Former Federal Reserve Board Vice Chairman Alan Blinder warned the bond market is likely to experience a surge in volatility this fall as the central bank terminates its quantitative easing program.
"I anticipate a major hawk-dove battle" resulting in a cacophony of different voices sending different signals when tapering ends and the Fed begins the debate over how and when to shrink its bloated balance sheet. "It's a recipe to rattle the markets," Blinder said.
Blinder told attendees at the annual Investment Management Consultants Association meeting in Boston yesterday that the U.S. economy's weak performance in the first quarter implied that the Fed was overly optimistic about growth in 2014. It was reported last week that GDP uncreased by a paltry 0.1 percent.
The Fed has predicted GDP will grow about 3 percent in 2014, meaning it would have to expand by 4 percent per quarter for the next three quarters. "I'll be shocked" if it sustains that pace for three quarters, Blinder said. If the Fed's prediction turns out to be accurate, Blinder anticipates it would terminate QE before the target date of October to December.
Many economists expected that 2014 would be the year that the U.S. economy would enjoy "lift-off," but Blinder voiced skepticism it would occur any time soon. Those who think business activity could expand at a 3 percent rate or better are reasoning that the wealth effect with from rising stock and housing prices will power a surge in consumption all the way back to pre-crisis levels.
Blinder considered this logic dubious. He doubted that housing will be as a strong a driver of growth as others do. Moreover, there is rising evidence that the wealth effect from the appreciation of equities in recent years has largely been confined to Lamborghini land.
Contrary to widespread perception, weak government spending since 2010 has acted as a drag on the economy. Had government spending simply flatlined at its normal level in the five years between 2009 and 2013, the U.S economy would have grown at 3.23 percent rate over that period, not its actual rate of 2.25 percent, Blinder noted. The nation could have repaired its crumbling infrastructure with cheap materials at a time when there were millions of unemployed construction workers.
In general, Blinder believes that the new transparent, "open mouth" Fed created by former chairman Ben Bernanke is a big improvement over the almost two decades when Alan Greenspan reigned as supreme leader. Many accused Greenspan of acting out a God complex. "God complexes are not a great thing," Blinder said.
But there is a cacophony problem and when the Fed starts to speak with 19 different voices, there will be confusion. Even though Stanley Fisher, who has yet to be confirmed as Fed vice chairman, is more hawkish than Chair Janet Yellen, Blinder expects Fisher to be very supportive.
But Greenspan's God complex aside, the Fed's powers are more limited than many think. In reality, Blinder said, they are dramatically amplified by the weight the financial markets ascribe to them in periods of uncertainty and volatility. That means "Janet Yellen will have her work cut out for her" this fall.
(You can watch an interview of Blinder by Editorial Director Evan Simonoff by visiting Financial Advisor videos.)