VERSACE: Making sense of Fed keeping interest rates low

ANALYSIS/OPINION:

Compared to the initial weeks of 2012, this week was chock-full of activity from a pickup in corporate earnings, Republican presidential candidate debates, the State of the Union address, economic forecast updates and, of course, the latest economic data. While we get to what all of this means in a bit, it would be remiss of me not to mention that this week the Dow Jones Industrial Average rallied to its highest level in more than three years and is up 4.9 percent so far this year. By comparison, the Nasdaq Composite Index is up 8.5 percent while the S&P 500 climbed 5.8 percent on a similar basis as I write this.

Sounds good, right?

On its face it sure does, particularly after the lackluster performance of the stock market in 2011. Domestic economic data has been improving as reflected by Thursday’s durable goods orders. While still relatively high, weekly jobless claims have been under the 400,000 level for a number of weeks now. Good, but not robust, is my take.

Yet, this week the Federal Reserve’s Federal Open Market Committee shared expectations to keep short-term interest rates near zero “at least through late 2014,” which is longer than previously stated. Of course that helped propel the stock market higher on Wednesday, but it does pose the question as to why the Fed feels the need to keep those rates that low for that long.

Could it be the Fed does not see a meaningful pickup in domestic economic activity and job creation as it gazes out over the next few quarters? Possible, if not probable, given recessionary concerns in Europe that have led to a number of revisions of projected global economic growth in 2012. Following a pullback by the World Bank of its economic outlook last week, the International Monetary Fund reduced its forecast for global growth this year to 3.3 percent from the 4 percent it projected just three months ago. Driving the negative revision, the IMF sees the seven-nation eurozone slipping into a mild recession this year. This downward adjustment and the associated ripple effect led to lower growth expectations for Asia as well. Of note there, the IMF cut its growth projection for Japan, the third largest economy, to 1.7 percent — down from its prior forecast of 2.3 percent.

On the domestic front, the IMF has been taking note of the improving but still less than robust economic data of late and continues to see the U.S. economy growing at 1.8 percent this year. That forecast is in line with that of the Conference Board, which is somewhat good news. Breaking down the Conference Board’s forecast, however, reveals the expectation for domestic economic growth in coming quarters to be slower than it was in the fourth quarter of 2011.

More specifically, the Conference Board sees the first quarter of 2012’s gross domestic product up 1.3 percent, rising to 1.6 percent in the second quarter of 2012 and averaging 1.8 percent in the second half of 2012. While the Conference Board sees a strengthening economy in 2013, its 2.2 percent growth forecast remains far slower than the GDP reading of 2.8 percent for the fourth quarter of 2011.

Reading between the lines, this suggests that despite the better economic data in December and January, expected data in the coming weeks is likely to paint a slower picture for the U.S. economy. It follows then that as the investor saying that perception is reality, the stock market and its indices are likely to hit a bumpy road in the latter half of the current quarter.

With that adjusted perspective as well as the continued overhang on the housing market, which includes weak housing starts and 1.89 million homes on the market at the end of December, the Fed’s plan to keep rates low for as long as it now expects to is far less surprising.

• Chris Versace, the Thematic Investor, is director of research at Think 20/20, an independent equity-research and corporate-access firm in the Washington, D.C., area. He can be reached at cversace@washingtontimes.com. Follow him on Twitter @ChrisJVersace. At the time of publication, Mr. Versace had no positions in companies mentioned; however, positions can change.