Fed Watch: Starting on an Ugly Note

Will the economic recovery package will be too "fleeting":

Starting on an Ugly Note, by Tim Duy: The only certainty for the New Year is that policymakers will continue to pull out all the stops to keep a floor under the US economy. And recent data highlights the difficulty they will face. Hope is high that the incoming Obama Administration can provide the stimulus necessary to generate economic growth by the second half of 2009. The numbers being floated look sufficient to do the job. But will the package provide little more than short term relief or a lasting fix?

The last two weeks were not pleasant. Working backwards, we were greeted on the first trading day of the New Year with a truly terrible report on manufacturing. Across the Curve has the details; my eyes were pulled to the decline in the export orders component. The external accounts should be cushioning the US downturn. Instead, it looks increasingly likely the opposite will happen – another sign that the global economy is hopelessly imbalanced.

Earlier in the week, the Case-Shiller index confirmed the expected ongoing decline in housing prices. Efforts to support this sector have proven insufficient to stem the pain. This should not be a surprise, as government efforts have focused on maintaining a market for mortgages made under conditional underwriting standards. Such standards limit home financing to that which is prudent for the borrower and lender, but well below that necessary to maintain housing prices. Moreover, lending for home purchases (and consumer credit in general) is now fighting against a deteriorating labor market. I don’t care how much money has been spent on TARP, you can’t reasonably expect banks extend fresh credit to the jobless. And there is no mistake that the floor is falling out from under workers. Look at the employment component of the ISM report. Or the recent trend in initial employment claims, with a four week average of 552k; discount the seasonally affected drop last week. This Friday is likely to see another blowout employment report.

New orders in durable goods report were better than expected, although I take little comfort in the improvement. The numbers tend to be volatile, and the ISM release noted above strongly suggests this indicator will trend lower in the months ahead. The personal income and outlays report was also better than expected as falling gas prices provided a significant boost to real incomes. But the downside in oil prices is likely limited at this juncture, and, consequently, gas is not likely to provide as much of a boost in future months. Moreover, the declining energy costs are fighting against rising joblessness and increasing saving rates. The latter two forces are likely to prove overwhelming.

Given the rising sense of despair, policymakers will continue to fall over themselves in a mad rush to pump massive amounts of stimulus into the economy. On the monetary side of the equation, traditional policy is obviously at its end. We are left with efforts to sustain lending activity that are asset-side directed expansion of the Fed’s balance sheet while waiting for economic conditions to deteriorate enough that the Fed officials switches to quantitative easing, or policy directed toward the liability side. Yes, I know, two sides of the same coin, but the Fed appears to view those sides differently.

Until the Fed shifts gears again, fiscal policy will be the main event. And quite an event it is likely to be, with estimates that the final package will be as high as $1 trillion. That is real money that will soon start flowing into the economy, and it is difficult to see how it does not have a measurable impact. We can all respectively debate the long term effectiveness, the impact on job growth, the ultimate cost, etc., while still acknowledging it should provide significant support to the economy. The near-term risk, I think, to bonds is that it is enough support that Federal Chairman Ben Bernanke does not leap into outright purchases of Treasuries (a liability side maneuver). This does not imply that the stimulus “fixes” the US economy, just that at a minimum it should delay the most bearish day of reckoning.

The structure of the upcoming fiscal stimulus will determine whether this is money wasted trying to sustain a broken consumer/debt driven economic model or on investments that foster future economic growth. I was heartened two weeks ago by incoming head of the National Economic Council Larry Summers:

Some argue that instead of attempting to both create jobs and invest in our long-run growth, we should focus exclusively on short-term policies that generate consumer spending. But that approach led to some of the challenges we face today -- and it is that approach that we must reject if we are going to strengthen our middle class and our economy over the long run. Far from being an excuse for inaction or delay, the magnitude of the work ahead is all the more reason to begin that work.

How quickly the winds shift. From today’s Wall Street Journal:

President-elect Barack Obama and congressional Democrats are crafting a plan to offer about $300 billion of tax cuts to individuals and businesses, a move aimed at attracting Republican support for an economic-stimulus package and prodding companies to create jobs.

The size of the proposed tax cuts -- which would account for about 40% of a stimulus package that could reach $775 billion over two years -- is greater than many on both sides of the aisle in Congress had anticipated. It may make it easier to win over Republicans who have stressed that any initiative should rely more heavily on tax cuts rather than spending.

The Obama tax-cut proposals, if enacted, could pack more punch in two years than either of President George W. Bush's tax cuts did in their first two years…

True, “not exclusively” a focus on short-term consumer spending policies, but 40% of the total is massive tax relief nonetheless. To think that many of us were voting for change…looks like we are getting more of the same.

To be fair, what the Obama team is likely quickly realizing is that while talk of infrastructure spending is great, actual implementation is slow – there are not enough shovel ready projects. Some, yes, but not enough to fill the gap the Administration is trying to fill. Other initiatives, while, worthy, have a similar problem. Fostering productivity enhancing innovations, such as education and green energy, are long-fuse policies – they take time to work. For instance, when I think about education, I think about what is necessary to do for the kindergartner today so they will develop the human capital for the workforce 15 years from now. That is a long time horizon. Too much time for an incoming Administration that has promised 3 million jobs. Hence, tax cuts are necessary to move money into the economy quickly, and an easy way to build favor among Republicans early on. Moreover, the Obama team appears to be hoping that, unlike last summer’s package, these are permanent tax cuts that will be largely spent rather than saved. Given the public’s current predilection toward deleveraging household balance sheets, this may be a pipe dream.

Good intentions notwithstanding, the policy is fundamentally what it is – an effort to sustain consumer spending. Rather than households taking the debt onto their balance sheets directly, they take it on indirectly as taxpayers. You cannot borrow your way to prosperity, especially if you always borrow for consumption goods.

Of course, the US is not the only economy where policymakers want to sustain the status quo…

To be sure, I am hard pressed to deny a role for tax cuts; I think that it should be part of the package to provide an immediate boost. My concern is that 40% is too much, and there is a nontrivial chance it will not give sufficient longer-term bang for the buck. This is especially the case because I don’t view the current episode as something that is easily solved with a two year stimulus package. The US economy has become dependent on asset bubbles that are now looking few and far between. Thoughtful, sustainable policy needs be in place for the long haul to help activity transition away from bubble-dependence. I worry that massive tax cutting now is neither thoughtful nor sustainable.

Bottom Line: Like most, I anticipate the incoming economic data will maintain the recent dreary tone. Policy will continue to be accommodative. Monetary policy is now a game of waiting for Bernanke’s next rabbit. While we wait, eyes are on fiscal policy, which promises to be large enough to measurably boost activity latter this year, perhaps enough to keep some of Bernanke’s rabbits in the hat. The heavy focus on tax cuts in the emerging fiscal policy, however, looks like yet another short term fix that attempts to sustain a consumer heavy pattern of economic activity. The impact of that portion will likely be fleeting; hopefully some of the remaining stimulus will have more legs.