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Monday, September 08, 2008

Fed Watch: Short Takes

Tim Duy on bailouts, media problems with export data, data inconsistency, inflation damage, the employment report, and, of course, the Fed:

Short Takes, by Tim Duy: One of my goals for this school year is to concentrate on writing shorter posts rather than lengthy analysis. With that in mind:

On Bailouts:

The Freddie/Fannie bailout was inevitable. There was never really an implicit guarantee of a taxpayer backstop for these institutions; in practice, the guarantee has always been explicit. Moreover, they evolved into institutions that are too big to fail. Cutting them loose at this juncture would be an unacceptably risky strategy. Teaching lessons in moral hazard (beyond that of the substantial losses likely to be borne by shareholders) is interesting coffee table talk, but not practical policy when the potential downside broadly impacts the public. True, there may be a consequence for future taxpayers, but they too will be spared the ramifications of letting these mortgage giants collapse today.

Moreover, the bailout provides an important policy lesson – nothing truly bad can happen as long as the US Treasury is willing and easily able to float debt onto the global financial markets. Presumably, Treasury will finance any cash injections into Fannie and Freddie by issuing debt that will be forced fed to foreign central banks, the same way Treasury financed the now forgotten stimulus package. The US can always inflate away the real value of that debt at a later time. As long as foreigners are willing to continue to take that risk, let them.

To arrive at a truly bad outcome, the US needs to be cut off from foreign financing. Otherwise, the economy will muddle along at anemic growth rates until a broad restructuring away from consumer dependent growth is complete.

On Exports:

There is a consistent mischaracterization in the media regarding the contribution of exports to 2Q GDP growth. Take, for example, the Wall Street Journal:

Last week economists were surprised by 3.3% growth in gross domestic product in the second quarter. Nearly all of the gain (3.1 percentage points) came from strength in U.S. goods sold overseas. The stronger exports managed to offset continued weakness in the housing sector and slowing consumer spending, once the bedrock of American growth.

The 3.1 percentage point figure is not exports but NET EXPORTS. Only 1.65 percentage points of the gain came from export growth. The remaining 1.45 percentage points came from import compression (falling imports). This distinction is important, as overseas sales are not the only factor limiting the impact of the consumer slowdown. A significant portion of that slowdown is offshored to overseas producers. In others words, if I put off the purchase of a new flat screen TV, the impact of my decision falls almost entirely on foreign, not domestic, producers.

The media seems incapable of understanding this distinction, but it explains why consumers feel miserable but a decline in overall growth that is less than expected. Of course, one could still expect that export growth will slow in concert with declining global growth, but import compression will still serve as a source for growth (or offshoring weakness) in the quarters ahead.

On Consistency:

I always look for consistencies and inconsistencies in the data flow. From the latest ISM report on manufacturing:

The past relationship between the PMI and the overall economy indicates that the average PMI for January through August (49.5 percent) corresponds to a 2.6 percent increase in real gross domestic product (GDP)

Interestingly, average GDP growth for the first half of the year was not far off at 2.1%, which means that the ISM data – created via an entirely different methodology – implies that the hand wringing over the surprise gain in GDP is overdone. Likewise, there has been a willingness to dismiss the gains in nonair, nondefence capital goods orders as simply a byproduct of inflation. This depends on your choice of deflator, and caution is required as we lack an appropriate deflator (the mix of new orders may change each month, but the weightings in the deflator do not). That said, if you use the PPI for capital goods as your deflator, the pattern of new orders remains qualitatively unchanged in the sense that we do not see the steep drops consistent with the previous recession:


A more aggressive choice of deflator results, obviously, in more worrisome drops in new orders. This, however, would not be consistent with the ISM or GDP data.

Looking at the GDP, ISM, and new capital goods orders data jointly, I still see anemic overall growth driven by very weak domestic demand growth, for an outcome that is bad yet still not as bad as might be expected for an economy in recession. Of course, it could get worse, and I have no rose-colored glasses about the second half of the year.

On The Damage Wrought by Inflation:

For a recession that many believe began in late 2007, growth in nominal private wages and salaries has held up remarkably well:


This is a reflection of relatively small job losses compared to previous recessions (see below). Why, then the more severe slowdown in consumer spending?


The impact of inflation is the primary culprit here (although the loss of the housing ATM is not inconsequential). This is a reminder that inflation is not as innocuous as is often believed– in a period of tepid nominal wage growth, it crushes real demand as much as outright job losses, but with different distributional effects. The Fed has chosen a middle road between inflation and job declines, but for the overall economy, the destination is the same – anemic growth as the economy fundamentally restructures away from a reliance on debt-supported consumer spending.

On the employment report:

Unmistakable weakness – with the unemployment rate suggesting recession – but not quite as broad-based as on first take; note the jump in the one-month diffusion index from 41.4 to 48.9 (diffusion indexes improved until the 12-month horizon). Moreover, the manufacturing decline is largely attributable to the automotive sector (consumer weakness in the SUV component of this sector is less offshorable than weakness in, say, electronics). Indeed, almost half the decline in private payrolls is the transportation sector alone. Still, on net, the report not much different than my expectations. I anticipate a string of weak employment weak with NFP growth hovering around -75k throughout the rest of this year. This remains well above the 200k+ losses commonly associated with recessions. Bad, but not as bad as could be.

On the Fed

Policy remains on hold. A rate hike is clearly off the table for the remainder of this year; the plunge in commodity prices and coincident revival of the Dollar removed the motivation for such a policy shift. I also do not expect a rate cut; FOMC hawks would probably have strokes if Fed Chairman Ben Bernanke managed to push one through. The general mood on the FOMC will have to shift from “hoping for inflationary pressures to subside” to “fear of deflation” to force the FOMC from its current perch. I also doubt the latest employment report will have much of an impact, as FOMC members will spot the unusually large decline in the auto sector as well, and thus discount the report accordingly, waiting instead for additional data. The slow bleed in jobs, of course, also argues against a hike, but I suspect that given inflation concerns, you will need to a see a few 200k+ declines in payrolls to prompt a rate cut.

Bottom Line:

If you are hoping for a quick resolution to the challenges facing the US economy, be prepared to be disappointed. Our bubble-dependent growth is out of bubbles, leaving a lengthy restructuring process ahead that will fall particularly hard on households. Expect persistent weakness in economic activity, but that weakness still falls short of apocalyptic. The Fed is charting a course between excessive job loss and excessive inflation during this adjustment; given the precarious state of the economy, balancing between these two outcomes, a divergence of opinion on the FOMC is understandable. To get to an apocalyptic scenario, policymakers need to run out of options. And as long as the US Treasury can float debt at 4% - or 5%, or 6% - policymakers are not out of options.


My “short” post extended to four pages; sorry for the lengthy read. If a persistently weak economy unsettles your nerves, I recommend:

On Local Tradable Goods:

The Ninkasi Believer Double Red – brewed in Eugene, OR – is a remarkably good beer to make the transition from the lighter brews of summer to the darker ones I so look forward to in the fall and winter. Just as important in these troubled economic times, I deem it a best by at $3.99 for a 22oz. bottle ($3.79 at the local Albertsons). For those who want to jump the season, Deschutes Brewery in Bend, OR has released Black Butte XX to celebrate the 20th anniversary of their signature porter. At 11% alcohol, this dark, rich beer will warm the most bearish soul, but it will set you back $9.99 for the 22oz bottle.

    Posted by on Monday, September 8, 2008 at 12:24 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (3)


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