After a disappointing first quarter, economists largely predicted the U.S. recovery would ramp back up as short-term disruptions such as higher gas prices, bad weather and supply problems in Japan subsided.
But there's little indication that's happening. Manufacturing is cooling, the housing market is struggling and consumers are keeping a close eye on spending, meaning the U.S. economy might be on a slower path to full health than expected.
"It's very hard to generate a rapid recovery when rapid recoveries are historically driven by housing and the consumer," said Nigel Gault, an economist at IHS Global Insight. He expects an annualized, inflation-adjusted growth rate of less than 3% in coming quarters—better than the first-quarter's 1.8% rate, but too slow to make a meaningful dent in unemployment.
To what extent will incoming data impact monetary policy? At this point, I think policymakers are still in “wait and see” mode. To be sure, they cannot ignore the spate of weak data. I think it has to be a topic in upcoming speeches. But they can continue to view it as a temporary blip. Moreover, I think it has been made clear that there is a high bar for QE3 – especially as the commodity-induced inflation mouse passes through the belly of the snake. Which means that while the specter of inflation remains alive and well on Constitution Ave., we should expect at most talk of pushing back the eventual policy tightening. But I think we would need to see a serious downgrade of the 2012 forecast to push the Fed into another round of asset purchases.
The path of monetary policymaking to date looks eerily similar to the events of 2010. Recall that as the economy started to show signs of life, policymakers jumped in to snuff out that life with a swift focus on tightening. We are once again faced with a similar pattern. On the back of an admittedly positive 4Q10 GDP report, coupled with signs of life in the labor market, Fed officials rushed to the exits once again. Recall that some policymakers such as St. Louis Federal Reserve President James Bullard were pushing for an early end to QE2 at the last FOMC meeting. As of two weeks ago, Bullard was not as eager to withdraw policy:
Federal Reserve Bank of St. Louis President James Bullard said the central bank may keep its monetary-policy unchanged until late this year, and that declining inflation expectations have curbed the need to begin withdrawing record stimulus.
“It does take some pressure off the Fed,” Bullard, 50, said in an interview at Bloomberg News headquarters in New York. “I take it seriously that market indicators of inflation have come down. The data has been softer, and these global uncertainties have weighed on markets.”
Still, as of early last week he was sticking to the temporary blip story:
Bullard told reporters after his speech he was confident the U.S. economic recovery was sustainable, supported by a pickup in private-sector job creation. First-quarter growth may be revised higher from the reported 1.8 percent, Bullard said.
“The second quarter, I think, will come in between 3 and 4 percent, and I think job growth will continue,” he said. “We are in good condition in the U.S. economy. There is some risk from these events around the world, but generally speaking, we are in good shape.”
The extent to which this story remains intact in the coming months will be likely determine the Fed’s willingness to pursue QE3. Note the pattern of Fed forecasts over the past few years:
The sharp fall in 2011 forecasts in the fall of 2010 that triggered QE2 (along with fears of deflation). We have yet to see a significant change in the 2012 and 2013 forecasts. And we probably won’t until the end of this year. Without such a change it is difficult to see the Fed extending the current package of asset purchases. Until 2012 comes into clearer view, we are left with pushing out or pulling back the timing of tightening.
What is so incredibly frustrating is that anyone who seriously reviewed the data of the post-1983 period would come to the conclusion that commodity price shocks have tended to trigger monetary easing as they sap demand and induced deflationary pressure. Chicago Federal Reserve President Charles Evans did so. And New York Federal Reserve economists noted that inflation expectations as measured by professional forecasters did not signal trouble ahead. None of this prevented the Fed from turning hawkish in the first half of this year. As I lamented in February:
I think it is somewhat silly to be discussing an early end to the LSAP as it only adds another layer of uncertainty on what was already an increasingly uncertain environment. Somewhat pointless as well – the end is fast approaching in any event. Indeed, I find the debate disappointing, albeit expected. Policymakers appear to have learned little from their failed exercise in hawkishness this time last year.
It is now evident the spike in gasoline prices has taken the wind out of consumers, with real disposable income flat or falling since February and real consumption expenditures rising just 0.1 percent in four of the past five months. The 0.4% gain in February hardly compensates. Worse yet, the slowdown looks to be impacting labor markets, with initial unemployment claims climbing back upwards. Recall that the sharp declines in claims in the second half of 2010 was integral to the acceleration story. That this situation is reversing itself is very disappointing.
I continue to believe the economy has been operating near potential, a little above at the end of 2010, now a little below. Nothing sufficient to suggest there was a dire need to tighten policy. Indeed, the opposite most likely holds. That said, the expected inflation blip is working its way through the system:
And, in the minds of many Fed officials, that blip poses an obstacle to anything other than tightening.
Bottom Line: A disappointing Q2 should push down the Fed’s 2011 forecast, but the impact on 2012 forecasts will remain negligible until later this year. It is those forecasts that will have a more profound impact on policy than what is happening right now. Right now it is still about the timing of tightening.