Tim Duy's Fed Watch

More Confirmation of Steady Monetary Policy

Green shoots - or, as President Obama says - the beginning of the end of the recession aside, the Fed will not be ready to reverse their accommodative policy stance anytime soon.  New York Federal Reserve  President William Dudley said as much in a speech today:

If the recovery does, in fact, turn out to be lackluster, the unemployment rate is likely to remain elevated and capacity utilization rates unusually low for some time to come. This suggests that inflation will be quiescent. For all these reasons, concern about “when” the Fed will exit from its current accommodative monetary policy stance is, in my view, very premature.

The Fed continues to expect that low levels of resource utilization will keep a lid on inflation.  While some might object that emerging market economies can have both weak growth and high inflation, those economies still have an important transmission mechanism between higher prices and higher wages that appears to be missing in the US.  Indeed, while the press focused on the old news "recession is ending" angle of the Beige Book, the money quote for policymakers was:

The weakness of labor markets has virtually eliminated upward wage pressure, and wages and compensation are steady or falling in most Districts; however, Boston cited some manufacturing and business services firms raising pay selectively, and Minneapolis said wage increases were moderate. Boston, Cleveland, Richmond, Chicago, Dallas, and San Francisco cited a range of methods firms are using to limit compensation, including cutting or freezing wages or benefit contributions, deferral of future salary increases, trimming bonuses and travel allowances, reducing hours, temporary shutdowns, periodic furloughs, and unpaid vacations.

Until economic growth is sufficient to propel wages upward, any residual price pressures are likely to be snuffed out by deteriorating real wage growth.  Will the job market improve anytime soon?  We get a fresh look at initial unemployment claims tomorrow morning, but the July consumer confidence report from the Conference Board indicates that households see a deteriorating jobs picture:

The share of consumers who said jobs are plentiful dropped to 3.6 percent, the lowest level since February 1983. The proportion of people who said jobs are hard to get climbed to 48.1 percent from 44.8 percent.

Lacking a story that leads to strong wage growth in the near - or even medium - term, the Fed is almost certainly on hold at least through this year and likely well into 2010, allowing the size of the balance sheet to adjust according to the needs of the financial markets while keeping interest rates at rock bottom levels.   That doesn't mean all that easy money will not show up somewhere - technical analysts are looking for US equities to explode on the basis of recent market action.  But will the Fed lean against such an explosion without clear and convincing evidence that the labor market is poised for strong, sustainable improvement?  I doubt it - and for those looking for it, therein lies the ingredients for making the next big bubble.

The Debate Continues

The debate over the shape of the  recovery continues unabated.  Equities, at least this week, are voting in favor of the V-shaped recovery, with the Dow pushing past the 9,000 mark for the first time since January.  Never one to accept good news at face value, Nouriel Roubini predictably took the opposite position:

A “perfect storm” of fiscal deficits, rising bond yields, “soaring” oil prices, weak profits and a stagnant labor market could “blow the recovering world economy back into a double-dip recession,” he wrote in a research note today. “It is getting more likely unless a clear exit strategy from the massive monetary and fiscal stimulus is outlined even before it is implemented.”

 

Roubini, chairman of Roubini Global Economics and a professor at NYU’s Stern School of Business, predicted that the global economy will begin recovering near the end of 2009. The U.S. economy is likely to grow about 1 percent in the next two years, less than the 3 percent “trend,” he said.

 

Roubini based his short-term outlook on the worsening condition of the U.S. housing and labor markets, which he called “inextricably linked.” He said a “weak” job market will contribute to another 13 percent to 18 percent drop in house prices, bringing total declines nationally to as much as 45 percent from their peak.

I would add to Roubini's pessimism that  bond market investors as of yet do not share the optimism of their brethren in the equity side of the industry.  The run up in yields that brought a 4-handle to the 10 year Treasury appears to have been stopped dead in its tracks, and that maturity has pulled back to the mid threes.  If the run-up in yields foreshadowed a burst of optimism in equities, the pull back would suggest that this rally has nearly run its course.

 

 The challenge here is two-fold.  The first challenge is to determine how much of the recent equity run is attributable to the weight of evidence that indicates the worst of the downturn is behind us.  With the Armageddon trade off the table, some gains were inevitable, just as was the rise in Treasury yields.  The more difficult challenge is the strength and pattern of the subsequent recovery.  To be sure, one should not ignore the possibility of a blowout quarter here and there, as GDP data can bounce quickly to bounces in underlying data such as a stabilization in auto sales.  But will such a bounce reflect fundamental underlying strength?  A slow, jobless recovery - my dominant scenario - would most likely produce the seesaw trading we saw in the wake of the tech bubble crash, a pattern that held until the housing bubble gained full traction.  Such an outcome looks consistent with the sentiment of Federal Reserve Chairman Ben Bernanke in this weeks Congressional testimony:

Despite these positive signs, the rate of job loss remains high and the unemployment rate has continued its steep rise. Job insecurity, together with declines in home values and tight credit, is likely to limit gains in consumer spending. The possibility that the recent stabilization in household spending will prove transient is an important downside risk to the outlook.

Later, during questioning, Bernanke reiterated: 

What will the recovery look like?  Slow. “The American consumer is not going to be the source of a global boom by any means,” Bernanke says.

Sounds like he tends toward the low end of the FOMC's range of forecasts, and suggests, talk of withdrawal of various monetary accommodation aside,  this looks like a reasonable forecast:

BlackRock Inc., the biggest publicly traded U.S. money manager, recommends buying Treasuries maturing in two to five years on expectations the Federal Reserve won’t raise interest rates this year.

 

“They still see potential downside risks to growth,” Stuart Spodek, co-head of U.S. bonds in New York at BlackRock, said in a Bloomberg Television interview. “The Fed is not going to tighten. It has referenced keeping rates low for an extended period of time.”

With unemployment rates still headed north, it is tough to see the Fed tightening within the next twelve months, if not longer.  But will the job market surprise us?  No clear indications can be gained from initial unemployment claims data which, although battered by unusual seasonal patterns, overall remains consistent with further drops in nonfarm payrolls.  Indeed, this would be consistent with recent patterns of recession.  David Altig declares:

...I'm quite sympathetic to DeLong's theme that the dynamics of U.S. labor markets coming out of recessions appear to have changed starting with the 1990–91 economic contraction. And it might be hard for many people to argue with DeLong's point that the U.S. economy is likely headed toward another so-called "jobless recovery." But until more facts are in and we're able to look back on what transpired, I think we still, at this point, must reasonably count the current run-up in the unemployment rate as a puzzle.

In the comments from my last piece, reader spencer takes a different perspective, noting that forecasters have tended to underestimate the strength of recoveries, and further notes that recent moderate recoveries have followed atypical mild recessions.  The current recession, however, is more typical of the pre-1990 variety, and, as such could be expected to yield a rapid recovery.  A logical analysis from a long-time observer of business cycles; as always, one should have such an outcome on their continuum of possible events, but I tend not to be particularly sympathetic to the mild recession, mild recovery, big recession, big recovery analogy.  It seems to be that a cursory look at the data suggests something very different is happening in the labor market and thus the strength of recoveries since the early 1980s.  Look, for example at the pattern of durable goods manufacturing payrolls:

 

 

Previous to 1990, durable good jobs snapped back quickly, but that began changing after the 1980 recession, first with a muted rebound, than a slow return after the 1990 recession, and then with no return after the 2000 recession.  That lack of rebound alone cost the recovery roughly 2 million jobs - and it seems that if the downturn was only mild, we should have expected these jobs to return.  We will lose another 2 million at least by the time the current downturn is complete.  Does anyone think these jobs are coming back?  Anyone?

 

Likewise, nondurable goods manufacturing tells an even worse story:

 

 

In previous cycles, a rapid bounce, but simply an outright cliff dive since the mid 1990s.  Again, do we think this trend will be reversed in the upcoming recovery?  Another, albeit smaller sector:

 

 

To be sure, information services was coming off a bubble, but stability in the sector remained elusive even at the peak of the recent cycle.  

 

These patterns suggest to me that the last fifteen years has seen intense structural change such that even mild recessions result in permanent dislocations.  I have trouble that in the midst of such ongoing structural change a deeper recession will result in a less permanent dislocation.  No, I suspect many of these jobs are gone for good, placing an additional weight on the job market during the recovery.  Simply put, the danger is that in even a moderate recovery, the remaining expanding sectors will lack sufficient strength to compensate for these permanent losses. 

 

Anticipating the comments, another way some might describe the patterns in the labor markets during recent recessions is that a variety of economic policy decisions by both Democratic and Republican administrations have had the impact of dismembering the industrial base of the US without encouraging the growth of sufficient replacement jobs, thereby throwing the American middle class under the train.  That, however, is such a dark interpretation, as opposed to say, cheering the efforts of policymakers to lessen the burden of work on Americans by encouraging foreign nations to forsake their own consumption to provide goods for our citizens.  

 

Bottom Line:  I am not convinced that the equity run up confirms much more than the power of low expectations.  Indeed, the bond market has yet to follow suit (when I would actually expect it to lead the way).  I increasingly think that the debate between V and other shaped recoveries is really a debate over the degree of structural change occurring in the economy.  If you believe this is a typical cycle, and that what was demanded and how it was produced is roughly the same after as before the recession, a V-shaped recovery is your likely candidate.  If you believe that the current recession is simply intensifying a period of intense structural change, than you are looking for a U or L-shaped recovery.  Notably Bernanke, by acknowledging that the US consumer is in no shape to continued its 25 year role as a shaper of global economic trends, seems to be siding with the structural change side of the coin.

FOMC Forecasts - Reality or Fantasy?

It takes some time to work through the minutes from the June FOMC meeting.  They are, in the words of David Altig, "meaty."  Altig concentrated his remarks on the implications of the Fed's balance sheet explosion.  I found myself pulled to the various economic projections spread throughout the minutes.  Do those projections pass the laugh test?  Are they realistic?  Are they optimistic?  Or just plain delusional?  I think a little of all those descriptions are accurate.

 

The staff's projections comes first, and appear to be what Calculated Risk describes as an "immaculate recovery":

In the forecast prepared for the June meeting, the staff revised upward its outlook for economic activity during the remainder of 2009 and for 2010…The staff projected that real GDP would decline at a substantially slower rate in the second quarter than it had in the first quarter and then increase in the second half of 2009, though less rapidly than potential output. The staff also revised up its projection for the increase in real GDP in 2010, to a pace above the growth rate of potential GDP. As a consequence, the staff projected that the unemployment rate would rise further in 2009 but would edge down in 2010. Meanwhile, the staff forecast for inflation was marked up. Recent readings on core consumer prices had come in a bit higher than expected; in addition, the rise in energy prices, less-favorable import prices, and the absence of any downward movement in inflation expectations led the staff to raise its medium-term inflation outlook. Nonetheless, the low level of resource utilization was projected to result in an appreciable deceleration in core consumer prices through 2010.

 

Looking ahead to 2011 and 2012, the staff anticipated that financial markets and institutions would continue to recuperate, monetary policy would remain stimulative, fiscal stimulus would be fading, and inflation expectations would be relatively well anchored. Under such conditions, the staff projected that real GDP would expand at a rate well above that of its potential, that the unemployment rate would decline significantly, and that overall and core personal consumption expenditures inflation would stay low.

Leaving aside inflation (which will stay low over the long term if you assume that expectations remain anchored), the staff upgraded the forecast for 2009, is expecting growth to rebound to potential next year (which, is now less than six months away) and then acce lerate further in subsequent years.  Is such optimism justified?  Yes and no.

 

I think it is fair to say that mounting evidence points to the formation of a rather clear bottom in the most recent stage of this economic cycle.  Hear I refer to the sharp contractions beginning in late 2008, not to the "official" start of the recession in December 2007.  Indeed, I think one would have to be almost blind to not see the clear signals emerging in a wide range of data, such as the ISM data:

 

 

 

See also consumption data:

 

Not to mention to mention the initial claims data (see CR and his caveats).  To be sure, one could worry that industrial production continues to fall, but note the rate of decline is slowing and capacity utilization looks to be stabilizing.  Moreover, the recent stability in auto sales will lend support for manufacturing in the months ahead:

 

 

Notice that the vehicle sales increased 1.3% during the quarter, pointing to a gain in this component of GDP.  As always, do not underestimate the data impact of moving from significant declines to just flattening out.  With such clear evidence of bottoming out emerging, not only does the near term data get a boost, but downside risks fall - and both point to upward revisions of near term forecasts.   

 

The more interesting parts of the staff's forecast are in the 2010 and beyond range.   The fact that they suggest immaculate recovery, I suspect, is largely a model driven outcome.  Econometric models tend to force forecasts back to trend, and, in this case, are likely fighting with a large gap between actual and potential GDP.  The only way to close that gap is through rapid growth which would in turn lead to "significant" declines in the unemployment rate. 

 

How should we handicap this optimistic forecast?  First off, I would remind readers that the bar has been lowered.  The long run growth forecast from the FOMC participants are in the 2.5-2.7% range.  While this is not a revision, I think commentators tend to forget how much the bar has been lowered since the late 1990s, when some foresaw potential growth as 4% or higher.  Likewise, I believe evidence was building prior to the recession that the corresponding job growth rate is around 100k a month.  In other words, 100k holds the unemployment rate roughly steady, rather than the 150k that is commonly suggested.  In short, diminished expectations likely help the forecast clear the hurdle of reducing the unemployment rate in 2011 and beyond.

 

Moving toward the diminished expectation for potential output, I suspect, will not be terribly hard to accomplish.  Stabilizing consumer spending itself will go a long way toward keeping GDP growth in positive territory as will just a lessening of the inventory drag.  Moreover, fiscal stimulus will add positively over the next year, as will the external sector, especially if China can maintain its current dynamic and a weakened US consumer continues to weigh on import growth.  And if consumer and export spending hold together, then investment spending will also cease to be a drag.

 

That said, positive territory for growth could easily be consistent with an economy limping along above recession but insufficient for any significant job growth, a scenario that remains my favorite.  Given that 70% of the economy is driven by consumer spending, I find it hard to believe that you can supercharge growth well above potential without the active participation of households.  We know, however, that households continue to struggle under heavy debt burdens which, combined with the now tighter underwriting conditions that are likely to be more permanent than temporary, suggest that spending growth is likely to be constrained sufficiently to prevent supercharged growth.  I would imagine that to propel consumption growth to rates consistent with the staff's forecast, the staff must be anticipating significant real wealth gains sufficient to drive savings rates back to zero.  That, I believe imply a housing rebound…which I can't see unless conditions revert back to the "let's give everyone one with a pulse a loan" era. 

 

Could the Fed staff really believe that the stage is set for such a rebound?  More importantly, could FOMC members?  Perhaps some do, at least that is the impression from the growth projections:

 

 

The range of growth expectations is quite wide, as noted in this Bloomberg article.  Some policymakers are expecting a solid V shaped recovery evolving in 2010, while the other side of the spectrum is looking for a more gradual acceleration to potential growth (the scenario I tend toward).   The latter scenario suggests a jobless recovery, with growth insufficient to make much of a dent in unemployment.  From a policy perspective, such a scenario points to additional pressure to ease further, complicated by the unknown impact of general balance sheet expansion.  It certainly does not point to any rush to unwind the liquidity/credit support programs.  The optimistic view implies the opposite, a concern that programs need to be unwound quickly, with a rapid move to normalize interest rates.   Until the 2011 forecast comes more fully into view, sometime around the second quarter of 2010, policy will remain in a holding pattern.  But note that the wide range of forecasts imply a wide range of Fedspeak, which will lend an irritating feature to the discourse:  Seemingly opposite opinions nearly side by side in the press. 

 

A final point:  The range of forecasts, both high and low, can be used to argue against another stimulus package as the direction of growth is headed in the right direction.  This is especially the case if unemployment stabilizes, even if at a relatively high level.  Moreover, note that US Treasury Secretary Timothy Geithner is on something of a world tour, first China, now the Middle East, promising US fiscal restraint:

"Policies of the United States are designed to lay the conditions for a strong dollar," Mr. Geithner said on Tuesday, adding: "We are very committed ... to making sure that as we get through the crisis, we bring down fiscal deficits and we reverse these extraordinary interventions we've taken."

I suspect conditions would need to deteriorate markedly in order to force the Administration to push a fresh round of stimulus.  That is not the Fed's projection.

 

Bottom Line:  Clear signs of a bottom are an obvious reason to stabilize and boost near term forecasts.  Still, the Fed staff's projections appear overly optimistic, seeming to imply that future dynamics will be very similar to the past.  I am skeptical.  Remember to take forecasts relative of potential GDP in context of diminished expectations.  The wide range of projections speaks to an interesting spectrum of Fedspeak in upcoming months.  The game will be to track the data, being wary not to read to much into a short-lived bounce off the bottom.  I side with the low end of the FOMC forecasts; call me a pessimist.  Place your own bets, being prepared to adjust with the data.