.
The S&P 500 had risen about 6 per cent in the two weeks prior to the Fed’s monetary policy statement, released on Wednesday, with markets apparently psyched that another round of monetary stimulus would be just the thing to get the recovery back on track.
Since then, stocks have turned volatile – and that’s with an extension of the Fed’s so-called Operation Twist program to the end of the year and a clear promise to do more should conditions continue to deteriorate.
“The continuation of Operation Twist will not be enough to transform a mediocre economic recovery into a typical business cycle upturn,” said John Lonski, chief economist at Moody’s Capital Markets Research Group.
At best, the program – which involves selling short-term bonds and buying longer-term bonds – will give the U.S. and global economies a “valuable buoyancy,” he argues in a note. But in all likelihood, “financial markets may have earlier overestimated the benefits that are likely to flow from not only the extension of Operation Twist, but the possible introduction of additional forms of extraordinary monetary support by the Federal Reserve.”
The latter would be a withering reference to quantitative easing, or QE3, considered among many observers to be the Fed’s best stimulative option. In other words, Mr. Lonski sees the Fed as being relatively toothless as it faces down stumbling global economy.
Europe’s manufacturing sector is contracting. He expects that global manufacturing, as represented by purchasing managers indexes, will dip below a reading of 52 in the second half of this year – a level normally associated with global economic growth of 3.1 per cent, or well below the average of most of the past decade during economic expansions.
“Thus, both internationally and domestically, U.S. businesses cannot escape the drag of subpar growth by aggregate expenditures,” he said.
Mr. Lonski notes that the recent sharp decline in base metals prices also indicates that global industrial activity is grinding lower. A preliminary estimate of Moody’s industrial metals price index is at its lowest level in nearly two years. At the same time, the price of crude oil has slumped below $80 (U.S.) a barrel, to its lowest level since October 2011.
Yes, that could translate into lower gas prices at the pump, but Mr. Lonski argues that U.S. gasoline prices would have to fall further – to about $3.25 a gallon – to spur any meaningful improvement in domestic spending.
“A stabilization of the situation in Europe would go far at lessening risk aversion globally,” he said. “But, unless the 10-year government bond yields of Italy and Spain sink by at least 1.5 percentage points, markets will remain on edge.”