Tim Duy's Fed Watch

A Tangled Policy Web

 Incoming data continues to confirm an emerging period of relative economic tranquility following the financial storm of 2008.  Importantly, the bleeding in consumer spending has been staunched, despite ongoing job losses that look likely to remain a feature of the American economic landscape for months to come.  But incoming data also point to America's sustained and perplexing dependence on foreign capital inflows - a dependence that suggests an underlying economic vulnerability that has yet to be addressed.  Whether it needs to be addressed next month, next year, or next decade is still a question that continues to haunt the followers of global macro trends.

 

The most recent Personal Income and Outlays report, for May 2009, highlights many of the trends currently impacting the evolution of economic activity.   The headline jump in incomes, like that of the pervious month, was driven by federal stimulus.  Declining private wage and salary disbursements are a more telling indicator of the health of household finances, and are consistent with ongoing labor market weakness.  The best bet is the that private wage gains remain subdued, even as conditions stabilize.  Although the apparent peak of initial claims is in the rearview mirror, persistent high levels of claims points to a jobless recovery. 

 

Of course, in the absence of federal stimulus, the underlying weak income growth indicates sustained pressures on consumer spending power.  Indeed, the numbers tell a clear story of stabilization, but little to suggest that a V shaped recovery for consumer spending is at hand:

 

 

In addition, the report adds further credence to the claims that American's long affair with spending has ended in a bitter divorce, with the saving rate climbing to its highest level in 15 years.  To be sure, some of the increase is likely not sustainable in the short run, as it partly reflects a time lag between federal stimulus and the spending it was meant to encourage.  That said, the underlying saving increase is tempering the impact of stimulus spending, as households sock some of it away for the next rainy day and/or pay  down crippling debt loads, effectively turning private debt into public debt.  And note that large shifts in consumer behavior are not required to have significant macroeconomic implications.  Small changes across households - a little less, percentage wise, spending here and there adds up.  From Bloomberg:

Saks Fifth Avenue is cutting orders 20 percent after posting losses in the last four quarters. Kia Harris says some customers at the Washington shoe store where she works are buying one pair rather than three.

 

In the recession following a borrowing binge that sent consumer debt to the highest level ever, Americans are shutting their wallets and building their nest eggs at the fastest pace in 15 years.

 

While the trend will put the country’s finances in better balance and reduce its dependence on Chinese investment, it may also restrain economic growth in 2010 and beyond, said Lyle Gramley, a senior economic adviser with New York-based Soleil Securities Corp. and a former Federal Reserve governor.

The interesting line here is the implication that increased savings will jointly improve national finances and lessen dependence on foreign capital inflows.  To be sure, the increase in household saving or, equivalently, the decrease in household borrowing serves as the offset for increase federal borrowing.  Indeed, the data is supportive of those who argue the importance and necessity of deficit spending to support economic activity.  Given that low interest rates are insufficient to spur spending and, instead, households rapidly increase the pool of available saving, the federal government is best positioned to step up as the economic engine, and can do so without significantly impacting interest rates and crowding out private investment.  Case closed.

 

Or is it?  In closed economy, this story works.  In an open economy, the tangled webs of international finance are spun into a more complex tale.  Why, if rising households saving justifies deficit spending, are foreign central banks increasingly important again in financing a US capital shortfall?  From Brad Setser:

Over the last 13 weeks of data, central banks added $160 billion to their custodial accounts, with Treasuries accounting for all the increase.

$160 billion a quarter is $640 billion annualized — a pace that if sustained would be a record. Of course, $640 billion in central bank purchases of Treasuries would still fall well short of meeting the US Treasuries financing need. The math only works if Americans also buy a lot of Treasuries. That is a change.

The annualized inflow of $640 billion is nothing to sneeze at; at that rate, foreign central banks are supporting US spending to the tune of 4.5% of GDP.  Without those inflows, I find it difficult to think that US interest rate would have anywhere to go but up - an increase that would be necessary to resolve what remains a persistent element of the American economic landscape  - a smaller but still significant current account deficit.  A deficit that could perhaps be dismissed if it was being financed by individual investors in Shanghai looking to be shares in Apple to capture the profit potential of the US economic engine.  A deficit that is difficult to dismiss if it requires foreign central banks to continually compensate for the absence of interest from private investors. 

 

The ongoing US dependence on foreign central banks, long chronicled by Brad Setser, has another implication.  If foreign CBs only provided temporary financing, we could rightly view their actions as addressing a temporary liquidity crisis in the US.  No harm done, good stabilization policy.  The persistence of those flows, however, suggests something much darker…the US does not face a liquidity challenge.  It faces a solvency challenge.  From the Washington Post:

The nation's long-term budget outlook has darkened considerably over the past six months, and President Obama's plan to extend an array of tax cuts and other policies adopted during the Bush administration has the potential to "create an explosive fiscal situation," congressional budget analysts reported yesterday.

 

In a new report, the Congressional Budget Office found that extending the Bush administration tax cuts, reining in the alternative minimum tax and canceling a scheduled reduction in payments to Medicare doctors would dramatically slash tax collections at a time when federal spending would be "sharply rising." The resulting budget gap would drive the nation's debt over 100 percent of gross domestic product by 2023, the report says, and past 200 percent of GDP by the late 2030s.

Quite honestly, I find the implementation of temporary fiscal spending to fill an economic hole something of a no brainer at the current time; the likely persistence of deficit spending long into the future is cause for concern.  It is cause for concern because it is a problem that likely just builds so long as there is no market mechanism to signal a need for meaningful change.  The obvious signal would be rising interest rates.  But so long as foreign central banks are willing to be the buyers of last resort for US Treasuries, interest rates will remain in check; external policymakers will ensure that the US continues to receive the financial support to keep the dynamic in play.

 

When will this dynamic be brought to an end?  Still the multi-billion dollar question.  Chinese policymakers see the writing on the wall, as they played no small part in sustaining US spending prolificacy:

 The dollar declined the most against the euro in a month and dropped versus the yen after China repeated its call for a new global currency.

 

The Swiss franc declined against the euro and dollar this week as foreign-exchange analysts said the central bank sold its currency three times to support the economy. The greenback fell against most of its major counterparts after the People’s Bank of China said yesterday the International Monetary Fund should manage more of members’ foreign-exchange reserves.

 

“The dollar’s status as a reserve currency is being questioned,” said Benedikt Germanier, a foreign-exchange strategist in Stamford, Connecticut at UBS AG, the second- largest currency trader. “There are reasons to sell the dollar.”

This, however, does not appear to be a realistic stab at the bringing about greater balance to the global economy.  China wants to sustain large current account surpluses while avoiding any portfolio risk on  the offsetting rise in official reserves.  Ironically, the US wants the opposite - steady inflow of cheap goods without the risks associated with a large build up of external assets.  All players want upside without risk.  We are all well versed at this point with the wisdom of pretending that everyone can shed risk.  It doesn't disappear in those situations; it becomes concentrated.  Think AIG.

 

In any event, for now Chinese angst appears to be meaningful saber-rattling, as each threat to change behavior is quickly retreated from.  Bloomberg this morning:

People’s Bank of China Governor Zhou Xiaochuan said the nation won’t change its currency reserve policy suddenly, helping the dollar to snap a two-day decline.

 

“Our foreign-exchange reserve policy is always quite stable,” Zhou told reporters at a central bankers’ meeting yesterday in Basel, Switzerland. “There are not any sudden changes.”

Sudden changes in the Dollar's status as a reserve currency serve no purpose.   Best instead to use a pattern of outright threats and changes in patterns in bond purchases to keep American policymakers aware of the ultimate cost of Dollar hegemony.  Given that as of yet, there is no realistic alternative to holding Dollars, policymakers globally slavishly heed to past behaviors that have entrenched global imbalanced, hoping the problem spontaneously disappears.  But instead, it only grows, looming like a dark shadow over the global macroeconomy.

 

What are the policy options?  Short of imposing capital controls, open capital markets implies we can't stop foreign central banks from accumulating US assets.  Long needed has been an international agreement that brings sanity to the seemingly insane equilibrium in which poor nations finance the spending of rich nations.  Such a voluntary, multilateral withdrawal from the current regime, however, remains little more than a bedtime story. 

 

Domestically, the optimal path is to meaningfully address the long term budget challenge.  Does this mean cutting programs and boosting taxes now?  No, quite frankly, at this juncture that would be an almost insane policy response, one that would not be appropriate for either the US or our trading partners.  In the short run, such as policy response would be needlessly disruptive (indeed, that potential disruption is what keeps foreign central banks in the game of buying US Treasuries).  Instead, you need to examine the policy space to find an obvious candidate for controlling the growth of aggregate spending in the US.  And that exercise always leads you back to health care, and the realization that we spend an extra $1 trillion more than other industrialized nations, and we don’t get much if anything for it.  A trillion dollars is a lot of money; more in fact, than the recent pace of foreign central bank Treasury purchases.  If you can meaningfully "bend the curve" on health care spending, you can see a light at the end of the tunnel.  If you can't or are not willing to bend the curve, I fear waning global patience in sustaining US spending will result in a rude awakening that the tunnel of US fiscal policy ends at a hard wall.

Rate Hike?

Seriously, a rate hike in this environment?  Or anytime before the end of 2009?  At the moment, I just can't see it happening.  That said, long rate are higher, and inflation expectations in some corners of the market are rising.  What is going on?  My explanation for recent market action revolves around three themes:

1.)Financial Armageddon appears to have been avoided - at least for the moment.  The "all but explicit" implicit guarantee that no significant US financial institution will be allowed to fail established a return to financial stability.  And with that stability comes an end to the flight to safety that buoyed Treasury prices.  Something off a conundrum for Treasury Secretary Timothy Geithner - cheap financing of the staggering US deficit appears to be dependent on financial instability.

2.)Recent inflation numbers are not exactly what I would call benign.  The trend in core PCE is not  deflationary:

 

 

 I think deflation fears were always overblown - the current batch of monetary policymakers are simply dead set against such an outcome.  The deflation trade, like the flight to safety, needed to be priced out of Treasury's and TIPS.  The outcome:  Breakeven spreads are up sharply.

3.) The US, in aggregate, is borrowing less from the world than a year ago.  But make no mistake, we still rely on capital inflows to maintain a substantial US current account deficit.  Lacking a flight to safety, it is not clear that private investors are willing to support that deficit at 2.75%.  Or even 4%, for that matter.  That fact that foreign central banks are accumulating Dollars is proof positive that private investors don't want to do the job - and the transition in central bank purchases from the long end to the short end suggest that even they grow weary of this game.   Remember, the argument that "Japan ran a massive budget deficit so we can too" falls apart when you recognize that for decades Japan has been able to rely entirely on internal savings to finance the deficit.  My interpretation: The invisible hand (apologies to Gavin Kenndey) is still pushing for lower US consumption to bring the external accounts into better balance - and that means higher rates to maintain inflows while suppressing the pace of economic growth.  I understand this is in direct conflict with the output gap story; reconciling the two, I believe, requires an admission that the US economy is terribly structurally imbalanced internally.  We may have excess capacity, but not excess capacity to make anything anybody real wants.     

Where do Federal Reserve policymakers stand on recent dynamics?  Turning to Federal Reserve Chairman Ben Bernanke:

In markets for longer-term credit, bond issuance by nonfinancial firms has been relatively strong recently, and spreads between Treasury yields and rates paid by corporate borrowers have narrowed some, though they remain wide. Mortgage rates and spreads have also been reduced by the Federal Reserve's program of purchasing agency debt and agency mortgage-backed securities. However, in recent weeks, yields on longer-term Treasury securities and fixed-rate mortgages have risen. These increases appear to reflect concerns about large federal deficits but also other causes, including greater optimism about the economic outlook, a reversal of flight-to-quality flows, and technical factors related to the hedging of mortgage holdings.

Not terribly different from my interpretation.  The greater optimism and safety reversal is effectively the same as the end of the Armageddon trade, and the federal deficit concern ties into aggregate US borrowing.  The technical factors - referring to hedging against the increased expected duration of mortgage assets as mortgage rates rise - appears to me to be related to a general increase in rate pressures as a whole, but I will defer to fixed income specialists on that topic.  He does not identify the change in central bank purchasing patterns, but neither does he mention the Fed's decision at the last FOMC meeting not to expand their Treasury purchase program.  

 

Note that he also does not mention inflation concerns, which some believe is the true reason for recent market action.  On inflation, Bernanke covers familiar territory: 

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, and the unemployment rate is likely to rise for a time, even after economic growth resumes.

 

In this environment, we anticipate that inflation will remain low. The slack in resource utilization remains sizable, and, notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued. As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008. That said, improving economic conditions and stable inflation expectations should limit further declines in inflation.

He is sticking to the output gap argument to dismiss inflationary concerns.  Those expecting hyperinflation dismiss this Bernanke's position, arguing that emerging markets often experience weak growth combined with high inflation.  I believe this line of reasoning ignores the institutional differences that prevent price inflation from being propagated via wage inflation in the US.  We simply lack the populist/union dynamic that makes such a dynamic possible.  Can such a dynamic develop?  Sure, over time, with sufficient policy errors.  But in time to prompt a rate hike in 2009?  Doubtful.  Very, very doubtful.

 

( As an aside, the rise in unit labor costs reported by the BLS will not be interpreted by  Fed policymakers as evidence that wage inflation is accelerating .  Note how unit labor costs are constructed - a drop in output, as one typically sees during a recession, if not matched by an equal drop in hours worked, is almost certain to generate a jump in labor costs.  But this is not a signal that labor costs are rising rapidly; it signals that firms are not bringing capacity in line with demand - they need to fire more workers, or cut their wages.)

 

Combine Bernanke with the Beige Book:

Reports from the twelve Federal Reserve District Banks indicate that economic conditions remained weak or deteriorated further during the period from mid-April through May. However, five of the Districts noted that the downward trend is showing signs of moderating. Further, contacts from several Districts said that their expectations have improved, though they do not see a substantial increase in economic activity through the end of the year.

No significant growth implies a widening output gap and higher unemployment rates, which means no rate hike on the horizon.  Even more important, with no mechanism to link price inflation to wage inflation, the Fed will not respond to high core inflation (above) and certainly not rising headline inflation, instead viewing the higher prices as a deflationary force via the erosion of real incomes.  Which, interestingly, fits with my hypothesis that the invisible hand is attempting to suppress US demand growth.  This suggests that neither of the deflation/inflation extremes will be correct; most likely correct is a slightly elevated inflation rate combined with low wage growth.  Not pretty, but not a disaster.  That is, of course, assuming policymakers will accept such an outcome.  The most significant risk, in my opinion, is that the Fed has lost monetary independence.  Not there yet.

 

To be sure, market participants will react to the occasional loose cannon from the hinterlands of US central banking, district bank presidents.   The most direct has been Kansas City Fed President Thomas Hoenig, but Richmond Fed President Jeffrey Lacker often gets the more prominent headlines:

In his speech to North Carolina's lawmakers, Lacker stressed the importance of not waiting too long before raising interest rates in case this allowed inflation to take root.

How long is too long?  Even Lacker does not sound itching to raise rates this year:

But he emphasized during his discussion with reporters that he still expected the very weak state of the economy to warrant low Fed rates for a while.

 

"I think growth is likely to warrant rates as low as they are for some time, but just how long is uncertain and hard to predict in advance. We'll just have to wait to see how the growth process unfolds this year and into next year," he said.

Note his timeline, "into next year."  Even the hawkish are not really hawkish.

 

Bottom Line:  Looking for a rate hike this year is premature.  Too much slack in the US economy will keep the Fed on the sidelines.  If you are arguing for an incipient inflation outbreak that requires a policy response, you need a story explaining how price pressures are translating into wage pressures.  Right now, I don't see that story.  Maybe after another decade like this, but not right now.