The Rapid Reversal, by Tim Duy: The rapid shift in financial markets over the past month caught me off guard. I have long been of the view the US economy was undergoing a fundamental adjustment to an unsustainable external imbalance. That adjustment required a lengthy period of relatively slow domestic demand growth to bring US consumption in line with productive capacities – a process that should reduce the magnitude of the US current account balance. Effectively, the US economy would ease into some new equilibrium characterized by a fresh constellation of exchange rates, interest rates, and prices.
The exact constellation of these nominal variables, however, was not predetermined and likely to be impacted by policy decisions. Excessive monetary and fiscal stimulus would interfere with this adjustment, overstimulating real activity and thus forcing prices higher and the value of the Dollar lower than would otherwise be the case (of course, the tradeoff would be lower unemployment). In essence, if the policy refused to allow the adjustment to occur, financial markets would force the adjusted via alternative channels. One consequence was the sharp rise in commodity prices, particularly energy.
I did not expect that oil would choke off US demand until prices closed in on $175 or higher, sending gas prices north of $5/gallon. As it turned out, $145 and $4 were the magic numbers at which households were forced to take as cold, hard look at their finances and start cutting expenses that would result in the least real reduction in living standards. Not surprisingly, Detroit suffered a grievous blow in the process, experiencing a sharp fall in sales:
Automakers were not alone. Whole Foods (Paycheck) took a beating as consumers suddenly began to doubt the value-added of trending food. And chain store sales slowed in July, with fresh warnings of a weak back to school selling season. In short, fiscal stimulus offered the anemic initial support that many expected, and that limited support was offset by the steep rise in energy prices. The stimulus saved will continue to trickle through the economy in the quarters ahead, but will not offer anything eye-popping in the way of consumption growth. And, as noted by Calculated Risk, slow demand growth coupled with falling energy prices should put downward pressure on the US current account deficit, reducing the necessity of capital inflows over time.
The consequences for monetary policy are straightforward as recent trends help relieve the current dichotomy of opinions on the FOMC. Indeed, I was left uneasy by the last FOMC statement, which by my read implied heightened worries over both growth and inflation. The reversal in energy prices should help on both fronts, bringing relief at the pump for households (supporting real incomes) and easing inflationary pressures. Couple with the stronger dollar, this should allow Bernanke & Company enough breathing room to keep rates on hold for the remainder of this year and maintain focus on the growth outlook and still fragile financial markets.
I anticipate the second half of 2008 will look much like the first half – weak, more like the average growth of 0.9% recorded for the past three quarters than the nearly 2% reading from Q2. In the near term, there appears to be little room for additional stimulus, either fiscal or monetary. The latter is hampered by still high inflation rates, while the former is unlikely considering the need to wrap up Congressional business ahead of the prime campaign season. Household spending will remain subdued under the combined weight of stagnant labor markets, tight credit, and weak housing. Commercial real estate will slow in the coming quarters as well, while I anticipate that investment in equipment and software will hold steady export and import competing industries expand. I do not anticipate another lurch downward. The relatively steep yield curve argues against such a forecast. And, more importantly, I tend to think that another significant negative shift requires a jump in long term interest rates, a jump that seems unlikely given that the rest of the world continues to absorb US debt, maintaining a relatively liquid financial environment despite a devastating financial crisis.
Incidentally, the steepness in the yield curve works to heal the banking system, as noted in today’s Wall Street Journal:
The Federal Reserve has come up with plenty of newfangled ways to shore up the financial system in recent months. But its oldest, and simplest, trick has been to let banks try earning their way out of trouble by cutting short-term interest rates.
The question is how long this gift can last.
In past recessions, the Fed has slashed rates to revive the economy. This move typically allows banks to borrow short-term at low rates and invest the money in higher-yielding, longer-dated assets. This "trade" produces easy profits that can go a long way toward repairing balance sheets trashed by bad loans.
It did the trick in the early 1990s recession. And, going by banks' recently reported second-quarter results, they are once again turning cheap funding into good money.
In contrast, Caroline Baum at Bloomberg argues that a yield spread of closer to 400bp – twice the current spread – is necessary to heal the banking system. But if the Fed is locked at a Fed Funds rate of 2%, and external support is keeping the 10-year Treasury near 4%, where would that additional steepness come from? I think that widening the spread requires foreign central banks to dramatically slow purchases of US assets, at least in the near term (longer term, one would hope that an increase in loan demand would emerge). In effect, US banking is not highly profitable because China, Russia, and the Gulf States are willing to lending money on the cheap (coupled with, of course, the lack of takers to expanding lending). If so, this is an interesting conundrum – although I am admit to somewhat thinking aloud hear. The US banking system cannot heal quickly because profitability is limited by a relatively narrow long-short spread. But widening that spread requires the rest of the world to cut off the financing that so far has limited the depth of the US downturn, engendering an increase in longer term rates which would almost certainly accelerate the housing crisis. Without the support of the rest of the world, US interest rates would spike and the ensuing demand destruction would achieve an external rebalancing via rapid import compression. But higher rates would improve lending profitability, setting the stage for a solid recovery once the economy rebalances.
But such shock therapy, however interesting in theory, is likely not the best policy prescription. Which brings me back to where I began – the US economy needs to find a more sustainable growth path less dependent on external production. This process can occur slowly or quickly. The policy actions taken to date have slowed the process, but cannot prevent it, as evidenced by the rise in inflation and its role in softening demand. Instead of an apocalyptic collapse in demand, the result is path of below-trend growth and persistent weakness in labor markets, similar to the period of extended weakness earlier this decade. The endpoint is the same; the paths are different.
Bottom Line: Lacking an asset bubble to promote growth while still working through the aftermath of the last asset bubble leaves the US economy hobbled. While I think another downward lurch in line with the more apocalyptic outlooks remains unlikely, stabilization at relatively low rates of growth looks like the best we can expect for the foreseeable future. The collapse in energy prices gives the Fed room to avoid a rate hike this year, but the sting of this year’s burst of inflation will keep policymakers from cutting rates as well. Like the US economy, monetary policy is in limbo.