Fed Watch: The Calm

Tim Duy says the economy is entering an eerie calm, and the Fed is holding steady as it waits to see what will happen next:

The Calm, by Tim Duy: The flow of data suggests economic activity is entering a very unnerving period of calm, not unlike the state of financial markets, which some commentators liken to the eye of the hurricane. Myself, I prefer Mark Gongloff's view that we are entering a state of "economic purgatory," one of neither expansion nor recession. That leaves the Fed stuck in an uncomfortable position. Enough rays of hope will seep through the data to convince policymakers that enough is enough already, while sufficient weakness persists to maintain pressure for the Fed to cut rates further.

For now, the Fed is shifting into the wait and see mode, preferring to expand its efforts to free immobile credit markets while holding rates steady. Following suit, market participants have acquiesced to the view that the Fed is done, and a look at the December COBT Fed Funds contract reveals an implied rate of 2.09% - indicating that traders envision the possibility of rate increases by the end of 2008. Of course, this is not exactly a strong conviction that the Fed will raise rates. With so much easing in the pipeline, and a Fed statement that indicates a commitment to pause by dropping the reference to downside risks to growth, traders have little choice but to look for a rate hike at this juncture.

Why a rate hike and not additional cuts? Incoming data simply is not supporting the direst prognostications. True, we can agree at this point that regardless of an actual declaration of recession by the NBER, households feel that they are in recession as real consumption gains have hit a wall. Still, there remains a notable lack of classic recession hallmarks. The ISM reports on both manufacturing and service sectors both hover around the 50 mark, whereas rapid, sustained deep declines would be expected in a recessionary environment. Initial unemployment claims hover just south of 400k, which, combined with continuing claims, signals more hesitation to hire than mass layoffs. And the 20k decline in nonfarm payrolls reported in April was certainly mild by typical recession standards -- especially if you believe the recession is intensifying.

As always, none of this is meant to imply the economy is on solid ground. But at the same time, the worst has not come to pass. We are stuck in between -- economic purgatory.

I am not completely surprised; I have long believed that the economy would enter a prolonged period of pain as we transition away from dependence on foreigners to sustain excessive consumption. I still liken the current situation more to the Asian Financial Crisis more than the Japanese experience, and I see that Greg Ip draws that analogy in Monday's WSJ:

For a parallel, the U.S. might look to South Korea. Its financial crisis peaked on Dec. 24, 1997, when its currency, the won, hit a record low against the dollar. The International Monetary Fund and the U.S. Treasury orchestrated a rescue and persuaded foreign banks to roll over their loans to Korea. Over the ensuing year, the won rose 63%. But the Korean economy sank into a deep recession. In 13 months, the jobless rate soared to 7.9% from 3%. The economy shrank 6% in 1998, a huge shock to a country accustomed to 8% growth...

...Ted Truman, a scholar at the Peterson Institute for International Economics who worked on the Korean rescue as a Fed official, says the overexpansion and excessive borrowing of Korea's corporate sector in the run-up to its crisis are analogous to the overexpansion of housing and consumption in the U.S. in its crisis. In each case, a collapse in the affected sector severely wounded the financial system. Korea's recovery was led by exports, much as exports are proving a cushion to the U.S. now.

Korea's recovery began in 1999. Mr. Kim says that capital investment never fully recovered and that economic growth, while a healthy 4% to 5%, hasn't returned to the precrisis pace. Unemployment is deceptively low, he says, because of hidden unemployment, such as students who can't find jobs staying in school. Korea's lesson to the U.S., he says, is that "imbalances must be corrected." A recovery doesn't need a full resolution of those imbalances, he says, only a "convincing sign that change is taking place."

I find it amazing that Ip uses the Korean analogy but completely ignores the differing policy responses -- specifically, the tight fiscal and monetary policy that the US Treasury imposed on Korea. Amusingly, this is defined by Ip as a "rescue." Massacre would be another description. Of course, the Treasury did teach developing nations a lesson: It is important to put the IMF out of business, and the easiest way to do so is to prevent currency appreciation and accumulate massive amounts of Dollar reserves. One cannot have a balance of payments crisis if they do not run a deficit. (Note: I see that in the WSJ blog, Ip acknowledges the IMF austerity program, suggesting it is more appropriate for a later article. I look forward to his thoughts).

But that is something of an aside -- the key is recognizing that the US actively encouraged nations facing balance of payments crisis's to address the underlying internal imbalance. US policy threatens to pursue the opposite path, and via low interest rates and fiscal stimulus, fight the adjustment. Here policy walks a fine line. Policy needs to be appropriately stimulative to limit the pace of the adjustment, but not prevent the adjustment itself. In a sense, policy needs to maintain an extended period of economic purgatory.

A charitable analysis is that the combination of monetary and fiscal policy to date is just about right in that the economy has eased into that state of purgatory. Less charitable is that the Fed has already lowered rates too far, setting the stage for a Dollar collapse and a commodity price surge. I have criticized the Fed on these points, especially the latter, but should note a mitigating factor -- the Fed's actions are being propagated by nations who then suffer inflationary consequences. I was reminded of this reading William Pesek's recent Bloomberg opinion piece:

Central bankers in Asia could be excused for feeling a bit, well, fed up by sliding U.S. rates. Their concern is over ''hot money'' flows of the kind that wreaked havoc in Asia a decade ago. Investors who had poured in amid rapid growth fled even faster at the first sign of trouble. Large amounts of the liquidity created by the Fed are heading Asia's way to tap its rapid economic growth..

Excess liquidity is dovetailing with Asia's record buildup of currency reserves. China, Japan, Taiwan, South Korea and India hold a combined $3.5 trillion of reserves. There's increasing evidence that Asia's currency holdings are seeping into the money supply, adding to inflationary pressures.

In a perfect world, economists would be predicting aggressive rate increases in Asia. Yet with more that two-thirds of the world's poor living in the region, central banks may be reluctant to slam on the brakes...

What ails the U.S. is too much consumption, too much debt, too little household savings and a financial system that's more vulnerable than once thought. Fixing these imbalances will require strong action from lawmakers and economic officials -- not more liquidity.

Much of the article tends to blame inappropriate Fed policy for Asia's inflation problems, but that seems to me somewhat misguided -- it takes two to tango. Policymakers in Asia could have focused on minimizing their accumulation of Dollars long ago, fostering greater reliance on internal demand as an engine of growth. It was apparently easier to enable the US to pursue an unsustainable mix of fiscal and monetary policy. Pesek does question the wisdom of continued adherence to this policy:

Timidity might be a mistake. Inflation is the real risk to Asia's long-term prosperity, not slowing U.S. growth. China's inflation has quickened to the fastest pace in 11 years, and consumer prices rises in Sri Lanka and Vietnam have exceeded 20 percent. Singapore's consumer price gains have reached levels not seen since 1982...

''It's hard to exaggerate how much of a problem rising inflation is to Asia's short-term stability and longer-term prosperity,'' ADB Chief Economist Ifzal Ali told me in Tokyo last month. ''It really is THE issue.''

At this point, the ability of US policymakers to chart a middle course -- or hold in economic purgatory -- is dependent upon the willingness of the rest of the world to continue to enable the process via continued accumulation of US assets. Rising inflation could trigger a policy shift abroad.

Note that the Fed's pause is not likely to provide much relief on the global inflation front. The insistence of many central banks to follow lock-step to Fed policy creates an immense amount of global liquidity, supporting global demand (note that the Baltic Dry Index is retracing its losses) and higher commodity prices. See for example the rise of oil to $120 even with clear indications the Fed intends to pause, and despite the strengthening of the Dollar. A Fed pause in and of itself is not the same as a policy reversal -- a reversal that will not happen until domestic inflation becomes intolerable. And recent trends in core inflation and soft wage growth indicate we are nowhere near intolerable yet. Thus, if foreign central banks are waiting for the Fed to fix their inflation problems, they will have a long time to wait -- they should expect help from the Fed only after they abandon the Dollar. Of course, by then it will be too late.

In addition, the threat of continued economic purgatory will place pressure on the next Administration to stoke the fiscal fires to lift us out of purgatory. And some central bank somewhere will have to provide the fuel for that fire by absorbing the resulting bond issuance. Yves Smith at Naked Capitalism points us to the Wall Street Examiner and the latest report of the Treasury Borrowing Advisory Committee, in which they note estimates of the 2008 fiscal deficit have risen to more than $500 billion. That is starting to look like real money. Moreover, even that may pale compared to future deficits, as it increasingly looks like the stimulus checks currently being delivered will have a less than imagined impact. If so, there will soon be calls for another large(r) stimulus package, and it will be increasingly difficult for Clinton or Obama to role back the Bush tax cuts. How much US debt will the rest of the world absorb?

Timing is a critical issue -- many have predicted that sustained fiscal imprudence and internal imbalance will end disastrously when foreign agents cease accumulating Dollars, only to learn that they have grossly underestimated the willingness of foreigners to enable US spending. The benefits of maintaining the current international financial architecture apparently still outweigh the costs. Rising global inflation is challenging that calculus -- but it may have to go much higher to significantly impact policy. Which suggests that even with a Fed pause, the commodity price boom is still in its early stages.

Bottom Line: The Fed's hesitation to continue lowering interest rates, and instead shifting its entire focus to reliquifying credit markets, looks sustainable as the economy slides into economic stagnation. This is especially the case as still rising commodity prices -- particularly oil -- keep sufficient fear of inflation alive at the FOMC to offset the weak job market and as the Fed waits to see the impact of the stimulus checks. I would not become complacent, however. The US position remains precarious, with a delicate combination of monetary and fiscal policy, combined with substantial external support, keeping the train on the tracks. It is simply far too easy to envision a scenario -- excessive US stimulus coupled with a loss of foreign support -- that switches the train to a broken track.

Comments

[Winslow R.]

"I am not completely surprised; I have long believed that the economy would enter a prolonged period of pain as we transition away from dependence on foreigners to sustain excessive consumption. "

Loaded statement as we switch from foreign savings to foreign spending.
Could still consider it foreign dependence if you like :)

says...

TD wrote: "Policy needs to be appropriately stimulative to limit the pace of the adjustment, but not prevent the adjustment itself. In a sense, policy needs to maintain an extended period of economic purgatory."

Not extended, just until we elect a new power structure.

[Winslow R.]

Pasek wrote"What ails the U.S. is too much consumption, too much debt, too little household savings and a financial system that's more vulnerable than once thought"

How about specifically targeting wartime spending?

[Winslow R.]

TD wrote:"Asia could have focused on minimizing their accumulation of Dollars long ago, fostering greater reliance on internal demand as an engine of growth."

Or just taxing or issuing long term bonds to keep domestic inflation in check by absorbing excess currency.

[RW]

There is a point where an approaching tsunami drains the coastline of water which then appears to pause as the onrushing mass gathers itself for the overarching and catastrophic leap to land. I've been told by survivors that there is an eerie calm then, aside from stranded sea life everything able to do so is already gone in a mad dash for deeper water or higher ground.

[bakho]

Maybe our economy is at a point where it will not respond much to a decrease in the Fed rate? Could really low interest rates actually cause another housing boom?

[hari]

In contrast to Mark's analogy, any remedy that would avoid a serious recession is better ..., Feds hands may be tied by this WH/Paulson if BB wants to stop unnecessary foreclosures and avoid the next train wreck...because if the forclosures become unstoppable then there will be a cascade to the bottom and the market will finally decide that bottom.

This market, if we can take Pual's anlysis seriously, has come a long way under GP and now BB. Perhaps this correction was foreseen and inevitable simply because of the SIVs and its implications.

[Redistribution of Lower Total Consumption]

"...limit the pace of the adjustment, but not prevent the adjustment itself..."

IOW, the aggregate national standard of living must fall without increasing unemployment. (We must collectively consume less.) Either the real hourly wage must fall, or borrowers must consume less. Inflation subsidized negative real interest rates will maintain borrower consumption (to cushion the adjustment). Since borrowers will maintain consumption, while total domestic consumption falls, this means workers must consume less per hour worked (many retired workers may consume much less).

Cushions for borrowers are expensive to the standard of living of workers/retired workers. Workers/retired workers cannot consume products that monetary-expansion-subsidized borrowers have already consumed.

Borrow from foreign workers, and domestic borrowers consume more (foreign workers consume less, but hope to get paid back later). Give borrowers newly created money, and borrowers consume more (domestic workers consume less-they never get paid back).

[Who Will Consume Less?]

Borrowers have been living high using foreign deferred consumption. If borrowers are to maintain their standard of living without the use of foreign workers' deferred consumption, domestic workers/retired workers must consume less. To put it another way, workers must consume less, but work just as many hours anyway, so that borrowers can maintain their standard of living.

Of course, we could just let borrowers consume less, now that they can't borrow as much deferred consumption from foreign workers. Why should borrowers alone maintain their standard of living? Why do workers/retired workers always have to consume less just so borrowers can maintain consumption?

[Rajesh Raut]

So if inflation is a consequence of central banks following Federal Reserve policy, why is inflation so high in Europe? Given than the ECB has been so much more hawkish about inflation why is their such a small spread between inflation in the U.S. and in the Euro area?

A large component of inflation is due to years of under investing in commodity extratraction/production/processing. No amount of monetary policy changes will have an immediate effect on the amount of copper, wheat or oil produced.

U.S. consumption of gasoline is down compared to the same period last year. If oil prices are still high, that indicates that it is a global problem and not just a U.S. one.