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First the third quarter’s downward revised 2.8% real GDP growth rate was piddling both absolutely and relative to the magnitude of the contraction and the degree of monetary and fiscal stimulus that was delivered. Second the current quarter has gotten off to a slow start with relatively weak readings on housing starts, industrial production, and manufacturers orders. Third inventory turns have typically provided the impulse for recovery, but current inventory-sales ratios are not abnormally low, reducing the odds of a major rebuild. Fourth deleveraging is progressing but it is not complete. Finally under current policy both monetary and fiscal stimulus is set to expire next spring and to be replaced with fiscal drag in the form of tax increases and possibly higher mortgage rates.
Were the economy to double dip, an already weak labor market would suffer further deterioration. This is of utmost importance to those seeking re-election in 2010. With one political party controlling the legislature and the White House, it seems logical that maximum effort will be directed toward stabilizing and improving the labor market. The Obama administration has already scheduled a “jobs summit” in Washington in the coming week.
If efforts to increase jobs are a given, then ideally policies should be implemented that might actually work. This would be a departure from the silly stimulus package that was devised and implemented last spring. Borrowing an old “trader” axiom, we would hope that lawmakers adopt the KISS principal. Keep It Simple Stupid.
So what is simple? The answer is tried and true. If you reduce the price of something, you usually get more of it in varying degrees depending on the item’s demand elasticity. When the homebuyer tax credit was enacted it effectively reduced the price of a home and more homes were sold. When the cash for clunkers program was enacted it effectively reduced the price of a vehicle and more were sold. It is reasonable to assume that if the price of labor were reduced, labor demand would rise.
In this vein we would strongly urge a complete suspension of the payroll tax on employees and employers. (The direct cost would equal the size of the first stimulus package, but it would quickly become much less as economic and employment growth revived.) This would effectively reduce the price of labor for employers, inducing them to hire more workers. It would put more disposable income in the pockets of employees, hastening the rebuilding of depleted savings and/or increasing the demand for goods and services. It is an action that would be much more easily reversed or scaled back as economic conditions improved, unlike silly federal spending programs that never seem to disappear and only aggravate the long term budget deficit.
The argument that a payroll tax suspension would worsen Social Security’s long run financing problem is a sham. Payroll tax revenue is incorporated in the general revenue mix under unified budget accounting so these are indistinguishable from other types of revenue. Nevertheless, the tax suspension would have a significant adverse short term budget impact even with a strong economic recovery. So coupled with payroll tax suspension should be the formation of a bi-partisan commission to enact long term entitlement reform. This already has some sponsorship in the Senate. Were the two actions to be commingled, we think financial market concerns over the short and the long term budget deficit would be ameliorated, helping keep interest rates low, and thus supporting economic recovery.
This plan should have appeal across the political spectrum. For the Reagan Republicans it is a tax cut, and this camp never met a tax cut that it did not like. For others there are multiple appealing features. As currently constituted the payroll tax is a regressive tax i.e. the burden falls mostly on lower income wage earners. So getting rid of it would actually make the tax code more progressive. The program would actually work to boost economic activity and disposable income, improving the fortunes of all those seeking re-election. Most of all the prescription for entitlement reform would be an antidote for what is becoming an overwhelmingly intractable problem.
Short term gain and long term gain would be a mix to be really thankful for – regardless of who gets or takes the credit. Twitter your Congressman; e-mail your Congressman; call your Congressman; send up smoke signals. Do whatever can be done to draw attention because if our money is going to be spent – which is something we can count on – at least have it be spent effectively.
November 01, 2009
The Commerce Department reports that real GDP rose at a 3.5% annual rate in the July – September quarter while inflation was only 0.8% annually. Several months ago we suggested a 3% to 5% rise for real GDP in the quarter so it is disappointing that growth was at the low end of our modest expectation. But there is some good news. Growth was at the low end because inventory liquidation, while slower than during the spring, was actually larger than we assumed. The less inventory there is, the more support there is for production going forward. So the pace of inventory liquidation is likely to be a plus for the economy in coming months.
The good news in the report was that the grip of recession eased in the spring as real GDP contracted at only a 1% annual rate. This was primarily due to a burst of government spending associated with the government’s stimulus program. The only other good news in the report is that inventories were liquidated at a record rate for the second consecutive quarter. Because inventories fell so much more sharply than sales, it is expected to serve as a springboard for recovery in the year’s second half.
This may already be under way as the ISM reported that its new orders index rose to 55.3 in July, while the orders less inventories measure climbed to 21.8. It was negative as recently as February. Meanwhile, retail sales will be bolstered this summer by the positive reception to the government’s cash for clunkers program, further augmenting production and employment prospects in the motor vehicle industry. As a result, we think real GDP could be between 3% and 5% annually this quarter. Unfortunately, though, income will not keep pace so we are likely to see a big slippage in the saving rate.
To some degree the clunkers related boost to vehicle sales is borrowing from the future, and sales will slip upon its conclusion. Similarly recent improvements in home sales were undoubtedly positively impacted by first time homebuyer tax credits. And of course government stimulus monies are boosting activity at the state and local level. This is all fine if there is sufficient oomph in these programs to precipitate a sustained rise in come, employment, and demand.
But this is where we have our doubts. Balance sheet repair in the household sector is incomplete, and significant wage and benefit deflation will be a continuing restraint on incomes even if employment conditions improve. In July payrolls fell by 247k which is terrible absolutely, but an improvement from the past several months. (Less bad reports as opposed to good reports only work for so long.) On balance, these pressures are leading us to expect a relapse in GDP growth to between 0% and 2% annually in this year’s final quarter and the first part of next year.
In the near term, though, indicators of economic recovery should proliferate, boosting prospects for corporate profits and some restoration of household wealth. This is all well and good, but income revival is the key to sustained growth and while we are hopeful, we are skeptical of its emergence.
July 26, 2009
Do not confuse an economic recovery with economic recovery. Prior to this downturn the two most serious post World War II business slumps occurred in 1973-75 and in 1980-82. The peak to trough declines in real GDP was 2.7% and 2.9% respectively. In this recession, which began in late 2007, the decline in real GDP is approaching 4%, and unlike all other post war recessions this one has so far seen two consecutive declines in nominal GDP.
The reversals from the 1973-75 and 1980-82 recessions were sharp and sustained. It only took three quarters for real GDP to exceed its prior peak in 1975, and only four quarters elapsed for a new recovery high in 1983. In other post war recessions, which were milder, recoveries to new peaks in real GDP were equally swift. The only period since 1900 that real GDP rolled over before exceeding its previous peak was in the 1930s. After the 1929-32 crash the economy recovered into 1936-37. It then slumped from a lower peak level of GDP in part because of monetary and fiscal tightening.
Assuming real GDP hit its nadir in the first quarter and flattened this spring, a constant 2% annual growth rate from here would elicit a new peak in GDP in the second half of 2010. A constant 3% growth rate would push forward the peak to spring 2010. While growth rates coming out of prior recessions have been swifter, we think there are several reasons for believing even this modest expectation may be the best we can hope for.
It is not clear that economic recovery is underway or that if it is, that it will be sustained. Economic activity is currently benefiting from a mini inventory cycle whereby just a slowing in the rate of liquidation is contributing to stabilization in production and new orders. This, however, can only carry so far, and for stabilization to endure and progress, demand conditions need to improve. On the positive side government stimulus monies are flowing and export orders are picking up thanks to an acceleration of activity in Asia, particularly China.
But potential pitfalls may overshadow these. For one thing the flow of government stimulus monies will peak by winter, contributing less to economic recovery in 2010. Further, for U.S. exports to be a significant source of stimulus there would need to be a rapid transition from export led growth to domestic demand led growth in Asia. This transition is in its infancy and it will take time to become meaningful.
Meanwhile, in the U.S. a huge overhang of residential dwellings, commercial real estate, and excess production capacity still has to be absorbed before a measurable pick up in output can occur. State and local government budgets are in disrepair so spending is being pared and taxes are being raised. In past periods this segment has been a source of economic stability. Finally, too, taxes are going up at the federal level regardless how health care reform and cap and trade legislation fares. If these pass, which is becoming doubtful, tax increases will be onerous.
These restraints on growth could be overcome if households had entered this period in sound financial shape. But they did not. Wealth has been damaged by declines in home values and equity values, while debt levels are at record highs. Households are attempting to rebuild wealth through traditional savings. However, unlike any other post war recession, wage and salary deflation is acute, making the wealth rebuilding effort more difficult. Hourly earnings may actually decline on a yearly basis in coming months which means that unless job growth suddenly explodes – unlikely – further attempts to boost savings would either have to be deferred, or it would be achieved via reduced spending.
Finally, the Federal Reserve’s balance sheet is already contracting, and money supply growth is slowing, while money velocity remains depressed. It seems that not only makes the economy more vulnerable to some unforeseen shock, but that it also raises the odds that the economy could slip into a renewed slump. Even if the economy does not roll over, the odds seem to tilt heavily in favor of a much more mild recovery than those of previous post war business cycles. This means that inflation risks will remain negligible while deflation risks will prevail. And it implies that the Federal Reserve will remain vigilantly accommodative for a lengthy period i.e. at least through 2010.
March 08, 2009
Revised data show that real GDP fell at a 6.2% annual rate in last year’s final quarter. More recent data reports suggest that when the final tally is in the decline will prove to have been even steeper. A similarly steep fall is expected for the current quarter, meaning that nominal GDP will show a decline for two consecutive quarters.
For quite some time our view has been that demand would fall at its peak rate in November – December while the peak rate of decline in production would hit in the current quarter as excess inventory got washed out of the system. Under this scenario we have been expecting a technical bounce in the economy this spring, with follow on strength being dependent on fiscal stimulus and an unclogged credit system.
Some support for this view can be found in recent data. First, inventory liquidation late last year was greater than initially reported. A sharp decline in manufacturers order rates in January – February imply a further acceleration in the liquidation process. Additionally the fact that ISM indexes have been essentially flat at a rock bottom level for the past five months suggests the process is almost complete.
On the demand side we can take some comfort that both income and consumption were stronger than expected in January, and both rose in real terms. Further, thanks to Social Security and pension adjustments, income so outstripped consumption that the saving rate rose to 5% in January. Our long standing assumption has been that the saving rate would stabilize around 6% from less than 0% last year. So, if sustained, this is good news.
But the caveat – if sustained – is key; and here is where there is considerable uncertainty. First, our assumption of a 6% equilibrium saving rate may simply be too conservative. Given the wealth destruction that is occurring, and extreme labor market weakness, the desired saving rate may be considerably higher. Only time will tell, but in the serious 1980 – 82 recession the saving rate climbed into double digit territory. February’s jobless rate climbed above 8%, and hourly earnings growth maintained its slowing pace. Judging from anecdotal reports of wage and hours reductions, downward wage pressure is likely to intensify. We have never seen this before in the post war period, but if incomes slide as households boost desired saving, consumption will suffer further, blunting any potential stabilization or upturn in production.
This is why timely fiscal stimulus is so important. We have gotten a timely stimulus program, but how stimulative it turns out to be is questionable. The $800 billion Economic Recovery Program sounds impressive, but it is spread over two years. Thus, it amounts to only about 2.5% of GDP per year, which is less than the Reagan stimulus program of 1982 and the Bush program of 2002-03. Second, the program is heavily weighted toward transfer payments as opposed to tax reduction and direct job creating spending programs. Transfer payment expansion may be laudable, but it does not have much punch.
We still anticipate a technical bounce in the economy this spring. We still hope the Economic Recovery Program surprises us and generates forward momentum. But we have our doubts for the above reasons, and because the credit system remains clogged with no apparent program yet in place to unclog it. We suspect that if our doubts are realized, the Administration will come back with a request for additional stimulus later this year.
If so, we think or hope that it will be smart stimulus, comprising immediate tax relief, infrastructure and defense spending programs, and measures to directly boost housing demand like real immigration reform. If they blow this one, then we suspect there will be a strong push for protectionist measures, especially given this Administration’s penchant for shifting blame.
Think about it; first the current economy was inherited as a result of bad policies from the Bush administration and a bunch of greedy bankers and Wall Streeters. The current budget proposal from the administration presumes that with the stimulus in place the economy will be able to grow above trend; bring about a return to full employment; and halve the current budget deficit by 2012. Who or what might stand in the way? Certainly not a flawed economic program but rather self- serving CEOs of large corporations who subvert domestic growth by continually shipping jobs and production overseas. We shall see on this one, and hopefully it will not come to this.
Meanwhile, assuming an optimistic outcome with smart fiscal measures in a second stimulus program, and assuming the credit system returns to a semblance of normalcy, we think a real recovery could get underway by mid 2010. However, this would come at the cost of long term budget imbalances which will have to be addressed, and a much more humble power elite in Washington.
December 14, 2008
Our economic forecast remains in tact. We have and continue to expect a current quarter decline in real GDP of 4% to 5% annually – more like 5% - a further 3% annualized drop in next year’s first quarter; followed by the beginnings of a tentative improvement next spring. Labor markets are very weak, and retail sales are horrible while inflation pressures are giving way to deflation pressure. This is not new however, and because this has been our expectation, it is not affecting our outlook.
Amidst all the economic gloom a number of recovery precursors are beginning to assert themselves. First, unlike the Federal Reserve and the Treasury, which responded to last year’s emerging weakness too late and too timidly, business has been very quick to reduce payrolls and manage inventory. Thus, productivity growth was actually positive in the summer quarter, and indications are that it should fare well this quarter. With labor and input costs under control, the hit to the bottom line from declining output is being ameliorated.
Second, because household wealth has been battered by declining home and equity market values, we have been expecting the consumer saving rate to structurally rise from 0% to about 4.5% over the next year. This adjustment is occurring more rapidly. And simultaneously, discretionary income is being bolstered as a result of sharp declines in food and energy costs, thus benefiting cash flows.
Third, new residential construction is now well below the level needed to accommodate replacement and household formation. Vehicle sales are also below the replacement rate, meaning the fleet is getting older. As these are discretionary and postponable purchases, this trend will continue near term. But at the same time low interest rates and declining prices are making purchases of both these items more affordable than any time this decade. With demand becoming pent-up, a stabilization of business activity and credit conditions will be a major stimulant.
Fourth, economic policy itself is stimulative. The Federal Reserve will very likely reduce its target rate again this coming week, and other Central Banks are doing the same. More important the Fed is no longer sterilizing its liquidity injections so money supply growth is exploding. For some time we have been suggesting that the Fed would adopt unconventional measures to maintain policy stimulus as the Federal Funds target approaches zero. Chairman Bernanke recently highlighted the possibility of direct purchases of government coupons, and we suspect the Fed will have more to say on this topic in its upcoming policy statement.
Banks are still not aggressively lending, so rapid money growth is necessary to offset declining velocity. Velocity will remain weak as long as balance sheets are impaired. But the Fed and Treasury seem to be on the case by buying mortgage securities in the open market so as to push mortgage rates toward 4% to 4.5% and possibly modifying mark to market accounting rules. This should support values of mortgage securities and set off a wave of refinancing activity. This would in turn boost prices of toxic mortgage assets. Banks will begin lending to each other once balance sheets improve. The LIBOR rate has finally begun dropping this past week, and assuming this continues – which we think it will – banks will be more willing to lend to each other and then eventually to you and me. This would in turn stabilize or even boost money velocity.
Finally there is fiscal policy, which will soon be introduced by the incoming Obama administration. We are hoping to have specifics in coming weeks, as it would be far more preferable that the administration offer a proposal than having one formulated by the likes of Nancy Pelosi and Harry Reid.
Infrastructure spending will be a part of any program. The size is unknown, but the presumption is that it will be large. We have nothing against infrastructure improvements except that there is typically a long lag between the appropriation and expenditure, and such projects often are unproductive and subject to political influence. Our hope is projects are targeted and the lags are short. We expect a tax reduction package to complement infrastructure, but here again the size, scope, and duration are all important. Anything is superior to a tax rebate, which from past experience has proven to be anything but stimulative. Our preference is for a suspension of the payroll tax. This affects both business and individuals; it can be implemented quickly (a top priority of any measure); and it would boost after cash flow by about $200 billion annually.
We all know a program is coming, but until the size and composition is known, a quantification of its impact is guesswork. However, if done right, we think the internal dynamics of the economy will turn positive by spring such that the right fiscal stimulus would add measurable momentum by summer and thereafter.
November 30, 2008
Economic data for November, to be released in coming weeks, will paint a bleak picture. Real GDP is declining at between a 3.5% and 5.5% annual rate this quarter. Our estimate has and continues to be at about the mid-point. Inflation as measured by the GDP deflator will be nil or possibly even negative for the first time in the post World War II period. The decline is global, and economic policy will continue to respond to weakness.
The Federal Reserve and Treasury have announced additional measures to unclog credit markets. The Fed will very likely reduce its interest rate target again at the mid-December FOMC meeting while perhaps announcing that it will begin targeting rates across the coupon curve. Foreign Central Banks will continue easing as well, although the European Central Bank remains way behind the curve.
Financial institutions remain very cautious despite actions to unclog credit markets. But is it reasonable to expect banks to lend to you and me if they are refusing to lend to each other. Indeed, the interbank lending rate LIBOR remains very elevated relative to other benchmark interest rates, and it is imperative that policy be directed to bring LIBOR into alignment. To do so requires three actions. First, there needs to be further interest rate reductions. Second, bank balance sheets need to be further purified. Third the European Central Bank needs to become more active by cutting rates sharply and injecting capital into its banking system. Of these three we are only confident in the first, but hopeful on the other two. The mid-December time period will be crucial in this regard.
Meanwhile, fiscal policy measures are on the horizon. Our favorite tool i.e. a suspension of the payroll tax is beginning to attract attention and get some traction. This would be great. Infrastructure programs, state and local government aid etc. will be forthcoming. But the lags in implementation are long whereas stimulus needs to be immediate. The President-elect is promising a formal proposal in January, and while the details are uncertain it now seems quite likely that it will be big and permanent. Thankfully this implies that tax rebates are off the table.
Assuming interbank rates decline and fiscal policy measures are quickly approved, we still think the global economy could hit bottom by spring and begin a halting recovery in next year’s second half. Indeed, under the right conditions the recovery may even surprise on the upside. At that point both the Fed and the Treasury will have to prepare financial markets for a policy shift from quantitative easing toward neutrality and budget control. This will surely test the mettle of the incoming administration’s economic policy team. However, this is a task that we all would welcome.
November 02, 2008
In the face of declining price pressure and declining economic activity the Federal Reserve lowered its benchmark federal funds target to 1%. Unlike its rate cut earlier in October, this one was not coordinated with other Central Banks. But this is academic as other Central Banks will be lowering rates for the same reasons that the Federal Reserve acted.
Real GDP fell at a 0.3% annual rate in the summer quarter. The decline would have been greater had it not been for a sharp rise in government spending. Gross domestic purchases fell at a0.8% rate. The driving force behind the quarter’s decline was consumer spending, which fell at a 3.1% rate. The consumer saving rate was 1.3%, down from the tax rebate related rate of 2.7% last spring. Importantly the consumer saving rate was in excess of 6% until the mid 1990s. We do not necessarily expect a return to that saving rate level, but we think consumers will be hell bent on boosting the traditional saving rate given the debacle suffered in equity holdings and housing values this year. Our guess is that the saving rate will recover to around 4% over the next year or two.
Unfortunately consumers will be attempting to boost traditional savings in an environment of weakening employment and income. Thus, spending will be weaker than the general economy going forward, restraining activity in this country and among our trading partners. This will make the current recession a global one, but it will also help steadily improve the U.S. trade and current account deficits so as to stabilize or even help appreciate the dollar exchange rate going forward.
The U.S. economy is currently in recession, but recovery will come. The problem is that the recovery will on balance be an anemic one, meaning that economic growth will probably be below trend for the next few years. Inflation cannot get started in this setting; indeed deflation is the greater threat and will probably continue to be.
Because the economy’s credit spasm asserted itself in September with the Lehman Brothers bankruptcy and AIG bailout, third calendar quarter GDP growth was hardly affected. Hurricane Ike and the Boeing Corp. strike did negatively affect activity however. The impact of the credit spasm will be visible in the current quarter and in the winter and it will be significant. We have been expecting about a 4% annual rate decline in the current quarter and about a 3% decline in the winter. We think a snap back to between 3% and 5% growth could occur next spring, but then a sustained slowing to between 1% and 2% growth would occur through 2010.
The closest post World War II analogy to this period’s credit freeze that we could find is the spring and summer of 1980 when the Carter administration imposed credit controls on the economy. Real GDP fell at a 7.8% annual rate in the spring quarter of that year. Controls were lifted in July 1980 and real GDP improved to only a 1% decline in the summer and then it rebounded late in 1980 and early 1981 when a real recession got underway.
We have to be mindful of a repeat even though our forecast assumes that we will avoid a double dip recession. In 1980-81 the underlying fundamentals were very weak as the economy suffered an oil shock; it was burdened by high inflation; and interest rates were prohibitively high. Now the economy is suffering from a different set of bad fundamentals i. e. low savings, heavy debt, declining wealth, a real estate debacle; and a broken banking system.
What may make this period different is that we have been enduring a skirting recession type economy for the past year so some imbalances have been being corrected. Moreover, The Fed, the Treasury, and global authorities are all fighting the same war as opposed to fighting each other. This is in contrast to previous periods.
So, if credit conditions can continue improving, as our forecast suggests, the economy should experience a reprieve in coming months. How durable a reprieve may well depend on whether or not government delivers a meaningful fiscal stimulus package. As we have documented, our preference is for a payroll tax cut, but it seems that spending programs are getting the most attention currently. This would be unfortunate in our view, but at any rate it would contribute to the notion that the worst may soon be behind us. The worst being behind us is a far cry from a sustainably strong economic recovery.
Even an anemic recovery is not without beneficial side effects however. Indeed, the U.S. economy will be better balanced as the current account and trade deficits drop and domestic private savings go up. Further, the housing market will bottom and housing will be more affordable, obviating the need for obtuse mortgage programs. Also, inflation will not be problematic for a long time.
The issues that will be lurking down the road are formidable however. One is how the government will finance its huge deficits without crowding out private sector demand for credit. This should not be overwhelming in a slow growth environment. The second is how the Federal Reserve will extricate itself from its current policy of quantitative easing. This we will all await with bated breath.
October 05, 2008
Deflationary pressures are rising as a consequence of global financial chaos and recessionary conditions. The yearly rise in the CPI slowed to 4.9% in September from a peak of 5.6% while the core inflation rate held at 2.5%. Crude and intermediate materials prices at the producer level are declining, and this will act to continue to reduce pressure at the consumer level. Given weakness in consumer spending amidst rising joblessness and falling household wealth, real GDP likely contracted in the third quarter. We are expecting 2% - 4% declines in real GDP over the next two quarters. But with the right policy prescription, a recovery seems in the cards by spring. And we think it could be surprisingly robust.
In our last Commentary we proposed a three part plan to combat global economic problems and foster an economic recovery. The first was a swift 50 basis point coordinated interest rate cut. This has since been enacted, and thankfully money supply growth is beginning to accelerate after two years of stagnation. We are expecting further rate cuts in coming months – at least other 50 and perhaps as much as 100 basis points.
The second part of our plan is that through FAN and FRED the Treasury should go directly into the market and buy distressed mortgages, then subsidizing qualified beleaguered homeowners. Thankfully Treasury has since announced that FAN and FRED will buy $40 billion per month of distressed mortgages going forward. Just as important, Treasury seems to be deemphasizing its reverse auction program – of which we have been skeptical – while emphasizing direct equity purchases in financial institutions. This would hopefully be an eventual spur to lending, which would boost money velocity.
The third part of our plan is fiscal stimulus. This is necessary to spur demand which in turn is a prerequisite to an expansion of lending. However, it is important to distinguish between “stupid” fiscal stimulus and “smart” fiscal stimulus. From our vantage point tax rebates, extended unemployment benefits, food stamps etc. fall in the category of “stupid” fiscal stimulus. These may have laudable characteristics, but they have been tried repeatedly and they have never stimulated economic activity. Items like capital gains relief, infrastructure spending, and state and local government grants are less stupid. But the lagged impacts are long, and they invite fraud and abuse.
In our view “smart” fiscal stimulus is an across the board tax cut, and even more preferably a reduction in the payroll tax. This is immediate; it affects all wage earners in a progressive manner; and it affects both business and individuals with one stroke of the pen.
Our plan is to halve the payroll tax for 2009, and then to phase it back in over the next three years. Its beauty is in its simplicity and immediacy. It is also clean in that this measure reduces the likelihood that “pork” would be included as it always is in other tax and spending legislation.
We would like to see Bush, Obama, and McCain embrace this plan so as to enhance prospects for immediate enactment by the Congress. The business community should initiate a strong effort to move this proposal forward for its sake, the country’s sake, and for the sake of longer term budget sanity. Indeed, this plan would be much less fateful from a budgetary standpoint because it would be temporary whereas history shows that “stupid” fiscal stimulus programs take on a life of their own. This invariably imposes budgetary distortions that erode policy flexibility. To appease purists we would even countenance an increase in the income ceiling in exchange for a payroll tax reduction as long as the net effect were a significant cash infusion to the economy.
Were our three step plan to be fully enacted, and recognizing that the first two parts are being enacted, we think economic recovery in 2009 would be assured and we suspect that Milton Friedman would then rest quite comfortable in peace. Here we are again with another “lengthy” Commentary.
October 05, 2008
For the record we’ll repeat a mantra from past Commentaries. Chairman Bernanke may soon face his old nemesis, namely deflation. In 2002-03 his concern about deflation was misguided. After all, how can there be deflation when asset prices are inflating. Well, there cannot be, but now deflation is coming from all quarters. There is commodity deflation; real wage deflation; equity market deflation; real estate deflation; and credit system deflation.
The Treasury’s Troubled Asset Rescue Plan {TARP} is in our opinion an ineffective approach to addressing the real estate and credit system deflations. Instead of targeting real estate and credit head on, TARP is meant to reactivate the credit system by removing toxic securities from the balance sheets of financial institutions. Determining the right price for these securities is key. We know less about how to do this than others who are undoubtedly working feverishly on this issue.
The goal of TARP is to purify balance sheets; boost financial institutions’ capital; and thus induce institutions to start lending to each other and to step up money velocity by lending to the economy. It does nothing to directly stabilize housing prices which is really at the heart of the entire global credit crunch. So we think the real estate problem should be confronted head on and quickly.
Homeowners have negative equity amidst rising joblessness and declining real income and negligible financial savings. Thus, consumption is being adversely affected. Inflation adjusted consumer spending will have declined in the third quarter, dragging real GDP growth to zero at best. As spending continues to falter and production is cut, real GDP is likely to drop sharply over the next six months, perhaps at a negative 2% to 4% annual rate; far worse than current consensus estimates.
One could divide the economy according to a pre and post September 15 timetable. This is the approximate date of the Lehman bankruptcy, the AIG bailout, and some bank failures. Recent increases in jobless claims to near 500k and September’s sharp decline in vehicle sales are mostly pre September 15 phenomena. So too is the September jobless rate which held steady at 6.1%. Data reflecting the post September 15 period is immediately ahead and it will be ugly.
Thus, it is now not a matter of if but when the Federal Reserve will cut interest rates. With other Central Banks already beginning to cut and even the European Central Bank finally acknowledging a concern over growth versus inflation, we think a coordinated rate cut will soon be enacted. Hopefully it will be at least 50 basis points.
A rate cut would inject permanent liquidity into the banking system. It would steepen the interest rate yield curve, and it would enhance bank profits. It would push mortgage rates down, making housing more affordable, thus boosting demand and helping stabilize prices.
A rate cut is not enough in the current environment. The TARP allows Treasury to subsidize mortgage rates offered by FAN, Fred, and the FHA. Since these entities are now under the Treasury’s wing, the Treasury could direct them to grant forbearance. In other words they could offer below market mortgage rates to new homebuyers as well as attractive refinancing rates to existing owners who are in financial difficulty. This would keep people in their homes, reducing the foreclosure rate. The effect would be to further the home value stabilization process.
Finally, the President and his two possible successors should join forces and propose a serious fiscal stimulus program. From what we can see neither candidate’s current proposals are very serious or stimulative. We would like to see the three get behind a halving of the payroll tax for one year and then phased out over a three year period. This would be a boon to business, and it would simultaneously get households back on track. Its beauty is that it is a simple program, which probably immediately dooms its enactment. While the first two actions we have proposed could be enacted immediately, tax changes will have to await the next Congress. However, if all sides joined forces now, there would be an immediate psychological benefit.
Dangerous times require bold action. And these are dangerous times – so dangerous in fact that we felt obliged to expand our normal one page Commentary!
September 07, 2008
Real GDP growth for the second quarter was revised to 3.3% annually from the original 1.9% estimate. But activity will slow sharply over the remainder of the year. Our guesstimate for the current quarter is 0.0% to 2% annually, and even lower in the year’s final quarter. Importantly, inflationary pressures and expectations are dissipating rapidly. This can be attributed to slowing global growth, declining commodity prices, and extraordinarily disciplined labor costs.
To us there are three major forces that will shape activity and market performance going forward. The first is the global credit crunch. It is causing a contraction in lending activity and thus a slowing of money velocity. Credit spreads have widened measurably in recent months indicating that strains persist. We will be watching to see if Treasury’s latest action to shore up Fannie and Freddie is at all successful in reducing risk aversion. However, it seems that for this to occur housing price deflation needs to end. Recent measures suggest a slowing in the rate of decline, but inventories of unsold homes remain huge and these have to be whittled down.
The second force is inflation and if and when diminishing inflation alters global monetary policies. In the wake of hurricane Gustav oil and gas prices have fallen to multi month lows as has the overall CRB index. As a result, headline inflation could swing negative in the next few months, bringing yearly inflation rates down sharply. In light of sluggish activity this should cause global monetary policy to shift from fighting inflation to spurring growth. Indeed, just this past week the Australian Central Bank cuts its benchmark rate, and others should soon follow. Lower inflation would boost real income and consumer confidence as well. But its effect on spending is likely to be minimal near term as nominal income growth is being stymied by weakening job markets. Rising unemployment, falling housing wealth, and depleted savings will hold back spending and overall economic activity through year end.
The third key to us is the performance of U.S. export demand. The U.S. trade balance will continue narrowing in coming quarters as weakness in consumption slows import penetration. But a U.S. import is some other country’s export, so a slowing of import penetration will further slow activity among our trading partners. To be sure, manufacturers orders are still holding up well, but export orders in the non-manufacturing arena have already fallen for two consecutive months through August. This could be a harbinger of weaker manufacturing exports.
Most analysts still believe the Federal Reserve’s next move is to raise rates, although the date for the onset of this policy move is being pushed further and further into the future. We have and continue to believe the Fed is more likely to cut than to raise rates late this year or early next. Two things might change our mind. One is a reduction in risk aversion and thus a renormalization of credit spreads. The other is a significant second round of fiscal stimulus. With both political parties in panic mode now that the jobless rate is over 6% and heading higher, another fiscal package is very likely. Whether it can be implemented before the election is doubtful, and it will take more than mere rhetoric to affect economic activity. Thus, the ball is likely still in the Fed’s court.
August 24, 2008
Economic growth, as measured by real GDP, will likely show an upward revision toward 3% annually for the spring quarter. The reasons are less inventory liquidation and a narrower trade deficit than originally assumed. Nevertheless, domestic purchases will remain in negative territory, and the upward revision does not alter prospects for a weakening trend going forward.
Economic stimulus in the form of tax rebates and business incentives were instrumental in boosting activity. However, tax rebates are wearing off at the same time that the labor market is deteriorating. Thus, income growth is slowing amidst a depleted saving rate and home equity. The outlook for consumer spending going forward is poor.
Meanwhile, the banking system remains broken, and consequently lenders are continually raising lending standards. This is a negative for all domestic sectors so commercial construction, state and local government spending, and even residential construction can not be expected to improve any time soon. We say “even residential construction” because this sector has already been beaten silly.
In this environment import demand will likely ease, weakening output growth outside the U.S. Indeed, Europe and Japan appear to be entering recessions, adding further weakness to emerging economies. In some sense the economic stagnation/contraction among the largest economies is becoming global. For the U.S. we would expect export growth to moderate, but not as fast as import growth. Thus, an improving trade deficit should continue to cushion the U.S.
Inflation and inflation expectations are yesterday’s concern. But even if they were still today’s concern, it is inconceivable to us that monetary policy could be tightened given the fragility of the financial system. Given this, regardless of upcoming inflation data, which we expect will moderate sharply, monetary policies will shift from fighting inflation to spurring growth. We think coordinated interest rate cuts may be on the docket as the year wears on. In this country lofty rhetoric from the Presidential candidates will overwhelm serious fiscal policy proposals. However, as the campaigns progress, fiscal stimulus will appear increasingly likely for 2009.
The key question of course will be the complexion of fiscal stimulus. We would hope policymakers will shy away from temporary feel good measures like tax rebates, and focus instead on longer term stimuli like permanent tax reductions and responsible energy policy. When dealing with responsible legislation, however, hope springs eternal.
August 10, 2008
We’ll repeat from July 13 Commentary that Fed Chairman Bernanke may soon be facing his old nemesis, namely deflation. Nonetheless, it was not surprising that the FOMC voted to hold interest rates steady even as it acknowledged that economic and financial market conditions deteriorated since it last met. Importantly there was only one dissenting voice at this meeting so we think this could be a prelude to an easing bias at its next meeting and rate cuts subsequently.
There are compelling reasons for the Fed and other Central Banks to cut rates in our view. First, GDP growth in the spring quarter was only 1.9% with downward revisions over the past few years. Growth in this year’s first half is now pegged at 1.4% which is in line with the Fed’s mid-year internal forecast. But the outlook is clearly deteriorating. The labor market is softening; the motor vehicle industry is reducing production amidst slumping sales; mortgage money is tight; economic stimulus from tax rebates is quickly wearing off; and economic conditions outside the U.S. are rapidly weakening, thus endangering the outlook for U.S. exports.
Meanwhile, inflation prospects are improving. Productivity growth is holding in a 2% to 3% zone despite weakening output growth. Employment cost is rising at only a 3% to 3.5% rate. With labor cost thus rising 1% to 1.5% it seems highly unlikely that inflation could get embedded in the economy.
What inflation there has been was in commodities. But there is encouraging news on this front. The overall CRB index fell measurably in July and among a broad spectrum of items. Agricultural prices are easing thanks to excellent growing conditions. This should ease concerns over food inflation going forward. Crude oil and natural gas are slumping, bringing down gasoline, heating fuels, and business costs generally. Industrial and precious metals prices are beginning to slump as well, as global demand eases in the face of slowing business activity.
Finally, the dollar exchange rate has regained its footing on recent weeks despite continuing strains on the U.S. financial system. In our view the dollar exchange rate is more a reflection of developing weakness abroad than any improvement in conditions in this country. However, if the Fed were to reduce interest rates to promote economic growth we think a new bull market in the dollar could quickly develop.
All the factors outlined here signal a turn down in the global business cycle. We think the Fed and other Central Banks should be sensitive to this. For the Fed, cutting interest rates and steepening the interest rates yield curve would be a giant step toward restoring financial institutions to profitability. This is a necessary prelude toward renewed credit expansion which is itself a necessary condition for renewed economic growth. This is why the dollar would explode on a rate cut from the Fed. But the longer it waits, the weaker will be the global economy and the greater the likelihood that inflation will progress to disinflation and then to deflation.
July 13, 2008
Fed Chairman Bernanke may soon be worrying about his old nemesis, namely deflation. This may sound outrageous considering that Central Banks worldwide are striving to combat inflation. But here is our reasoning.
First, it has long been our contention that deflation is a senseless worry when real estate prices are spiraling upward as they did earlier this decade. Real estate is the principle asset of households, and borrowing on the rising equity in real estate at low interest rates was instrumental in pushing the U.S. and global economy forward. The fact is that the Greenspan – Bernanke Fed failed to appreciate this, and this was a major failing of monetary policy earlier this decade.
Now real estate prices are declining, causing depreciation in the household sector’s principle asset, and at a time when there is little or no equity left for homeowners to extract cash. This is now imposing a major drag on household spending, weakening aggregate demand and weakening prices for household goods and services. To emphasize this, were the Case – Shiller index of home prices to be substituted for the homeowner’s equivalent rent component of the CPI, the core CPI would be negative and the headline index would be rising less rapidly than the reported 4% yearly rate.
Next, food and fuel prices have been the chief culprits boosting headline inflation to a 4% rate. But employment cost is rising at a mere 3% rate, meaning that real earnings are declining. Declining real income and declining wealth are a major drag on households’ willingness and ability to spend, putting downward pressure on the prices of things on which households spend.
Companies worldwide that use energy and raw materials in the production process are experiencing profit margin erosion given an absence of pricing power. And so they have little choice but to seek to control labor costs by reducing staffs and limiting or eliminating wage increases.
This is all occurring at a time when the U.S. financial system is being challenged as it has never before been challenged. Financial institutions are raising lending standards and contracting balance sheets with the result that money velocity is collapsing. In a fundamentally weak demand environment declining velocity exerts downward pressure on the price level which in turn causes producers to make further efforts to reduce business costs. This is the classic negative feedback loop that monetary policymakers have been warning and fearing.
One solution of course is to quickly stabilize real estate values. Another is to get energy prices back down to a tolerable level. Responsible energy legislation is a prerequisite to the latter so this is probably unlikely. For the former the Fed needs to quit worrying about inflation and sharply cut short term interest rates so that mortgage foreclosure slow and the interest rate yield curve steepens so that financial institutions have a chance of returning to profitability..
June 29, 2008
This year’s first half has been disappointing for economic growth and for financial markets’ performance. The economy barely grew; equity markets slumped; and even fixed income markets underperformed. Meanwhile, commodity prices surged, in part because of natural phenomena. But this was still surprising given economic weakness. Commodities have undoubtedly affected the performance of other asset classes.
We may well be in for more of the same in this year’s second half as energy and agricultural markets continue to be buffeted by external uncertainties. With this caveat and assuming no external shocks, what follows is a somewhat Pollyannaish scenario for the second half.
For argument’s sake let us assume oil prices fluctuate in a $120-$140 range for the remainder of the year and that other commodity prices more or less stabilize as well. The economy’s adjustment will be difficult, but one implication is that headline inflation would already be peaking. Indeed, headline inflation could even move lower because core inflation would move lower. The reason is that fuel surcharges would level while new and used car prices plummet. In addition housing prices would remain weak, imposing big downward pressure on rents and the related component price indexes.
Economic activity will almost certainly remain soft given the many headwinds confronting it. Thus, labor markets are likely to remain sluggish, and the jobless rate is likely to continue rising. But this implies that wage increases will remain subdued while productivity growth is maintained. In this setting we would expect the Federal Reserve to be able to declare victory over short term inflation risks. This could lead to an eventual rate cut, but almost certainly it would remove the prospective rate increases markets have factored in. We would expect the Europeans to be less hawkish in this setting as well, in which case the dollar exchange rate would stabilize and likely improve once markets realize Central Banks are serious about promoting economic recovery.
For those arguing that the Fed should already be raising rates to boost the dollar, we would suggest a look back to the mid 1990s when the Japanese prematurely raised interest rates. Disaster not recovery is what transpired and we do not want a repeat of that. The Bernanke moved relatively quickly last year to cut rates and the banks moved relatively swiftly to recognize bad security holdings – relative that is to the Japan of the 1990s. This is why we do not expect a lost decade for the world economy. What we do expect or at least hope for is that Central Banks pursue growth oriented policies. And this will be easier if commodity prices merely stabilize; if they fall then all the better.
June 15, 2008
In our last Commentary we described a scenario in which the Federal Reserve might adopt a tightening bias at its late June FOMC meeting. It was predicated on an economy which continues to skirt recession, positive vibes from fiscal stimulus, a spike in headline inflation, and a notion that tough talk, if not action, would buoy the dollar exchange rate and offer some respite from commodity price pressure.
The Fed Chairman and his compatriots seem to have taken the bait as recent communiques have been framed along these lines. The first reaction has been a dollar rally, a drop in the gold price, a sharp upward move in market interest rates, and a flatter interest rate yield curve. The equity market slumped.
In the early stages of an economic upturn rising interest rates are typically welcomed by the equity market as it signals strengthening final demand. This is anything but an economic recovery, however, and in our view the Fed would be making a serious mistake if it continues to lead markets to higher interest rates and tighter money.
The Fed and financial markets may be fearing a 1970s replay of stagflation. But this is anything but the 1970s. Then the economy was engaged in a super hedge-buying inventory spree. Food and fuel price increases quickly got embedded in the price structure thru COLAs in collective bargaining agreements. Productivity was non-existent in the 1970s and there was no housing bust.
These do not exist today. The ECB’s Trichet has to worry about wage pressures because of a strong union presence throughout Europe. But Chairman Bernanke does not; as unions have lost their clout and COLAs are a relic of the past. Meanwhile, productivity growth is strong, helping hold down labor costs, and the housing bust is a deflationary force as is the continued deleveraging of the credit system. Thus, core inflation remains contained at even a lower rate than the mid 1990s when Greenspan was receiving platitudes for winning the war against inflation.
These conditions, coupled with negative financial savings, do not make for an economic recovery, nor does the current sales spike that is coinciding with tax rebates. These may boost sales for a few months, but after this the household sector will still be faced with declining wealth and declining real incomes. Thus, the real risk is a renewed slump in activity later this year.
This is why we think a better approach for the Fed would be the following. It should terminate its special lending facilities since there is little participation as the liquidity crisis winds down. This would be an important first signal to markets of a return to normalcy. Second the Fed should not focus on raising, but rather on cutting interest rates. This would reliquify the banking system; it would help the household sector; and it help make the housing market whole again. Then there would be a real economic recovery, and thus the dollar exchange rate would take care of itself.
June 01, 2008
Real GDP in the January – March quarter was revised to 0.9% annual growth, following a 0.6% rise in last year’s final quarter. While industrial production and payrolls have declined over the past several months, the ISM measures still point to expansion as do new order rates. With GDP growth still positive, then, calling the current period a recession remains debatable.
It appears to us that activity in the spring quarter is running between -1% and +1% annually. Tipping the balance is not the business sector which continues to benefit from strong balance sheets, conservative inventory policies, and solid export demand. This latter strong point may become problematic however. About 25% of the world’s energy use is by countries wherein energy is subsidized to users. With energy prices up so much this is beginning to strain government budgets to the point that in countries such as Taiwan, Indonesia, and Malaysia subsidies are being reduced. China and India may be next and this could well slow economic growth rates going forward.
Meanwhile, at home the household sector remains under duress from negative financial savings, excess debt, and an exhausted capacity to tap home equity. These are making the consumer sector increasingly vulnerable to a shock. Deteriorating employment conditions amidst rising food and energy prices may be providing just such a shock. Jobs are not disappearing as much as hiring is not appearing. Thus, initial jobless claims are holding steady, but continuing claims are rising steadily.
Meanwhile, prices for necessities are absorbing an increasing share of the household budget. To date about 50% of tax rebate checks have been distributed and this is providing some cushion to consumer finances, but not a big one. Consumer spending was flat in real terms in April, and retail sales in May were below plan. We never underestimate the consumer’s ability to adapt to circumstances, and the next month’s spending data will be important. Hopefully we are right in thinking energy prices will stabilize or recede somewhat into July as that would provide some welcome relief. But before this is felt we can expect another spike in the headline inflation data for May to be released this month.
Because Federal Reserve officials have been focusing recent remarks on inflation concerns, we are wondering if rising inflation could goad the FOMC into formalizing a tightening bias at the FOMC meeting in late June. The FOMC could argue that credit markets are slowly healing and that tax stimulus is in place. Moreover, the adoption of such a stance would probably boost the dollar exchange rate and weaken commodity prices, if only temporarily.
We think this is a low probability; that it would be a mistake if the Fed did so; and that ultimately the next FOMC move will be to lower rates. In 2001-02 tax stimuli boosted activity for only a brief period. But in 2001-02 housing prices were not in freefall; financial savings were adequate; food and fuel prices were tame; and home equity was plentiful – hardly the case now.
Headline inflation accelerated in March. The yearly rise in the PPI and CPI was 6.9% and 4% respectively. The yearly rise in the core components was 2.7% and 2.4% respectively. The good news is that food and energy price pressures have yet to pass through to the core. The bad news is that food and energy pressures will likely persist.
In our previous Commentary we focused on agriculture, pointing out that even with good luck and responsible policy decisions the global supply-demand crunch would take two years to be resolved. Energy faces a more secular crunch in our view which most observers are unwilling to acknowledge. For example, in 2006 and 2007 many claimed that a $15 terror premium was built into the oil price, which would soon dissolve. Prices have since risen further even as the so-called terror premium faded, and now it is conventional wisdom that the dollar’s weakness is behind the high and rising price of oil.
We think underlying supply-demand forces are a much better explanation. According to the Energy Department’s latest report, crude oil inventories in the U.S. were 6% below last year while gasoline and distillate stocks were 8% above and 6% below respectively. Natural gas inventories ended the heating season below the five year moving average.
The distillate market has been tight all year owing to strong worldwide growth in diesel usage. The gasoline market has been weak owing to stagnant demand in the U.S. Indeed, this stagnant demand has caused the Int’l Energy Agency to repeatedly reduce its forecast of this year’s global demand from 88mbd to 87mbd currently. Domestic refiners are responding to weak gasoline demand by reducing runs. As a result, gasoline inventories have fallen in each of the past five weeks, tightening the market ahead of the driving season and simultaneously creating a condition which will foreshadow tightness in distillates next fall. A more stable and lower price for crude would alleviate stress in the refinery industry. So the question is why in the midst of slowing global demand has the crude price risen by nearly 75% over the past year. For one thing, developing nations, where demand is rising fastest, subsidize the gasoline price, allowing for wasteful consumption. More importantly we think the answer lies in current and prospective supply constraints. Production is falling unexpectedly fast in Mexico, the North Sea, and Alaska. Output in Russia actually declined slightly last year as did domestic production in China. Meanwhile, output from Nigeria and Venezuela is no less secure than it has been, and Saudi Arabia is the only major producer in the world with spare capacity, a surplus which itself is being repeatedly questioned by the Hubbard’s Peak enthusiasts. Meanwhile, aside from a new discovery in the deep waters of the Gulf and off the coast of Brazil, there has not been a major discovery since the early 1980’s.
For all its protestations the U.S. has avoided an energy policy for over thirty tears. With energy prices rising to an increasingly painful level and a looming Presidential election in this country, it would seem that the time is ripe for a serious discussion. Could we be so lucky?
February 23, 2008
Real GDP growth for last year’s final quarter will likely be revised up from the 0.6% rate first reported. We think the current quarter’s pace will likely be between -1% and +1% annually. February is shaping up as a weak month, although some of this may reflect adverse weather in the nation’s mid-section. We continue to think the economy will skirt an outright recession, but conditions will remain sufficiently weak that the recession versus no-recession debate will rage on into next year.
As a consequence we fully expect the Federal Reserve to reduce its federal funds target to 2.5% at its March meeting. Then we think the Fed may well pause, barring a renewed credit crisis or some other externality. There are several reasons. First, the Fed’s forecast is for a reacceleration of business activity this spring and beyond. Second, monetary policy works with a lag, and the Fed has to be mindful of the stimulus it has already provided as well as forthcoming fiscal stimulus. Third, while the economy and credit market conditions are the Fed’s primary concern, it can not appear totally oblivious of the recent uptick in measured inflation and in the broad swath of commodity prices.
In some respects the Fed is in the same position that it found itself in early 2002. The Fed had cut interest rates sharply in response to economic weakness and to the 2001 terrorist attacks. Meanwhile, the new Bush administration had pushed through a fiscal stimulus program of tax rebates and business incentives. At the time the Fed stopped cutting interest rates to assess the impact of policy changes. Then when it discovered the economy had only a tepid response, the Fed ultimately drove its funds target to 1%.
Our suspicion is that this time around the Fed will pause until mid-summer. If at this time economic indicators are firming, it will hold at 2.5% and begin to think about a time when it may begin to push rates up, albeit not before the election. However, if economic activity is continuing to languish – as it did in 2002 – we think the Fed will resume driving interest rates lower. How the economy performs will be mainly dependent on whether or not lending standards begin to ease and the credit cycle turns toward expansion.
Frankly we have our doubts that this positive outcome will materialize. Indeed, even if the economy avoids recession but maintains a sluggish below trend growth pattern, we think the Fed would resume pushing rates lower; perhaps all the way down to 1%. It is hard to imagine a new administration in Washington allowing tax cuts to expire in such a setting. But it is easy to imagine major new spending initiatives. This we think would blow a hole in the budget and seriously aggravate inflationary expectations.
February 10, 2008
Economic indicators were uniformly weak in January. Home, vehicle, and chain store sales all slumped. The ISM composite index fell, reflecting a sharp decline in hitherto strong service sector activity. Jobless claims rose, confirming a weakening employment outlook. And the fact that aggregate hours worked in January fell more than 1% annually versus the previous quarter indicates that it will be a struggle for GDP growth to be positive in the current quarter.
The odds of an immediate bounce in activity seem slight. First off, adverse weather was not much of an impediment to activity in January so there is no pent up demand. Fundamental drags that have been gnawing at the economy are still in place and may be worsening. Indeed the nation’s senior loan officers reported a measurable tightening of lending standards in last year’s final quarter for both mortgage and non mortgage borrowers. Further tightening is probably occurring in the current quarter. An improvement is very unlikely.
This is consistent with a decline in money velocity, and with the need for the Federal Reserve to counteract it with lower interest rates and faster money growth. Federal Reserve officials had the lending survey data before the federal funds target was cut by 125 basis points in January. And we would submit that it was a principle factor in the decision to do so. In our view the Fed should have anticipated this and aggressively cut rates months’ earlier. But as we have stated in the past, it is better late than never.
With the federal funds target now at 3%, we think the Fed still has more work to do. We are expecting our long standing target rate of 2.5% to be reached when the FOMC meets in March. The question is whether this will be enough. On the plus side the interest rate yield curve would be positively sloped; mortgage refinancing is soaring; homeownership is more affordable than at any time in the last two years. Moreover, fiscal stimulus of a sort will hit by late spring.
On the negative side credit conditions remain tight despite rate cuts; credit spreads are still widening; and the household balance sheet is in disrepair at a time when employment growth is slowing and traditional savings are meager. We know how to deal with declining equity markets as these occur fairly regularly. A nationwide decline in real estate prices is far different however, with only the 1930s and the Japan of the 1990s providing guidance. In both of those periods Central Bank responses were late. In this period Central Bank responses are late but less so. In both those periods legislative response were inadequate. The jury is out on this one.
We would surmise that as long as housing prices are declining, consumer spending will be soft and the economy’s tone will be sour even if it is not recessionary. We would not be surprised if the Fed were to pause at 2.5%. But if real estate prices continue declining, we would suspect such a pause would be temporary absent a giant government bailout.
January 27, 2008
Potentially significant new wrinkles to the economic outlook have emerged in the past few weeks. First off, in response to voter anxieties about recession a bipartisan fiscal stimulus plan of personal and business tax cuts has been cobbled together amounting to about 1% of GDP. Expanding the role of Fannie, Freddie, and the FHA were also included. The year of the pander – not to confuse with panda -- is now in full swing. No doubt, whatever the final version of the stimulus plan is, it will be larger than 1% of GDP.
Trumping this was the Federal Reserve Chairman’s belated recognition of the severity of the credit problem. The result was a 75 basis point inter FOMC meeting rate cut, with an implicit promise of more to come. The Fed is quickly getting the Funds target to our long standing 2.5% to 2.75% objective even though they have been tardy and thereby inflicting needless pain on the economy and financial markets.
There is typically a long and variable lag between monetary policy and economic activity. We think the lag will be short this time. Most variable rate business and mortgage loans are tied to LIBOR which in turn is normally tied to the federal funds target. The relationship blew out late last year, but it has since normalized yielding a reduction in loan rates. With a renewed downturn in the federal funds target, mortgage resets, refinancings, and new mortgage and business loans are falling measurably. With housing prices continuing to fall, affordability is improving. By this year’s second half this could be reflected in broad economic activity measures.
Finally, credit markets were also buoyed this week by rumors of some sort of public private bailout of bond insurers. To the extent fears of another round of write downs are alleviated by such events, psychology would improve. The fact is though that credit market strains still exist, and they are not about to quickly disappear. On balance, a general credit contraction is and will remain. But we still think the general economy can skirt past a business recession. Recent events support our expectation.
Beyond this something more subtle may now be in play. We are thinking that the Fed Chairman’s most recent move may have shattered the Greenspan template of predictability. The Chairman may be signaling that he is ready to use the federal funds rate as a blunt policy instrument – in both directions.
For a Federal Reserve Chairman that began by wanting more transparency, this would be quite a switch; and for the better in our view. Indeed, it would be reminiscent of the Volcker Fed when rate changes not very predictable. This would be a way to wrest power from the markets -- a good thing in our view.
Global Central Banks can claim a partial victory in that liquidity pressures are easing. Term auctions have been successful in narrowing the spread between federal funds and LIBOR. That this has returned to normal is important because most business and variable rate mortgage loans are tied to LIBOR. As the funds target falls, so too will LIBOR. And in our view another 150-200 basis points of Fed ease would significantly tame the mortgage reset tsunami. Additionally the interest rate yield curve would steepen if the Fed now gets serious, significantly aiding a recovery in the condition of financial institutions. The Federal Reserve’s acknowledgement of reality may have come too late to avoid recession, but at least it might hasten a recovery.
Commodity prices may weaken with slower economic activity, but not because of excess supply. USDA crop reports showed a much tighter supply-demand condition for feed grains than was generally expected. Feed grain demand is more price sensitive than is the demand for wheat, which was last year’s big winner. Even if demand softens, crop prices will remain strong absolutely as the various grains continue battling each other for available acres. The agricultural bull market is firmly entrenched.
Meanwhile, in the U.S. crude oil inventories have declined by 32 million barrels since mid-November while there has only been a modest build in gasoline and distillate stocks. Various technical explanations have been offered for this drawdown. However, peak oil enthusiast Matt Simmons recently published a report showing that, according to Energy Department data, global crude oil production peaked in April 2005 while demand has continued rising. This is despite a near doubling in prices over the period. Importantly oil inventories should begin rising seasonally in February. If they do not, renewed upward price pressure could occur despite global economic softness.
All in all, a not very cheery start to the New Year. And just to add another worry let us hope the Chinese economy does not implode as a consequence of Nixonesque price controls and Carteresque export controls being imposed. More on this at a later date.
December 02, 2007
As signaled by the most recent senior loan officers’ survey, credit conditions tightened further in the past few months. Fortunately this has not gone unnoticed by Federal Reserve leaders Bernanke and Kohn who this past week signaled that the Fed is ready to support the credit markets with lower interest rates.
Given the Fed’s recently published forecast for 2008, current policy is too tight so the Fed should have already acted more aggressively, and they should act more aggressively. Despite the third quarter’s 4.9% real GDP growth upgrade, and an expected 1% growth rate for the current quarter, the Fed’s current forecast is for 2.5% GDP growth and about 1.8% inflation in 2008. This is 4.3% nominal GDP growth! Assuming the economy’s potential GDP growth path is 3%, the Fed’s forecast implies a widening output gap and thus more joblessness amidst lessening price pressures.
This should be unacceptable, especially in a Presidential election year. Using the Fed’s assumptions and applying the standard Taylor Rule formulation to derive an equilibrium federal funds rate, the result would be a 4% target. Thus we would expect the Fed to cut its target rate by 50 basis points at its December meeting. But if the Fed wanted to get out front and be accommodative, the cut would be even greater; ideally 100 basis points. If the Fed had gotten this message early on, perhaps a bail out of sub prime mortgagees might have been avoided.
We seriously doubt this large a cut will occur, at least at the December FOMC meeting. Indeed, most analysts would regard a 50 basis point cut as aggressive. Of course the Fed would also be expected to cut its discount rate, and an added option might be to widen the universe of securities that would be accepted as collateral.
Another option for the Fed is to do what it did in front of Y2K when it was feared the financial system might collapse from a computer glitch upon the millennium. There was no calamity but the Fed flooded the system with liquidity in advance. At the time this liquidity flowed into worthless internet stocks, but this time the Fed could ensure that the liquidity is used to normalize credit spreads.
If these approaches are followed we still think the economy can avoid recession. We still think the earnings cycle would bottom in next year’s first quarter. And we still think this would be favorable for the dollar exchange rate. In fact, we are becoming increasingly enamored with this prospect, believing that a short euro currency position may be 2008’s trade of the year. We do not think the timing is quite right yet to implement this trade.
November 18, 2007
n our view the Federal Reserve should have reduced its target interest rate by 150 to 200 basis points rather than the 75 points it deliver
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