Out of the Gate with a Bang, by Tim Duy: If you were
looking for a final, cataclysmic collapse of the US economy, you remain
disappointed. To be sure, the fallout from the
financial crisis is severe, with the palpable wreckage evident in the bottom
line, a rate of underemployment at 17.2%. Yet even the most diehard pessimist could not fail to recognize the
numerous signs of a cyclical turning point in the second half of 2009. And those signs continued into the new year with today's ISM release. The bulls had reason to run with these numbers; the near term outlook
appears baked in the cake. Yet the near term is not
an interesting question, in my opinion. The
interesting question is what will emerge in the second half of the year. Is the first half a head fake? And, more
importantly, where will incoming data lead policymakers, particularly at the
Fed? My expectation remains that the Fed
will wait until the medium term uncertainty is lifted before raising interest
rates, which would be well into the back half of this year if not into 2011. But that might not be the ball to watch; policymakers probably worry
about the size of the balance sheet more than the level of interest rates. The near term risk is that stronger than expected growth in the first
half would tempt the Fed to withdraw that liquidity before the recovery became
numbers for December stoked a fire on Wall Street Monday morning, with the
better than expected headline number bolstered by strong gains in new orders,
the lifeblood of future factory production.
Moreover, the employment numbers moved higher, which, coupled with steady
declines in initial unemployment claims, points toward actual - gasp - job
growth as early as the first quarter.
Industrial production gained a solid 0.8% in November, returning to
something resembling a "V" shaped recovery in the making after a flat reading in
core manufacturing orders continued their upward trend that same month.
Inventory to sales ratios continue to fall, arguing for continued restocking support. And
consumer spending continues to edge forward despite declining consumer credit
and rising saving rates, a dynamic that will be increasingly supported by
firming job markets. What's not to like? No wonder then that Treasury markets have sold off modestly, the 10 year
bond heading toward the 4% mark.
Indeed, using the
typical post war recession as a guide, one would think the pessimists would by
now have folded their cards, leaving that smoky back room of despair for the
clear air and bright sunshine that mark the beginning of a new day. But alas, the fear remains that there is no longer such a thing as a
"typical" post war recession. The recovery appears
inexorably linked to a host of stimulus measures that reach into virtually every
strand of the fabric that is the US economy. And
therein lies the uncertainty - few are confident that the economy can stand on
its own. And the hypothesis that it can has not been
tested. The Fed continues to expand its
holding of mortgage securities, still looking toward March as the end date for
that program. The
positive growth impulse from fiscal stimulus will continue through the first
half of this year. Support for housing comes
via many channels - and despite rising existing home sales and price
stabilization, no one believes the housing market remains anything but broken. Moreover, it is difficult to forget that solid US growth of the past
decade and earlier was dependent on asset bubbles to fuel consumer spending. No such convenient asset bubble is on the horizon at the moment.
Where does the
economy stand when the support for housing is withdrawn, when fiscal stimulus
runs its course, when the inventory correction process is complete?
The most dire predictions point to the
possibility of a double dip recession:
Prize-winning economist Paul Krugman said he sees about a one-third chance the
U.S. economy will slide into a recession during the second half of the year as
fiscal and monetary stimulus fade.
“It is not a low
probability event, 30 to 40 percent chance,” Krugman said today in an interview
in Atlanta, where he was attending an economics conference. “The chance that we
will have growth slowing enough that unemployment ticks up again I would say is
better than even.”
But as Krugman
notes, even a slowing in the rate of growth would be sufficient to derail any
nascent recovery in the job market pushing the unemployment rate higher. And the outlook for unemployment was not particularly optimistic to begin
with, especially if a job market revival draws discouraged workers back to the
despite an improving economy, the enormous uncertainty surrounding the path of
growth in the second half of this year coupled with still high unemployment
forecasts, look likely to keep policymakers on hold through at least the first
half of this year. Recent Fedspeak has not been
particularly optimistic at all, tending to favor stories of drags on the
economy. See Federal Reserve Governor Elizabeth Duke
Calculated Risk. See also
Federal Reserve Vice Chairman Donald Kohn:
constraints are a key reason why I expect the strengthening in economic activity
to be gradual and the drop in the unemployment rate to be slow. Even as the
impetus from fiscal policy and the inventory cycle wanes later in 2010, however,
private final demand should be bolstered by further improvements in securities
markets and the gradual pickup in credit availability from banks. In addition,
spending on houses, consumer durables, and business capital equipment should
rebound from what appear to be exceptionally low levels. We have already seen
some hints of this increase in private demand in recent months. But,
understandably, households and businesses and bank lenders remain very cautious,
and the odds are that the pickup in spending will not be very sharp.
And finally, note
that in Federal Reserve Chairman Ben Bernanke's most recent speech, he
explicitly relies on the Taylor rule as evidence that the Fed Funds rate was not
too low during the run-up to the housing boom. That
same rule posits that the Fed Funds rate should hold at zero. Indeed, Paul Krugman notes that Taylor rules coupled with the Fed's
point to negative interest rates through 2012, a point that Bernanke
ignores, clearly not wanting any criticism that he needs to more rather than
less, by imposing the zero bound on his charts.
Still, the point is clear; to the extent that the Fed's forecast is not
changing, there seems to be no need to back off the zero interest rate policy
any time soon.
But what about
the balance sheet expansion? Recall
Louis Federal Reserve President James Bullard from November:
In an interview
posted on the newspaper's website on Sunday, St. Louis Federal Reserve Bank
President James Bullard said he would not favor tightening monetary policy
before recovery was well-established.
"You are going to
need to have jobs growth and you are going to need to have unemployment
declining," said Bullard, who moves into a voting seat on the Fed's rate-setting
panel next year.
that tightening monetary policy "does not have to involve as its first step
moving the federal funds rate off zero". Instead, he favored at that point
selling back assets the Fed had acquired, the Financial Times said.
officials have said asset sales could disrupt financial markets and push up
long-term interest rates. But Bullard said that with proper planning, asset
sales did not need to be disruptive.
Suppose that the
combined effects of inventory correction and federal stimulus are sufficient to
pop the nonfarm payrolls numbers, a possibility enhanced if firms cut employees
a little too aggressively in 2009. This is likely
not enough to spook the FOMC into hiking rates, but could be sufficient to test
the waters on liquidity withdrawal. Would they spook
that easily? Note Kohn's words of caution:
monetary policy typically acts with long lags on the economy and price level,
the choice of when and how to exit will depend on forecasts. We will need to
begin withdrawing extraordinary monetary stimulus well before the economy
returns to high levels of resource utilization. The FOMC has been clear that its
expectations for the stance of monetary policy depend on economic conditions,
including resource utilization, inflation, and inflation expectations.
Accordingly, the judgment as to when to begin initiating steps to withdraw
stimulus will depend on the outlook for these variables.
Finally, it is
well to remember that we are still in uncharted waters. We do not have any
recent experience with financial disruptions of the breadth, persistence, and
consequences of those that we have experienced over the past several years. And
we have no experience with most of the sorts of actions the Federal Reserve has
taken to counter the shock. The calibration of our exit from these policies is
complicated by a paucity of evidence on how unconventional policies work. We
will need to be flexible and adjust as we gain experience.
While Kohn is
warning that the Fed would need to move quickly to get ahead of a turning
economy, a pop in payrolls might not be sufficient to force near term action. The addition of rising inflation expectations, however, could be the
final straw. Although actual core inflation was flat
in November while the unemployment rate suggests resource slack for years to
come, the 10 year Treasury TIPS breakeven has widened to a pre-crisis level of
239bp. But the general public appears
hold low inflation expectations. Will those
shift dramatically? Again, given high unemployment,
this looks unlikely. But what would surely cause
expectations to shift is a steady rise in energy costs. Oil has moved back through the $81 dollar mark (on the back of ease Fed
policy again?), and
Calculated Risk notes that this may already be impact driving habits. Last time inflation expectations spiked on oil, the Fed looked through
the gains, eyes firmly focused on the evolving financial crisis. But this time the balance sheet would be much bigger, a fact that would
stick out like a sore thumb at an FOMC meeting.
The risk of
course is that if the Fed is pushed into a premature withdrawal, financial
anarchy would ensue. Indeed, via naked capitalism,
some are already looking for that outcome on the back of the stabilization of
the Fed's balance sheet in the latter half of 2009.
Of course, risks are not all US centered. China
plays a role as well. From
bank Governor Zhou Xiaochuan reiterated government warnings that investment in
industries with excess capacity and in redundant infrastructure projects could
threaten banks’ loan quality.
The People’s Bank
of China will guide credit, seeking to avoid volatility in lending, Zhou said in
an interview dated yesterday on the Web site of China Finance, a central bank
publication. Investment in duplicated projects or industries with overcapacity
could “pose a risk to the quality of banks’ loans,” Zhou said.
makers are seeking to contain risks from an unprecedented credit boom, in which
banks extended 9.21 trillion yuan ($1.3 trillion) of new loans in the first 11
months of 2009. Liu Mingkang, chairman of the China Banking Regulatory
Commission, said yesterday that lenders have “more than” enough capital, while
also cautioning that asset bubbles may emerge in the world’s third-biggest
“The credit boom
last year to cope with the financial crisis has brought side effects, including
housing bubbles in some cities and overcapacity in manufacturing,” said Isaac
Meng, a senior economist at BNP Paribas SA in Beijing. “These are risks that
China will need to guard against this year.”
adds his concerns about Chinese inflation he sees evidence in rising garlic
wondering if the pent-up inflationary pressure takes the form of inducing
consumers and businesses in China to try to acquire any hard assets they can,
with the result that rather than overall inflation we see remarkable increases
in the relative prices of such items.
The concern, of
course, is that the next negative demand shock does not have to originate in the
US, fears of a Fed overreaction aside. Tighter
credit in China to stem inflation could be sufficient to once again push the
global economy to the brink.
Bottom Line: The economy is gathering steam. Can't deny
it. But the clear path to sustained recovery remains
clouded by government stimulus, both in the US and abroad. Few policymakers are confident that economic activity can stand on its
own as stimulus fades, leaving the Fed disinclined to rush for the exits given
existing forecasts. Indeed, there is reason to
believe based on Taylor Rules that interest rates should be held at the zero
bound through 2010 and beyond. But policy mistakes
happen. And FOMC worries about the timing of
withdrawal could be the basis for such a mistake if near term activity
accelerates rapidly and inflation expectations gain.
The focus on the Fed may be misplaced; the FOMC is not the only policymaker that
might upset the apple cart. The next negative shock
might come from abroad.
Posted by Mark Thoma on Tuesday, January 5, 2010 at 12:21 AM in Economics, Fed Watch, Monetary Policy |