Even after the weak first quarter, the Fed believes the economy is continuing to recover, and that the risks are now pretty much equally balanced between faster and slower growth. The discussion seems to have shifted from whether the recovery is valid to how quickly it’s moving—and the burden of proof is slowly shifting from those who want the Fed to back off to those who want it to keep stimulating.
That’s a big, if slow, shift in perception.
Policy is moving even more slowly, but it is moving. For the first time, the Fed has explicitly stated that it's planning to exit from stimulus at a specific date, in October—subject, of course, to economic and financial conditions. Discussions have also started, in a serious way, about when and how to deal with the reinvestment of existing holdings, and about actually increasing interest rates.
The market’s reaction to the Fed's plans was interesting. After two days of declines—led, in my opinion, by worries about earnings—we saw a small rally, which first slipped but then recovered when the minutes were released.
As I read the minutes, the news is almost all positive. The recovery continues, and is accelerating. But even as it plans to stop buying bonds—a vote of confidence in itself—the Fed also indicates that it intends to keep rates lower for longer, and to manage the process to maintain as much stimulus as possible.
From a growth perspective, this is the best of all worlds: a solid recovery that will continue to be juiced by low rates and accommodative policy.
Even with this very positive backdrop, the Fed’s growth expectations are still modest from a historical perspective. 2014 growth is expected to be below 2.5 percent on a real basis, while 2015 growth is projected to be around 3 percent. Longer-term growth is expected to remain below 2.5 percent, which is potentially a problem for markets.
Earnings, meanwhile, are expected to grow substantially faster, even as revenue growth is constrained by the growth of the economy as a whole. In order for earnings to meet expectations, either profit margins have to move even further into record territory, or stock buybacks have to continue at their record pace.
I’ll discuss earnings more tomorrow. For now, though, the idea that economic recovery will justify current valuations is starting to look questionable, even using the Fed’s relatively optimistic expectations.