THE BLOG

Tinker, Taper, Forward Guide: The Fed Confronts the 'Coldilocks' Economy

02/11/2014 09:21 am ET | Updated Apr 13, 2014

Once upon a time in a century far, far away, the U.S. economy was perceived by one and all as in a "Goldilocks" state: not too cold, not too hot, just right." Just like the porridge at the Three Bears' house -- or so it appeared -- conditions in the latter half of the 1990's were optimal for both bond and stock investors, consumers and producers, traders and investors, buyers and sellers, even mortgagors and mortgagees. There were no walls of worry for mountaineers to climb, no debt ceiling crises, no fiscal deficits. Greenspan was in heaven and all was right with the world of finance.

Well, that scenario turned out to be a fairy tale indeed, fueled by conventional Federal Reserve monetary largesse and conventional wisdom favoring deregulation of financial engineering. The worst economic debacle since the 1930's Depression followed the fable of financial nirvana. Clearly not everything was "just right." There were severe imbalances in the world of leveraged finance, especially in terms of the hidden costs of genuine risk that would emerge as interest rates were finally forced to rise, too late to halt the free-market excesses that had their way with Goldilocks while the Fed looked the other way.

Understandably, then, few observers of today's U.S. economy would dare to suggest we are anywhere near a Goldilocks moment, despite the recent (though much delayed) emergence of relatively benign data suggesting that a recovery from the great Recession is truly on track. Vito Racanelli of Barron's, just this past weekend observed that "The longer view is that some 150,000 to 200,000 jobs are being created monthly, on average; inflation is low; the Fed remains accommodative; and the quality of earnings is good." But he went on to note that, while these facts were good for the stock market, it was not a pretty story for 20 million un- or under-employed households. No Goldilocks economy yet. But maybe "Coldilocks" would be more apt description, especially considering the confusing jobs picture that confronts the new Fed Chair, Dr. Janet Yellen.

Perhaps buoyed by her now two degrees of separation for the discredited Greenspan, she nonetheless faces markets that may be pulling and tugging her to follow up the famous Greenspan and Bernanke "puts" that have been perceived to underwrite the rallies in both stock and bond prices (though obviously not bond returns) since 2009 that have put our generation of three "bears' to rout -- until very recently, when the jobs creation data turned much too cold.

Speaking of cold, the disappointing job numbers -- adding up to just 188,000 for December and January combined compared with the 194,000 one-month average since last January -- have been blamed on the unusually cold and snowy weather affecting two-thirds of the U.S. land mass. The same goes for declining auto sales, disappointing retail sales over the year-end holidays, and the softening in housing sales and prices over the same period. But multiple commentators rushed dismiss "weather effects" as lame excuses and rushed to predict a 20% "correction" in stock prices (i.e. a 1480 S &P) and even a turn toward recession unless the Fed reverses its tapering course for its monthly bond purchases, or even if they do that.

The renewed Armageddon trade worked for about a week or two with a little help from some overdone panic about the Turkish lira and the Hungarian whatever, giving the TV folks' friends in the hedge fund community ample opportunity to buy in cheaper (after missing the 2103 market rally) before the markets came to their senses. Or as Racanelli's Barron's piece put it: "despite Soft Jobs Data, Stocks Edge Up on Week." Perhaps, at least the stock market seemed to be thinking, there is something to the "Coldilocks" story. The economic recovery is real and will only be deferred, not derailed, by the bout of cold weather, Groundhog Day predictions be damned!

Stock market bulls have indeed been playing a game of "whack a mole" for a couple of weeks as the prophets of doom spun TV tales that some combination of China, Argentina, Hungary and the "Polar Vortex" (no, that's not a new derivative instrument) were forming a perfect storm of currency and consumer collapse that would bring on recession risk and put the new Fed in a classic bind: either dramatically reserve course on tapering (and thus lose credibility) or keep on course and risk killing the recovery.

A few bullish market participants might well have bought in to the idea that the Fed would flinch on tapering (the new "Yellen Put"), but most seemed to discredit the often-wrong monthly jobs creation data in the so-called "business establishment" Labor Department survey, and put more faith in the accompanying "household" survey, which actually showed a monthly employment gain of over 600,000. This figure is much more in line with the private SADP survey, which showed nearly 400,000 new private sector jobs, almost double Labor's "establishment" report. There was even some other, intrinsically good data amid the chill in the Labor report: new declines in under-employment and increases in labor force participation, both of which suggest even more "Goldilocks" turns in the recovery despite the weather.

A more pressing matter for Chair Yellen as she enters the 2014 bears' domain will be to finesse the Bernanke "forward guidance" legacy -- namely, a 6.5 percent unemployment rate "threshold" when the Fed would start thinking about raising short-term interest rates. Yellen helped create that legacy herself, but was also instrument in the Fed's push to fuzz it over last month by saying the Fed will find it appropriate to keep rates low "well past" the time -- maybe even next month -- when unemployment drops to 6.5 percent.

Both the bond and the stock market, of course, now want to know what "well past" means. Yellen will be testifying in Congress on February 11 and 13, but would be highly unlikely to get out ahead of her Fed colleagues on any specificity, since she has not even chaired one meeting yet. We are more likely to get clarity at the next Fed meeting (just about the time of (you guessed it) the Ides of March!

Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.