The major central banks of the world have been easing their monetary policies significantly since the financial crisis of 2008. They’ve succeeded in averting another financial crisis so far. They’ve also succeeded in recovering most of the fortunes that were lost during the crisis. Equity investors have benefited from the stock market rally. Bond investors also enjoyed big gains as yields fell and prices rose. The 12-month average of the median existing home price is up 29% since February 2012.

Nevertheless, the central banks have been frustrated by the slow pace of the recoveries in their economies since the crisis of 2008. Reviving self-sustaining economic growth hasn’t been as easy as easing has been. The ultra-easy monetary policies of the central banks might perversely have contributed to the slow pace of economic growth. Yesterday, I listed several reasons why the Fed’s policies actually have contributed to the subpar pace of the US economic recovery. Allow me to further elaborate:

(1) Not much trickling down from the wealth effect. It is widely believed that many retail investors who left the stock market following the bursting of the Internet bubble and the bear market of 2007-2008 never returned. If so, the wealth effect from the current bull market in stocks hasn’t trickled down to most Americans.

(2) Forcing savers to save more. Savers have been forced to save more, and spend less, as a result of the Fed’s NZIRP (near-zero-interest-rate policy). The 12-month sum of personal saving has been running around $700 billion since the end of the financial crisis in 2008, double the pace during the 1990s and the first half of the previous decade.

(3) Enabling fiscal excesses. Last Friday, Fed Chair Janet Yellen said that one of the headwinds that the economy faced during the current recovery until recently was fiscal drag. That’s true, as measured by federal, state, and local government spending in the real GDP accounts. However, it’s hard to see any such fiscal austerity in the federal deficit, which reflects the need to finance all government spending, including entitlements, in excess of tax receipts.

The Fed has clearly enabled the federal government to run large deficits. Fed officials may deny that their QE programs have monetized the debt, but that’s exactly what they have done. The Fed’s balance sheet now has $2.46 trillion in Treasury securities. The effective cost of that debt to the Treasury is just 25bps since all interest earned by the Fed is returned to the Treasury less expenses, which mostly includes the 0.25% paid on bank reserves deposited at the Fed.

(4) Worsening income inequality. Fed Chair Yellen in a 10/17/14 speech said, “The extent of and continuing increase in inequality in the United States greatly concern me.” She is quite alarmed: “It is no secret that the past few decades of widening inequality can be summed up as significant income and wealth gains for those at the very top and stagnant living standards for the majority.” She doesn't acknowledge that the Fed’s policies might also be contributing to inequality. An important source of income for many senior citizens has been the interest they receive on their fixed-income securities. Income inequality has certainly been worsened by the fact that older people are living longer on less interest income.

(5) Misallocating capital. The Fed’s policies have led to significant misallocations of capital. As a result of the Frank-Dodd Act, the Fed and other banking regulators have forced the banks to tighten lending standards. At the same time, extremely low interest rates have allowed investors to raise lots of money in the capital markets to buy up distressed properties around the country. As a result, home prices have rebounded significantly over the past few years, reducing affordability for first-time home buyers. Corporate bond yields have been trading below the S&P 500’s forward earnings yield since 2004, providing companies with an incentive to buy back their shares and engage in M&A rather than invest in plant and equipment. Relatively weak business spending to expand payrolls and capacity has boosted profit margins; the S&P 500 margin rose to a record-high 10.4% last quarter. Buybacks boosted earnings per share.

The result has been a great bull market in stocks, largely reflecting financial engineering rather than healthy economic activity.

(Based on an excerpt from YRI Morning Briefing)

The song “Tiptoe Through the Tulips” was originally published in 1929, just before the Great Depression, and famously revived by Tiny Tim in 1968. Fed Chair Janet Yellen and her colleagues on the FOMC have been tiptoeing all year through the economy, hoping that it will grow fast enough to handle the first rate hike in nine years without triggering a financial calamity that sets off another Great Recession.

On Friday, Yellen gave a speech on the economic outlook, observing, “As you all know, the economy is still recovering from the Great Recession, the worst downturn since the terrible episode of the 1930s that inspired its name.” She doesn’t seem to believe that it is completely over, though saying that it “began more than seven years ago.” Let’s have a closer look at her views:

(1) Labor market is laboring. Surely, she must recognize that the labor market has fully recovered. She answered her own implicit question: “Are we there yet?” by only conceding that it is “approaching full strength.” She then accentuated the negatives, noting that too many people have dropped out of the labor force, too many working part-time want full-time jobs, and wage gains remain too low, running around an annual rate of 2%. Notice that she highlighted the wage inflation shown in average hourly earnings rather than the wage component in the Employment Cost Index, which rose 2.7% y/y during Q1, the highest since Q3-2008. While she did mention the latter in a footnote, Yellen is certainly tiptoeing.

(2) Some homes still underwater. She also said that the economy continues to face some “headwinds.” The housing crash left lots of households with less wealth and more debt, leaving many of them “underwater.” Maybe so, but the Fed’s own flow of funds data show that real estate held by households has increased in value by $4.5 trillion from Q2-2011 through Q4-2014 and that owners’ equity as a percentage of household real estate has rebounded from a record low of 36.9% during Q1-2009 to 54.5% during Q4-2014.

(3) Less fiscal drag. A second headwind that “is mostly behind us” is the decline in fiscal spending. In real GDP, federal spending seems to have stabilized over the past three quarters after falling 13% from Q3-2010 through Q2-2014. State and local spending has recovered very gradually after falling 8% from Q3-2009 through Q4-2012.

(4) Global weights. The third and final headwind in Yellen’s list is the weakness in the global economy. During most of the US recovery, the biggest overseas problem was the renewed recession in the Eurozone. Now it seems to be a slowdown in emerging economies, especially China. She indirectly mentioned that the strong dollar might also have weighed on US exports. However, this too should pass, in her opinion.

(5) Headwinds still blowing. In any event, monetary policy will remain accommodative. She said that “the headwinds facing our economy have not fully abated, and, as such, I expect that continued growth in employment and output will be moderate over the remainder of the year and beyond.” She thinks that residential investment “is likely to improve only gradually.” Business investment will continue to recover modestly, though energy capital spending is likely to be weak.

Yellen said it all adds up to real GDP growth of about “2-1/2% per year over the next couple of years.” Given that real GDP excluding government spending has been hovering around 3.0% since 2010, Yellen seems to believe that the headwinds will shave about a half a point from growth.

(6) One and done. The Fed chair then laid out the implications for monetary policy. She came close to saying that there will be just one rate hike this year:

For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy.

That is as long as the labor market continues to improve and she is “reasonably confident that inflation will move back to 2 percent over the medium term."

She should certainly be pleased to see that the four-week average of initial unemployment claims during the week of May 16 fell to the lowest since April 2000, indicating that the pace of firing remains very low. Last week’s CPI news for April should make Yellen reasonably confident about achieving her inflation goal.

(7) Tiptoeing for many years. Finally, Yellen reiterated that the process of monetary normalization may take a very long time:

If conditions develop as my colleagues and I expect, then the FOMC's objectives of maximum employment and price stability would best be achieved by proceeding cautiously, which I expect would mean that it will be several years before the federal funds rate would be back to its normal, longer-run level.

Yellen’s term as Fed chair expires on February 3, 2018. That might be how long the Fed continues to tiptoe—unless she is reappointed for another four-year term by the next US president.

In my opinion, the Fed’s tiptoeing has significantly contributed to the weakness of the current economic expansion:

(1) By keeping interest rates near zero for so long, risk-averse savers have had to accept bupkis for returns on their liquid assets. Many of them have been saving more, thus spending less: The 12-month sum of personal saving has been running around $700 billion since the end of the financial crisis in 2008, double the 1990s pace.

(2) Ultra-easy money attracted investors rather than nesters into the housing market following the 2008 crisis. They bought up all the cheap homes and drove home prices back up to levels that may be unaffordable for many first-time homebuyers.

(3) Thanks to the Fed, corporate bond yields have been trading below the S&P 500’s forward earnings yield since 2004, providing companies with an incentive to buy back their shares and engage in M&A rather than invest in plant and equipment.

Cheap money did stimulate some business investment, but the increased capacity wasn’t matched by more demand, resulting in some deflationary pressures. Stock prices have soared, but this has exacerbated the perception of widespread income and wealth inequality. Nice job, Fed!

(Based on an excerpt from YRI Morning Briefing)

“This is Ground Control to Major Tom” are lyrics from David Bowie’s classic “Space Oddity.” In Bowie’s song, the astronaut responds to Ground Control: “This is Major Tom to Ground Control / I'm stepping through the door / And I'm floating / in a most peculiar way / And the stars look very different today.” Bond investors have recently had this lost-in-space experience.

Fed officials at Ground Control have been preparing the markets for lift-off, i.e., the first rate hike during the current economic expansion. Bond yields aren’t waiting; They’ve already blasted off. However, they are likely to orbit at their current altitude for a while even when the federal funds rate finally gets off the ground. That’s because Fed officials have said that once they start raising rates, they will do so very gradually. That’s especially likely if the recent backup in bond yields and mortgage rates slows economic growth.

One-and-done is an increasingly likely scenario for Fed policy this year, which means that the federal funds rate won’t be any higher than 0.50% by the end of the year. In other words, investors can expect that Fed policy will remain in inner space rather than go to outer space.

Since the FOMC’s latest meeting on April 28-29, three top Fed officials have spoken publicly and indicated that investors should prepare for lift-off, i.e., “take your protein pills and put your helmet on,” as the song says. A fourth one is still in no rush to lift interest rates. Let’s review:

(1) Yellen. On May 6, Fed Chair Yellen sat down with IMF Chief Christine Lagarde for a discussion at a conference in Washington. As I noted in Monday’s Morning Briefing, Yellen is obviously trying to do her best to prepare the financial markets for the start of Fed rate hikes:

We need to be attentive, and are to the possibility that when the Fed decides it's time to begin raising rates, these term premiums could move up and we could see a sharp jump in long-term rates. So we're trying to, you know, as I've repeatedly said, communicate as clearly about our monetary policy so we don't take markets by surprise.

(2) Dudley. On Tuesday, FRB-NY President William Dudley spoke at a conference in Zurich. In his prepared remarks, he commented on the timing of normalization:

To be as direct as possible: I don’t know when this will occur. The timing of lift-off will depend on how the economic outlook evolves. Since the economic outlook is uncertain, this means the timing of liftoff must also be uncertain.

At the same time, though, I can be clear about what conditions are needed for normalization to begin. If the improvement in the U.S. labor market continues and the FOMC is ‘reasonably confident’ that inflation will move back to our 2 percent objective over the medium-term, then it would be appropriate to begin to normalize interest rates.

Because the conditions necessary for liftoff are well-specified, market participants should be able to think right along with policymakers, adjusting their views about the prospects for normalization in response to the incoming data. This implies that liftoff should not be a big surprise when it finally occurs, which should help mitigate the degree of market turbulence engendered by lift-off.

Nevertheless, I think it would be naïve not to expect some impact. After more than six years at the zero lower bound, lift-off will signal a regime shift even though policy would only be slightly less accommodative after lift-off than it is before.

(3) Williams. Dudley had company this week. FRB-SF President John Williams echoed similar sentiments in a discussion on CNBC. He forecasted:

A year from now, yes, we will have unemployment below 5%. Broader measures of unemployment or underemployment will be down to more normal levels like we've seen in other good economic times. Inflation will be heading back to 2% and yes rates will be moving up.

Regarding the specific timing of rate hikes this year, Williams said:

My personal preference is that we don't have the most telegraphed policy decisions in history like we did in 2004. I do believe that the data dependence is what we should be doing. We should be coming together every six weeks discussing what the outlook looks like and what the right appropriate policy decisions at that meeting are and then adjusting policy going forward.

(4) Evans. On the other hand, FRB-Chicago President Charles Evans still thinks that the economy isn’t ready for rate hikes just yet. His research staff posted a paper on May 8 entitled “Changing Labor Force Composition and the Natural Rate of Unemployment,” obviously supporting the uber-dovish stance of their boss. Contrary to the Fed’s consensus view of a 5.0%-5.2% range for the natural rate of unemployment, the authors claim that the rate should be at or below 5.0%!

On May 4, Evans concluded a speech to the Columbus Economic Development Board as follows:

In summary, I think we should be cautious in the timing of the first rate hike and our pace of policy normalization thereafter. My current view is that my economic outlook and my assessment of the balance of risks will evolve in such a way that I likely will not feel confident enough to begin to raise rates until early next year. But there is no prescribed timeline that must be adhered to, and no preset script to follow, other than that we should let economic conditions and risks to the outlook be our guides. Given uncomfortably low inflation and uncertainties about the economic environment, I see significant risks, but few benefits, to increasing interest rates prematurely.

(Based on an excerpt from YRI Morning Briefing)

Fed Chair Janet Yellen gave a speech titled “Finance and Society,” on Wednesday at a conference sponsored by the Institute for New Economic Thinking, which was founded in October 2009 with an initial pledge of $50 million from George Soros.

The prepared text of her short speech was mostly boilerplate, with Yellen claiming that the Fed is doing a good job of monitoring the financial system and maintaining its stability. She has said so several times before. On the other hand, her comments in a subsequent discussion with IMF Chief Christine Lagarde at the conference caught the markets off guard. In particular, she stated that equity valuations are “quite high.” She’s made similar comments before too, yet stock prices sold off on the “news” that she still thinks stocks aren’t cheap.

She’s obviously trying to do her best to prepare the financial markets for the start of Fed rate hikes:

We need to be attentive, and are to the possibility that when the Fed decides it's time to begin raising rates, these term premiums could move up and we could see a sharp jump in long-term rates. So we're trying to, you know, as I've repeatedly said, communicate as clearly about our monetary policy so we don't take markets by surprise.

Regarding the stock market, she added:

I guess I would highlight that equity market valuations at this point generally are quite high. Now they're not so high when you compare the returns on equities to the returns on safe assets, like bonds, which are also very low. But there are potential dangers there. And in interest rates, obviously not only short but long-term interest rates are at very low levels. And that would appear to embody low term premiums, which can move and can move very rapidly. We saw this in the case of the taper tantrum in 2013 where there was a very sharp upward movement in rates and you do have divergent monetary policies, potentially around the world.

On Thursday, the S&P 500 rose 0.4% following a report showing that weekly initial unemployment claims remain extremely low, averaging just 279,500 over the past four weeks. On Friday, following the release of April’s “Goldilocks” employment report, the S&P 500 soared 1.3% to close at 2116, only 0.1% below the record high on April 24. Investors seem to have concluded that notwithstanding her warnings about valuations, Yellen remains the Fairy Godmother of the Bull Market.

This isn’t the first time that Yellen has given investment advice. In her prior two semiannual congressional testimonies on monetary policy and accompanying Monetary Policy Reports, valuations were mentioned. Notably, her tone has become increasingly cautious. Yellen’s qualifiers have gone from “in-line with historical norms,” to “somewhat higher,” and now to “quite high.” Let’s review, with the key words italicized by us for emphasis:

(1) In Yellen’s 7/15/14 testimony, she said: “While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms."

The Monetary Policy Report that accompanied her testimony noted: “…valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities.”

(2) According to the same July report: "Nevertheless, valuation metrics in some sectors do appear substantially stretched--particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year." Yellen added in her remarks: “In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk.”

(3) The 2/24/15 Monetary Policy Report stated: "Overall equity valuations by some conventional measures are somewhat higher than their historical average levels, and valuation metrics in some sectors continue to appear stretched relative to historical norms."

(4) At her last press conference, on March 18, Yellen was asked to update her views on the overall valuation of the market and on the biotech and social media sectors. Her curt answer was: “Well, I don’t want to comment on those particular sectors. You know, as we said in the [February] report, overall measures of equity valuations are on the high side but not outside of historical ranges.”

(5) Last Wednesday, as noted above, she said: “I guess I would highlight that equity market valuations at this point generally are quite high.”

The S&P 500/400/600 forward P/Es were 15.6, 17.2, and 17.9 on July 15, 2014;17.2, 18.2, and 18.9 on February 24 of this year; 16.9, 18.3, and 19.4 on March 18; and 16.7, 18.1, and 19.0 last Wednesday.

(Based on an excerpt from YRI Morning Briefing)