Tim Duy's Fed Watch

A Return to a Nasty External Dynamic?

At the moment, the economic dynamic is exceedingly complicated.  An understatement, I fear.  The crosscurrents in the data and the markets are treacherous, and I suspect will have Fed officials scratching their heads.  Hold steady with existing plans?  Step up the liquidity provisions?  More actively engage plans to tighten policy?  The latter option seems almost inconceivable; for the moment, the debate will focus on the issue of further easing.   At this point, I think the Fed will sit tight, allowing further easing to come from the already active TALF program, rather than expanding outright purchases of Treasuries.

 

The core issue is the steep rise in Treasury yields, which apparently were kept in check only by the expectation that the Fed would continued to gobble up the endless stream of securities issues by the US Treasury.  The Fed sank that hypothesis at the last FOMC meeting, and a subsequent statement by Federal Reserve Chairman Ben Bernanke made clear that the Fed does not have a 3% target on 10 year Treasury yields.  Since then, yields have climbed as high as 3.75% before prices rebounded today, bringing yields down to 3.61%.  Should we be concerned with the gains? 

 

Brad DeLong argued a few weeks ago that the Fed's reluctance to cap rates was a policy error in the making. Indeed, it would seem that rising yields are toxic for debt heavy balance sheets, especially where housing is concerned.  Officials repeatedly point to the importance of supporting housing prices, a policy that would be undermined as rising Treasury yields boost mortgage rates higher.  And while we have seen some stability in recent months in existing homes sales - of which foreclosures and distressed sales are no small part - the recent Case-Shiller data makes clear that housing markets remains under severe pricing pressure:

Home prices in 20 major metropolitan areas fell in March more than forecast as foreclosures surged, threatening to extend the housing slump.

 

The S&P/Case-Shiller home-price index decreased 18.7 percent from March 2008, matching the drop in the year ended in February. The measure declined 19 percent in January, the most since data began in 2001.

In contrast is the view that rising yields signal an unambiguously positive environment in future months, a sentiment echoed by US Treasury Secretary Timothy Geithner: 

Geithner, 47, also said that the rise in yields on Treasury securities this year “is a sign that things are improving” and that “there is a little less acute concern about the depth of the recession.”

Likewise, Alan Blinder is confused by thoughts that the Fed would attempt to control yields at all:

Blinder said he’s “more dubious” about the Treasury purchases themselves. Any reduction in long-term rates makes it more difficult for U.S. banks to generate earnings to make up for what the Fed estimated earlier this month would be $600 billion in losses under adverse economic conditions. “It makes it harder for them to earn their way out,” he said.

So we are stuck with two apparently contrasting views.  On one hand, rising long rates and the related steepening of the yield curve should indicate improving economic conditions - after all, rising yields simply imply that market participants are gaining confidence to put their money to work in more risky endeavors.  The steeper yield curve should boost bank earnings and, in time, encourage lending.  On the other hand, higher yields may undermine support for the housing market, thus extending the downturn.  The Wall Street Journal believes the Fed is choosing the positive spin:

Federal Reserve officials believe the recent sharp rise in yields on U.S. Treasury bonds could reflect a mending economy and a receding risk of financial catastrophe, suggesting the central bank won't rush to react -- even though some investors see danger in the government's rising cost of borrowing.

The WSJ is most likely correct.  Indeed, I too want to believe the first story; the steep yield curve should be a clear signal that economic activity is poised to soar.  Two things are holding me back.  First, the 10-2 spread went positive in mid-2007, which should have indicated that the expected Fed easing later that year would catch fire and the economy would be clear of recession territory by mid-2008.  Oops - the signal was premature.  Something was different (just as I had come to embrace the yield curve's signals).  My second concern is that rising yields indicate capital is fleeing the US, and the shape of the yield curve is being influenced significantly by shifts in patterns of foreign central bank purchases.  And while the resulting depreciation of the Dollar will support US growth over time, the transition can be very disruptive.   Interestingly, the Wall Street Journal story quoted above does not point to this possibility.

 

As Brad Setser highlights, the current dynamic is eerily similar to that of late 2007 and early 2008.  In hindsight, this should have been anticipated.  Financial market stability has improved dramatically as Federal Reserve Chairman Ben Bernanke and Geithner have made clear that no major US bank will be allowed to fail.  It just won't happen.   That stability makes way for a reversal of the flight to safety, and the Dollar comes under pressure, and, with it, US Treasuries.  The reversal must be strong - note how Treasuries sank this week despite a clear escalation in North Korean rhetoric, which should have driven some safety trades.  Moreover, with the US consumer widely expected to not be a driver of growth going forward, market participants look toward the emerging markets for growth.   In essence, the Fed's ZIRP policy combined with stable financial markets once again makes the Dollar carry trade attractive.  Since old habits die hard, this should "force" foreign central banks to accumulate Treasury assets - and it has. 

 

In this scenario, stable financial markets are now pushing for further reduction in the US external deficit.   To be sure, while the deficit is much smaller, it still exists .   And, once again, it looks like much of the world, from the Fed to the Treasury to the emerging market central banks, are resisting the adjustment as it requires continued soft domestic demand in the US to limit imports.    Eventually, that resistance will reveal itself.  For example, additional US weakness will be offshored to those regions not supporting the Dollar - hence Euro and Yen strength.  And commodity prices might catch a stronger bid.  Indeed, this explains the gains in oil in recent weeks. 

 

But Brad identifies an important twist on that story: 

Third, the rise in central bank reserves isn’t translating into a rise in demand for longer-term US bonds. Central banks are just buying short-term bills. That presumably is one of the reasons why long-term rates are rising now – while they remained (surprisingly) low back in 2006, 2007 and 2008. Central banks weren’t willing to buy long-term notes at 2% — or even at 3%. Maybe they just didn’t want to lock in low rates. Maybe they feared a mark-to-market capital loss if rates rose. Or maybe they fear that inflation will rise, eroding the real value of longer-term claims. In some sense, it doesn’t matter. The dynamics of the market changed …

Brad has more in a subsequent post.  It is almost as if foreign central banks know that the endgame of everyone's behavior is inflation, and thus avoid longer dated securities.  Not a particularly comforting thought - but one consistent with the steady rise in the 10 year Treasury-TIPS breakeven spread.  Perhaps too foreign central banks realize that if the Fed is no longer willing to be a buyer of last resort of longer dated Treasuries, why should they?

 

How will the Fed behave in this environment?  Presumably, if inflation expectations were to rise significantly, policymakers would need to respond by chasing long rates.  After all, they have made clear that the target range is 1.7-2%, and want to anchor inflation expectations at those levels.   With this in mind, expect policymakers to continue to emphasize their readiness to wind down their programs and raise the Fed Funds rates, when necessary, in order to combat inflation.  Also, policymakers will likely turn attention toward commodity prices, particularly oil  - saying something to the effect that they are keeping their attention on energy costs, but remain focused on the wide output gap, which suggests disinflation pressure in wages and core prices. 

 

It remains difficult, however, to imagine that the Fed is truly ready to start reversing policy in the near term.   Despite green shoots, US economic growth remains anemic.  The green shoots really don't look all that green.  Initial jobless claims may have peaked, but they are certainly not dropping at a rate consistent with a strong rebound.   Hovering just above 600,000 claims a week promises to sustain weak employment reports in the months ahead, as long as rising unemployment.  Can we see a policy reversal with unemployment rates on the rise?  Consistent with ongoing job market weakness, policymakers continue to commit to a sustained period of near zero rates.  See Federal Reserve Vice Chair Donald Kohn last week:

In my view, the economy is only now beginning to show signs that it might be stabilizing, and the upturn, when it begins, is likely to be gradual amid the balance sheet repair of financial intermediaries and households. As a consequence, it probably will be some time before the FOMC will need to begin to raise its target for the federal funds rate. Nonetheless, to ensure confidence in our ability to sustain price stability, we need to have a framework for managing our balance sheet when it is time to move to contain inflation pressures.

Moreover, the financial stability we have seen in recent months is clearly dependent on the willingness of the Fed to commit large quantities of liquidity in various guises.  Policymakers are wary that financial markets can stand on their own, and will not be eager to speed up their eventual withdrawal.  Start-stop policy would certainly impose a fresh policy uncertainty that could trigger a new chapter in the crisis.  No, policymakers will not change course unless a new disorderly Dollar-commodity price dynamic emerges.  Even then, Bernanke kept the accelerator to the floor as such a dynamic took hold in the early part of 2008. I would imagine that the bar to policy reversal is very high at this point. 

 

What about additional easing?  From Bloomberg:

“The market expects the Fed to enhance buying of Treasuries very soon,” wrote David Ader, head of U.S. government bond strategy at Greenwich, Connecticut-based primary dealer RBS Greenwich Capital, in a note to clients. “The bear market in Treasuries is having an impact on other things. Mortgages were the most notable victim.”

I was expecting more easing last month, believing the output gap would prod policymakers forward.   And there is no indication that the Fed is planning to back off the TALF program (they are even expanding it too include "legacy" but possibly soon to be "toxic" assets.)  But I am now wary that the Fed will increase the size of the expected Treasury bond purchases at this juncture.   This is especially the case if they view rising rates as consistent with economic healing.  Moreover, questions of outright monetization of the debt would intensify if the Fed appeared to be compensating for a lack of sufficient demand from the private sector, thereby driving more market participants, including central banks, out of the market.

 

So where does this leave us?  In a environment pushed and pulled by contradictory trends:

• The wide US output gap suggests there is plenty of room for monetary and fiscal stimulus to operate without triggering higher interest rates.  Yet rates have moved higher, and while I can’t say that 3.7%, or even 4.7%, or even 5.7%, would be surprising given the pace of Treasury issuance, the rapidity and direction of the move should give one pause  - especially given the likelihood of prolonged US economic weakness.  The rate increase should give policymakers pause, too. 

• The continued existence of the current account deficit suggests the US remains dependent on capital inflows. To be sure, the need is not as great as a year ago, but significant nonetheless.  Failure to attract those inflows would trigger downward pressure on bonds and Dollars.

• Greater financial stability should force market participants out of low yielding assets.  But, absent a safety flight to US Dollars, there is no reason those assets have to be in the US.  Low short term rates - and the Fed's promise to keep those rates low for an extended period of time - open up opportunities for a Dollar carry trade that yields capital outflows.

• If so, we would expect downward pressure on the Dollar and upward pressure on long rates.  The former supports export growth and import compression, while the latter helps prevent the decline from becoming disorderly by attracting capital into the Dollar and by further import compression (slower domestic demand).

• If foreign central banks choose to resist these trends, we would expect global reserves to rise.   We are seeing this.  The shift to purchasing at the shorter end of the yield curve, however, indicates that global central banks are wary of taking on additional Treasury risk.  Perhaps they are finally beginning to choke on the debt.

• Downward pressure on the Dollar, in addition to the liquidity provided by central bank reserve accumulation, should put upward pressure on commodities.  This is particularly evident in oil prices.  This will increase headline inflation, and with it inflation expectations among the general public.

• US labor market weakness appears inconsistent with a sustainable inflation dynamic; thus, rising oil prices simply cut into domestic demand.  Thus, the Fed will be inclined to hold policy steady, rather than exacerbating oil driven weakness by tightening.  Tightening policy would also reverse the evolving stability in financial markets and threaten a new credit crunch.   And given the Fed's willingness to accept a benign view of the yield increase, they are not likely to increase Treasury purchases.  Policy on hold.  This may again have the side effect of putting relentless downward pressure on the Dollar.  This is probably necessary to achieve further rebalancing of economic activity, but I suspect in the near term it will be disruptive.  Alternatively, the dynamic could be reversed again by a new crisis that drove flows back to Dollars.  There may be so much directionless liquidity flowing through the global financial system that it just starts constantly shifting here and there, looking for a home.

Bottom Line:  I want to believe that the rapid reversal of Treasury yields is a benign, even positive, event.  This is likely the Fed's view; consequently, the will hold steady on policy.  Challenging this benign view is that the reversal appears to be lock step with a return to dynamics seen in 2007 and 2008 - exceedingly low US rates encouraging Dollar outflows, stepping up the pace of foreign central bank reserve accumulation and putting upward pressure on key commodity prices.  I worry that policymakers have forgotten the external dynamic that was hidden by the crisis induced flight to Dollars last fall.  Indeed, capital outflows (indicated by a foreign central bank effort to reverse those flows) would signal that much work still needs to be done to curtail US consumption to bring the global economy back into balance.  Policymakers are unprepared for this possibility.    

Not So Green Wednesday

Federal Reserve policymakers are working overtime to temper expectations of additional quantitative easing.  From Bloomberg:

The Federal Reserve considers the recent jump in Treasury yields more as a reflection of a better economic outlook than a signal it needs to step up purchases of U.S. government debt, according to central bank officials who declined to be identified.

This follows Federal Reserve Chairman Ben Bernanke's efforts to discredit the idea that 3% is a magic number:

The move above 3% isn’t fundamentally important, [Bernanke] suggested. “We are not targeting a particular interest rate” with the long term Treasury note purchase program, he said.

The confusion over the Fed's policy intentions stems from the now familiar conflict between what the Fed defines as "credit easing" and what market participants define as "quantitative easing."  The latter requires some quantitative goal, something the Fed acknowledges.  But no such target has been defined, nor has the Fed committed to a 3% rate.   This is something of a failure of Fed communications - they cannot adequately define their policy intentions to a group of market participants yearning for the simple target rates they have come to expect.  But committing to a rate target would rob policymakers of a signal that the economy was improving.  Former Fed Governor Lyle Gramley:

The situation poses a “dilemma” for the Fed, because if the rise in yields reflects “erroneous market views” about the economy, it will hold back growth, said former Fed Governor Lyle Gramley. “The Fed is probably scratching its head at the moment and will wait and not react until the smoke clears,” said Gramley, who is now a senior economic adviser with New York-based Soleil Securities Corp.

And no doubt there is still plenty of smoke.  So much, in fact, that practitioners are extremely at odds over what signal we should get from the Taylor Rule.  From Bloomberg:

The Federal Reserve may soon need to raise interest rates, said John Taylor, the former Treasury official who devised the “Taylor Rule,” a formula for rate- setting based on the outlook for inflation and growth.

 

“My calculation implies we may not have as much time before the Fed has to remove excess reserves and raise the rate,” Taylor, a Treasury undersecretary under President George W. Bush from 2001 to 2005, said yesterday at an Atlanta Fed conference in Jekyll Island, Georgia.

 

Fed Chairman Ben S. Bernanke said earlier this week at the conference the Fed was prepared to withdraw monetary stimulus “in a timely way” to prevent inflation from becoming a threat when the economy recovers. Former Federal Reserve Chairman Alan Greenspan said yesterday that the decline in the U.S. housing market may be bottoming and it’s “very easy to see” financial markets continuing to improve.

 

Taylor, a Stanford University professor, disagreed with economists who say his rule suggests the need for stimulus and justifies cuts in the federal funds rate to negative territory. Laurence Meyer, vice chairman of Macroeconomic Advisers, said in March the rule might suggest the need to reduce the funds rate to minus 7.5 percent by the end of 2009.

 

He said his rule, based on inflation and economic growth compared with the long-term potential for growth, suggests a fed funds rate of 0.5 percent. The central bank has cut rates to between zero percent and 0.25 percent.

Taylor's calculation - I believe - is based on the current figures for inflation and the output gap.  The more dire -7.5% figure is a prediction based on expected widening of the output gap and decrease in core inflation.  Of course, what is most important is the Fed's estimate of the Taylor Rule.  The FT suggested last month that the Fed's estimate was on the pessimistic side:

The ideal interest rate for the US economy in current conditions would be minus 5 per cent, according to internal analysis prepared for the Federal Reserve's last policy meeting.

 

The analysis was based on a so-called Taylor-rule approach that estimates an appropriate interest rate based on unemployment and inflation.

 

A central bank cannot cut interest rates below zero. However, the staff research suggests the Fed should maintain unconventional policies that provide stimulus roughly equivalent to an interest rate of minus 5 per cent.

 

Fed staff separately estimated what size and type of unconventional operations, including asset purchases, might provide this level of stimulus. They suggested that the Fed should expand its asset purchases by even more than the $1,150bn (€885bn, £788bn) increase policymakers authorised at the last meeting, which included $300bn of Treasury purchases.

The Fed chose not expand the program, however, the pause supported by those green shoots.   I genuinely believe that the Bernanke & Co. are concerned that the money they are pumping into the economy will light a fire they can't control, and thus from this point on will be much more cautious about the pace of easing.  They will want confirmation of economic stagnation prior to an accelerated pace of bond purchases.  And Wednesday's data was consistent with the stagnation story. 

 

The retail sales report disappointed traders who were oddly optimistic about the condition of consumers.  From the Wall Street Journal:

Sales at auto dealers ticked up. Excluding automobiles, retail sales were down 0.5% in April. The steepest declines were among sellers of big-ticket items, such as home-furnishing stores and appliance dealers, as households remain wary about major purchases.

 

People need food, people need electricity, but they don't need a brand-new piece of furniture right now so they just aren't buying," said Randy Weires, the sole employee working the 14,000-square-foot showroom of Carr's Furniture & Appliances in Old Town, Fla., a store his sister and her husband bought four years ago. Carr's is eliminating its appliance offerings -- including dishwashers, microwaves, and refrigerators -- because of weak demand and recently began selling used furniture alongside the pricier new options.

Funny how the market for $10,000 ovens disappears with the housing boom.  Surprise - people are thinking that maybe this is too much to pay for a device primarily used to boil water.  The simple fact is that the consumer is downshifting, with very real and long lasting implications for business behavior.   One of the best examples of this came from Briggs and Stratton:

Briggs & Stratton Corp., which supplies engines for mowers, tillers and tractors, recently noted consumers are shifting away from riding equipment to lower-horsepower equipment, a trend that holds implications not only for equipment makers but also the retailers, said Raymond James analyst Budd Bugatch. Higher horsepower riding equipment has a higher average selling price and margin "for everyone in the channel," he said.

Note the "everyone in the channel" quote.  Consumer downgrading crushes profit margins across the board.   And this is a problem that will not be easily fixed; as I argued earlier this week, households are likely to remain credit constrained despite the heroic efforts from the Fed.

 

A second disconcerting signal was the unchanged inventory to sales ratio for March, holding at a still too high 1.44 months despite a sharp fall in inventories.  Green shoots aside, firms find it hard to match the pace of sales declines, which suggests that we need to be prepared for additional capacity reduction in the months ahead.  This also suggests that while initial claims looks to have rolled over, the pace of layoffs will not drop precipitously.  We should learn more on that this morning.

 

Finally, on the deflation watch, commodities are not seeing the economic turnaround suggests by the rapid run up in stocks, today's setback notwithstanding.  From the WSJ, steelworkers are protesting plant closings:

Although ArcelorMittal has already cut production in half and shut down plants and blast furnaces around the world -- including some iron ore operations idled Tuesday in Indiana -- it still makes more steel than customers need and expects global steel demand to sink by up to 20% this year.

Ironically, falling metal demand may be met with additional supply as emerging markets crank up production to keep workers employed.  From Bloomberg:

China, the world’s largest aluminum producer, may have restarted as much as 1.4 million metric tons of capacity in April, according to an analyst at Aluminum Corp. of China Ltd.

The country may produce as much as 12.6 million tons of the metal this year, Ru Xiaojie, an analyst at the company’s Henan branch, said today in Beijing at a conference. Ru said after her speech that the analysis represented her own views.

 

Alcoa Inc., the largest U.S. aluminum producer, this week said there is still “significant oversupply” in the global market and restarts by Chinese smelters aren’t needed. Chinese smelters may resume output at too many smelters in April and May, which will depress prices, the China Nonferrous Metals Industry Association also said this week.

 

“Due to a quick restart of idled aluminum smelters in April, the demand for the raw material alumina has increased, leading to restarts of alumina refineries as well,” Ru said.

 

Aluminum futures in Shanghai rose 0.2 percent to 12,860 yuan a ton at 9:48 a.m. local time. Prices have rallied 12 percent this year after the government bought excess metal to support domestic producers.

The rally in copper is also proving difficult to maintain:

Copper prices fell for the fifth straight session in New York, the longest slump since December, after a report showed U.S. retail sales dropped unexpectedly in April.

 

The metal has tumbled 7.1 percent in five sessions on signs that a rebound in the global economy will be subdued. Retail sales declined 0.4 percent last month, following a 1.3 percent drop in March, the government said today. Economists forecast sales would be unchanged, according to the median of 67 estimates in a Bloomberg News survey.

 

The report “adds to the list of reasons why the recovery won’t be as strong as people had been expecting,” said Michael Pento, the chief economist at Delta Global Advisors Inc. in Holmdel, New Jersey. “I wouldn’t be surprised to see copper consolidate and head a bit lower.”

Finally, another Wall Street Journal article paints a dreary picture of the overall industrial sector:

U.S. railroad freight traffic is running about a fifth lower than a year ago. It is one of several less-obvious indicators that all isn't well, despite the financial-market rally since early March.

 

The slump in weekly rail traffic reflects sluggish industrial activity and consumption. Shipments of industrial products are down almost a third in the past year, while raw materials like coal, metals and crops also show steep drops. The pace of decline has picked up relative to the first quarter's 16% fall, according to Credit Suisse analyst Chris Ceraso.

 

In commodities, while crude oil and copper have been on a tear, prices for lumber and natural gas remain depressed. Lumber is exposed to construction and has been in a bear market since 2004, so it might be regarded as a special case. Still, there is little sign of a rebound.

 

Natural-gas prices, meanwhile, are perhaps half the marginal cost of production. Such weakness reflects a glut of natural gas, exacerbated by falling electricity demand, down 6% in March. That can't be put down merely to quiet building sites.

Note that the pace of decline accelerating since the first quarter, again suggesting that the green shoots story has been overplayed.   Some stability, yes.  A slower rate of decline overall, likely.  But enough to start looking for the next economic boom?  No.

 

Where does this leave us?  The Federal Reserve is caught; policymakers are warily watching the economy, worried that their liquidity injections will catch fire.  On the other hand, they suspect that the economy will demand greater stimulus, if their estimates of the Taylor Rule are any guide. Caught, they want to remain flexible, and hence are unwilling to commit to numerical targets, either money growth or long rates.   Hard to blame them; for the last decade, excessive easing has always caused something seemingly good that was followed by something very bad.  But with the output gap certain to widen, the bias will be on the side of additional easing, while the timing will be data dependent.  The green shoots story is looking a little tired today; a wide swath of indicators in the commodities market suggests that overall demand remains subdued.   That will not stop a segment of market participants from playing up the green shoots story - they want to get ahead of the next big move.  I remain wary that there is any room for an easy bounceback; I can't shake off memories of 2001-2003, and I don't see where we get another asset bubble in the US to crank up the wealth engine.

Turning Which Corner?

 

Is the economy turning a corner?  And, if so, which corner is it turning?  In my view, economic activity has been influenced by two separate trends since 2007.  One is the structural response to an over-leveraged household sector  that pushed the US economy into what was initially a mild recession.  The second trend is the sharp cyclical recession that began in earnest in the second half of 2008 as the commodity price shock decimated already weakened households and the deepening credit crunch cut financing for a broad swath of firms.  Excess capacity emerged throughout the economy, triggering the familiar phenomenon of rising unemployment.  Difficult though they may be, the cyclical dynamics do not last indefinitely - generally speaking, output declines stop well short of zero GDP and unemployment will not rise to 100%.   Market participants are rightly anticipating the economy is turning the corner on the cyclical trend.  But I suspect we have a long path ahead of us on the structural challenge poised by overleveraged households - suggesting that the green shoots we hear so much about will yield little more than stunted growth.  Hence why the risk remains that Bernanke and Co. and more likely to fertilize the fields than plan for the next harvest.

 

If there is one picture that sums up the cyclical story of the past year, it is the path of real consumption:

 

 

The sharp deceleration has come to an end, of that there can be little doubt.  Nor should there be much surprise.  The collapse in commodity prices, lower interest rates to allow mortgage refinancing for those homeowners still above water, and tax cuts all joined to provide powerful support for household budgets allowing consumption to stabilize despite the massive job losses experienced in recent months.   The stabilization in consumer demand will eventually slow the pace of job cuts.  Indeed, this is already evident in the data - analysts have pointed topeak of initial claims as a key hurdle in the race to recovery.   To be sure, it is difficult if not impossible to characterize the data flow as "good."  But it is certainly less "bad."  The path to Great Depression II has hit something of a speedbump.  And seeing that, market participants have priced out some of the most cataclysmic scenarios, supporting equities and commodities while pushing bond yields higher. 

 

There will be more opportunities for euphoria - do not underestimate the power of pent-up demand to trigger bursts of positive data.  There is a portion of the population who are not credit constrained, biding their time for the perfect moment to buy a new car or schedule a vacation.  Indeed, such bursts of data are more likely than not following a sharp decline in activity (the 2.2% gain in consumption spending in 1Q09 is such an example).  I believe, however, that those bursts of data will not be sustainable.  Far from it - at a minimum, the ability of households to carry activity forward is at its end, which by itself would leave the economy floundering . 

 

I think it is difficult to ignore the implications of the growth of consumer dominance in defining patterns of economic activity:

 

 

The story of the last 25 years has been an increasing role for household spending, rising to perhaps a peak of conspicuous consumption, with the motto "a filet mignon in every stainless steel oven, a RV in every garage."  Patterns of economic development - more to the point, capital formation - have favored taking advantage of this trend.  Countless business plans are based on the expectation that this trend will continue.  The baby boomers have endless wealth (not so anymore, if it ever was), there is a never ending supply of equity rich Californians to support our [insert locality] housing market, etc.  Those plans will be stressed, to say the least, if the trend stalls.  The implications for a reversal are even more significant.  And for those that believe reversal is necessary, note that the reversal has really not even begun.  What took 25 years to build may take another 25 years to destroy. 

 

How sure are we that the trend is at an end?  My thought is that the factors that supported the trend - a steady march down in the saving rate to zero and a steady march up in household debt, coupled with   monetary policy that had room to go from 15% short rates to zero over nearly three decades, are at an end.  Even if you believe that savings rates will not rise to 12%, the inability to sustain below zero rates puts a limit on household spending growth (as well as debt accumulation).  And with underwriting conditions tightening - a permanent tightening, given the changing regulatory environment - the role of debt financing in the life of the consumer is sure to stagnate. 

 

The challenge then is to transition the economy away from the debt-supported consumption trend that looks no longer viable to a trend more reliant on  investment and external spending.   This, however, is easier said then done.  How quickly can 25 years of growth directed at consumer spending be reversed?  And reversed to what, especially if the rest of the world continues to struggle?  I see little hope of an "immaculate conception" of a fresh, sustainable pattern of economic activity.  Until the transition path reveals itself, fiscal policy will be necessary to fill the economic hole likely to exist if the savings proclivities of households continue to exceed the investment intentions of firms.

 

Ironically, the "best" road to growth is also the riskiest from a policy perspective - a rapid expansion of emerging market activity.  Such an expansion, however, would once again place the US in competition for global resources, and threaten a reversal of the commodity and interest rate trends that have been so important to supporting US consumers.  Indeed, just the whiff of recovery has supported oil prices, promising an abrupt end to one of the factors supporting US consumers.  In the worst case scenario, a flight of capital away from the Dollar (in response to more promising investments abroad) would generate an inflationary and structural shock that would leave the Fed juggling between renewed recession and higher inflation.  In short, the optimal external shock would be one only partially supportive; anything more would push the globe to a revisiting of the commodity price surge of early 2008. Looking for a decoupling story now, however, seems like almost a naïve dream. 

 

What is the Fed's next move?  One email crossed my inbox after the April employment report suggested some thinking that the Fed could hike rates as early as November.  Such a scenario (absent a stability threatening run on the Dollar) must come from a spectacularly optimistic take on incoming data.  Data, I might add, that is a reflection of the massive crutch provided by the Federal Reserve and US Treasury, not necessarily a sea change in the underlying economic environment.  Look too how quickly bond rates began to climb after the Fed declined to expand Treasury purchases at the last FOMC meeting.   More generally, consider this tidbit on Federal Reserve Chairman Ben Bernanke's thinking back in 2003:

The 2003 FOMC transcripts showed then-Governor Ben Bernanke very tuned into financial markets as he pressed for earlier release of Fed forecasts and a willingness to lower interest rates to zero.
From the June 2003 FOMC meeting, when the Fed lowered the target fed funds rate to 1%:

“I wonder if you might give some thought to whether or not it would make sense tactically to say publicly that we are willing to lower the federal funds rate to zero if necessary…I think it would have a beneficial effect on expectations in that there would no longer be a feeling in the market that we had reached the end of our rope.”

“It’s extremely important that we do what we can to maintain the supportive configuration in financial markets. That means continuing our easy monetary policy and, even more important, using our statement to signal our willingness to keep policy easy so long as there is a risk of further disinflation and continuing economic weakness."

A year and a half after the end of the 2001 recession, Bernanke was looking at the possibility of lowering rates to zero in order to maintain support for financial markets.  And comparatively, financial markets were leaps and bounds healthier in 2003 than now.  Is a rate hike really feasible this year - or even next - given the current state of dependence of the financial system on government largess?  Moreover, consider the disinflation worries in 2003 and fast forward to last week:

Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, implying that the unemployment rate could remain high for a time, even after economic growth resumes.

 

In this environment, we anticipate that inflation will remain low. Indeed, given the sizable margin of slack in resource utilization and diminished cost pressures from oil and other commodities, inflation is likely to move down some over the next year relative to its pace in 2008. However, inflation expectations, as measured by various household and business surveys, appear to have remained relatively stable, which should limit further declines in inflation.

 

Now consider the output gap over the last decade:

 

 

The current  gap already far exceeds that of the last disinflationary scare, and Bernanke expects it to continue to expand further, and then diminish only gradually.  As long as the gap continues to expand, Bernanke's bias will be in favor of additional easing.  The only question is whether he remains content to allow TALF funds to slowly trickle into the economy, or speeds the pace of policy with expansions of longer dated Treasury purchases.  Given Bernanke's past behavior, expecting patience on his part seems unrealistic.   Moreover, the last jobs report provides less room for optimism than observers suggest.  Importantly, Jim Hamilton notes the decline in hours worked appears unabated; threat of a currency collapse aside, there will be no policy tightening, only easing, until hours worked moves unquestionably and sustainably in a positive trajectory.

 

Bottom Line:  The economy looks to be turning a corner relative to the downward cyclical force of last year.  But this is only a partial victory, as the factors that that started us down this path - namely, a debt-supported consumer spending dynamic - remain in play, and will likely remain in play for years, arguing for a long period of slow growth, punctuated by short-lived bursts of positive data.  In such an environment, and considering the importance of government support to sustain financial stability, the odds favor continued policy easing.  Those looking for a more positive scenario are pinning their hopes on either an unlikely rapid return to past patterns of consumer behavior, an unlikely rapid evolution in patterns of economic activity that are not consumer dependent, or a decoupling of emerging market economic activity from the US (which could pose a different set of policy challenges).