Tim Duy looks at monetary and fiscal policy options in light of an economy that continues to slide downhill:
Bad to Worse, by Tim Duy: From bad to worse is about the only way to describe the flow of data last week. With each new data point, the case for additional stimulus grows. But does the Fed have much room to maneuver before pursuing a significant shift in policy? And should we listen to those nagging concerns that the limits to US deficit spending are soon approaching?
Adding to the dismal manufacturing report early in the week, the ISM nonmanufacturing numbers confirmed what most suspected – the downturn has moved solidly into the service sector. The details were as weak as the headline, including a fresh drop in the employment measure. The latter set the stage for the weekly initial claims release, which unsurprisingly pointed to further deterioration in the labor market even as the jobless total climbed to the highest level in 25 years. The all important employment report only added to the gloom – a solid analysis from HBSC is available via Across the Curve, with more to read from Jim Hamilton. I would shy away from analysis that focuses on the relatively small percentage loss of employment, or minimize the consequences. From Justin Fox (hat tip Menzie Chinn):
The vast majority of workers remain employed--and will remain employed even if the recession deepens. Barring an unraveling of the financial system, they will eventually get back to spending at a healthier pace than in the scary month of October.
Justin Fox is apparently not worried about the economic consequences of having the U-6 broad measure of unemployment at 11.8%.
If the economy was still shedding jobs at less than 100k a month, and the losses were most sector specific, you could say that a relatively mild restructuring process was underway. That is no longer the case – the breadth and depth of payroll declines scream something much worse. Note also that these numbers are appearing closer to the beginning of the recession than at the end. It could and will get a lot worse before it gets better.
Simply put, these are not numbers to take likely, and suggest that the October retail sales report Fox refers to will not be merely an aberration. In the first stage of the crisis, consumer spending power was constricted by the bursting of the housing bubble, although the tightening in mortgage markets could reasonably be described as a reversion to traditional lending conditions that necessitated a slowing of consumer spending growth. In the second stage, households were pummeled with high inflation. In the third stage, households are hit with rapidly deteriorating job markets and a fresh tightening of credit channels, not that they were in much of a position to extend debt loads in any event. Consider, for example, household financial obligations as a percentage of disposable income:
What always strikes me about this chart is that households never deleveraged in the wake of the 2001 recession; they just kept piling on the debt load. I have long been of the opinion that the economy is terribly unbalanced, with too much reliance on consumer spending. Adjustment is inexorable; it always is. Consequently, financial commitments will fall further. Remember too that financial obligations represent leverage on the household balance sheet – to reduce $1 dollar of obligations requires a much greater reduction in debt (lost/foregone spending power). Simply put, there is still plenty of downside ahead for consumer spending, either in outright declines or sustained lower growth rates. Consumer spending will not fall every month, but future patterns will be very different than the past.
The downward shift in economy puts additional pressure on policymakers to act. On the monetary side, options are limited – the Fed’s traditional policy tools have lost stimulative traction. To be sure, Fed officials continue to remind us that they have another 100bp left:
Dennis Lockhart, president of the Fed Bank of Atlanta, said the Fed’s key rate, which stands at just 1.0%, could “in theory” go down to zero if problems persist, and said this could be considered.
The reality, however, is closer to the view of Jim Hamilton:
...the target itself has become largely irrelevant as an instrument of monetary policy, and discussions of "will the Fed cut further" and the "zero interest rate lower bound" are off the mark. There's surely no benefit whatever to trying to achieve an even lower value for the effective fed funds rate.
Policy traction comes from the balance sheet at this point. Balance sheet related actions have focused on ungluing the financial markets – actions that have been critical in preventing the system from collapsing by replacing lost liquidity, but have so far be insufficient in preventing recession. The Fed is simply cushioning the deleveraging underway. Hamilton suggests moving to the next stage in the game:
…I would urge the Fed to be buying outstanding long-term U.S. Treasuries and short-term foreign securities outright in unsterilized purchases, with the goal of achieving an expansion of currency held by the public, depreciation of the currency, and arresting the commodity price declines.
One only has to read a few of Fed Chairman Ben Bernanke’s past speeches to known that some variation of this option is on his mind. Still, I think the Fed will opt to pass the baton to fiscal authorities before shifting to a policy of unsterilized asset purchases.
The push for a rapid fiscal response is building, including an effort to pass at least one measure during the upcoming lame duck session of Congress. The main event, however, will not be until next year, and the resulting package will be significant. A final price tag of $500 billion would not surprise me (can’t let ourselves be outdone by the Chinese), and will hopefully include a wide array of elements currently on the table; for example, extending unemployment benefits, aid to state and local governments, some tax cuts, and infrastructure spending.
How much bad policy will be included? There will always be some bad policy, even in a more enlightened administration. For a change, the good should vastly outweigh the bad. Still, how many more blank checks will be handed out, such as the one to AIG? How many more industries will come begging at the government’s door? Automakers are almost certainly going to get their piece of the pie. And, most importantly, will the focus of policy be supporting and cushioning the transition from a consumer/debt supportive growth dynamic, or preventing/reversing the adjustment already under way?
The US economy is restructuring; I suspect the process will be lengthy, and that patterns of growth on the other side will be very different. According to President-elect Obama:
"I have said before and I will repeat again: It is not going to be quick and it is not going to be easy for us to dig ourselves out of the hole that we are in, but America is a strong and resilient country," he told the news conference, which lasted a little less than 20 minutes.
A realist – notice that he doesn’t claim that everything will be solved with a tax cut? The US has spent the better part of 20 year favoring nontradable sectors over tradable sectors, ultimately pushing the nation to focus on the production of overpriced housing and financial services (the latter arguably tradable, but no longer in demand). Reversing these patterns will not happen overnight – a period of structural unemployment is almost certain. Preventing this process (by, for example, pretending that we can fix the economy by fixing housing prices) would be misguided. But the restructuring process is now disorderly, and threatens to undermine employment in sectors that need not be negatively affected. There is a strong case for fiscal stimulus, even massive fiscal stimulus, under such circumstances.
If in fact we are pushing too hard on the fiscal gas pedal (particularly possible if foreign nations follow China’s lead and shift stimulus efforts toward domestic growth), the financial markets will send a warning sign – long term rates will rise to push down spending in other sectors. Policymakers should not turn a blind eye to such a warning, although I think they would be tempted to do so, especially if structural factors were holding unemployment high. Hamilton’s suggestion that the Fed just move to unsterilized asset purchases would look tempting as an effort push long-term rates back down (you need to support the mortgage market, after all). In short, I don’t see the fiscal stimulus, even on a large scale, as necessarily unmanageable, but I believe it is possible. Where there is room for policy error is ignoring the warning signs that such stimulus was unmanageable.
Bottom Line: The data flow points to the worst recession since the 1980s. The pressure for more stimulus is growing, but the Fed’s policy options are limited to more of the same – unless Bernanke & Co. are ready to make the leap to unsterilized balance sheet expansion. They are not there yet, a reasonable stance given that substantial fiscal stimulus is almost certain. If the stimulus is too much for global financial markets to stomach, the yield curve will steepen dramatically.