Tim Duy's Fed Watch

More on the European Impact

Some clarification and expansion of my recent off-consensus analysis of the implications of the European debt crisis is in order.   In short, I noted that lower energy costs and interest rates were generally positive for the US.  Responses came from Scott Sumner, Felix Salmon, Ryan Avent, and Paul Krugman. 

 

The context in which I considered my remarks are well described by Michael Pettis, in his rebuttal to claims that China should avoid currency revaluation in light of the Euro's decline.  He argues that the Euro's decline makes the a shift in Chinese currency policy all the more critical.  In his summary:

5. If Europe’s current account surplus grows, there must be one or both of two automatic consequences.  Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.

 

6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports – let alone try to grow them – most of the adjustment burden will be shifted onto countries that do not intervene in trade directly.  The most obvious are current account deficit countries like the US.

A collapsing trade surplus in Europe needs to be met with an expanding trade surplus somewhere else, and my view is that the US is the most likely candidate, especially as the trend is already in place - the external sector is a drag on growth, despite all expectations that a sustained rebalancing will occur in the wake of the US financial crisis.

 

I think that the decline in oil prices and interest rates is one mechanism by which markets essentially offset some the contractionary consequences of the European debt crisis.   Like the declining Euro, they are price signals that correspond to propping up demand elsewhere, such as the US, thereby allowing the US to absorb the European contraction via an expansion in the US current account deficit.  Thus, the surprising effect of the crisis is that US demand growth is higher than would otherwise be the case, even  as global growth in aggregate suffers.

 

Pettis argues, I think correctly, that this sets the stage for a rather nasty increase in trade tensions:

I don’t really see how the numbers are going to work.  Europe, China and Japan are all implicitly demanding that the US trade deficit rise to help them through their domestic employment problems.  The US has its own domestic employment problems and is determined to bring the trade deficit down.  Both sides cannot win and there doesn’t seem to be much serious attempt at global coordination.  In fact the easiest part of any global coordination – that between surplus Europe and deficit Europe – has already degenerated into a nasty round of accusations, counter-accusations and insults.

Note that Pettis is hinting at one of Ryan Advent's criticisms regarding domestic employment problems:

For another, it seems unreasonable to expect personal consumption to power recovery all the way back to full employment, no matter what interest rates or oil prices do. Household balance sheets are simply too stressed. Consumption can act as a bridge from government-driven growth to export- and investment-driven growth, but little more, and export- and investment-driven growth is looking dicier now than it was a month ago.

I agree - it seems ludicrous to expect the US consumer to continue to power forward sufficiently to hold the US economy and the global economy together.  Yet, I suspect that it is the course of least resistance, or at least appears to be at the moment.  For what it's worth, consumer spending growth has been on something of a tear - a trend that stretches back to the middle of last year.  One can argue that this spending is simply propped up by the expansion of government debt rather than private debt, but note that that dynamic becomes more sustainable given lower interest rates.  It is almost as if market participants are encouraging the US government to take over where the Greeks, Spanish, etc. let off.  Indeed, it seems to be clear evidence that public debt is nowhere near crowding out private spending in the US.  Room for more, not less.

 

Is this economically healthy?  No, no, no.  Felix points out that an expansion of the US imbalance now only implies higher interest rates later.  The adjustment will come, and will only be more difficult in the future.  That is a story I have told many times, but I have to add this - going bearish on US debt has been risky.  Like Japan, economists keep saying the end is near, but it has not yet happened.  Timing is everything. 

 

Sumner argues that declining commodity prices in response to demand shock are rarely a good thing, and the recent episode is another reason to believe that central bankers are failing to support nominal GDP growth.  With respect to my earlier argument, I see no reason why a decline in energy prices due to a demand drop in Europe cannot be a net positive for the US.  But, nonetheless, I agree with Sumner's broader point regarding the  need for more aggressive monetary policy:

It’s true that US exports to Europe are modest, but if the strong dollar is symptomatic of unintentional tightening of monetary policy, despite low rates, then it may not be good news at all.

He reiterates the point here.  The European Central Bank, in particular, should be working more aggressively to counter deflationary pressures internally.  But, alas, policymakers don't want to be seen as bailing out weaker members for fear of losing credibility.  One of the cut of your nose to spite your face situations.  Likewise, with the US facing ongoing disinflationary pressures, the Fed arguably should be expanding policy more aggressively.  In theory, the two expansions could leave the relative currency prices unchanged, yet sink both against other trading partners.

 

This, of course, brings us back to the apparently intractable Chinese currency issue.  A Dollar and Euro depreciation against the renminbi and other emerging market currencies looks like a nobrainer approach to preventing an intensification of global imbalances.  Moreover, it just makes economic sense given relative inflation trends.  Consider today's Wall Street Journal:

U.S. inflation slid last month to its lowest level in 44 years, highlighting a potentially troublesome unevenness in the global recovery.

 

Inflation has sped up in booming economies such as China and Brazil, while in many developed nations like the U.S., prices remain tame, even flirting with deflation in some cases.

 

The U.S. government reported Wednesday that consumer prices, excluding volatile food and energy, rose a meager 0.9% in April from a year earlier. It is the latest sign that high unemployment and excess production capacity are holding down wages and prices in much of the developed world.

 

At the same time, emerging economies are taking steps to contain high inflation in their booming markets—moves that some economists worry could dampen demand for exports, which many developed countries are depending on to help fuel their recoveries.

Note that US Treasury Secretary Timothy Geithner said again this week that Chinese currency policy is set for a change:

The Treasury chief also yesterday reiterated his call that China will abandon its exchange-rate peg. The government is moving toward changes in currency policy that would allow market forces to play a greater role, he told reporters after the speech.

Of course, Geithner says things like this a lot.  And one gets the expected pushback from China:

Yuan forwards weakened for a second day after Chinese officials said the nation won’t yield to global calls to end a 22-month peg, damping speculation next week’s U.S.-China trade talks would trigger appreciation.

 

China won’t succumb to external pressure and will modify the currency based on the economic situation, Assistant Finance Minister Zhu Guangyao said in Beijing today. Stability between the world’s major reserve currencies will aid the global economic recovery, he said at a briefing to discuss the May 24- 25 Strategic & Economic Dialogue in Beijing…

 

“Only the authorities of a sovereign country have the right to decide how to form the exchange rate,” Zhu said. Countries should “work to maintain the stability of exchange rates between currencies so as to create a favorable environment for the global economic recovery,” he said.

Note that Chinese policymakers hold all the cards regarding any policy shifts.  They know that Giethner is not going to push for capital controls, nor will he request the Fed to beginning stockpiling renminbi on Treasury's behalf.  The latter policy - a tit for tat response to Chinese dollar accumulation - would be interesting to say the least, but no US policymaker wants to be accused of initiating a chain of competitive devaluations that will only end badly.

 

Sorry if this rambled a bit; external adjustment stories on a global scale tend to get messy.  Which I imagine is why we have yet find a sustainable path to resolving imbalances.

Fed Disconnect

Federal Reserve Governor Daniel Tarullo's recent testimony on the European debt crisis illustrates a significant inconsistency with between the Fed's outlook and its policy.  Honestly, if Tarullo actually believes with he says, the Fed needs to be pursuing a much more aggressive policy.  But the FOMC is actually debating the opposite - when and how to reverse its swelling balance sheet.

 

 Tarullo highlights the two obvious negative channels by which the European crisis will feed into the US economy.  The first is financial:

These effects on U.S. markets underscore the high degree of integration of the U.S. and European economies and highlight the risks to the United States of renewed financial stresses in Europe. One avenue through which financial turmoil in Europe might affect the U.S. economy is by weakening the asset quality and capital positions of U.S. financial institutions...

 

...In addition to imposing direct losses on U.S. institutions, a heightening of financial stresses in Europe could be transmitted to financial markets globally. Increases in uncertainty and risk aversion could lead to higher funding costs and liquidity shortages for some institutions, and forced asset sales and reductions in collateral values that could, in turn, engender further market turmoil. In these conditions, U.S. banks and other institutions might be forced to pull back on their lending, as they did during the period of severe financial market dysfunction that followed the bankruptcy of Lehman Brothers.

 The second is via trade linkages:

Another means by which an intensification of financial turmoil in Europe could affect U.S. growth is by reducing trade. Collectively, Europe represents one of our most important trading partners and accounts for about one-quarter of U.S. merchandise exports. Accordingly, a moderate economic slowdown across Europe would cause U.S. export growth to fall, weighing on U.S. economic performance by a discernible, but modest extent. However, a deeper contraction in Europe associated with sharp financial dislocations would have the potential to stall the recovery of the entire global economy, and this scenario would have far more serious consequences for U.S. trade and economic growth. A resultant slowdown in the United States and abroad would likely also feed back into the health of U.S. financial institutions.

Tarullo acknowledges that the European crisis is largely a European problem, while the Fed is reduced to a limited supporting role.  What caught my attention was first this section regarding the potential for financial disruption:

The timing of such an event in the current instance would be unfortunate, as banks generally have only recently ceased tightening lending standards, and have yet to unwind from the considerable tightening that has occurred over the past two years. Moreover, aggregate bank lending, particularly to businesses, continues to contract. The result would be another source of risk to the U.S. recovery in an environment of still-fragile balance sheets and considerable slack. Although we view such a development as unlikely, the swoon in global financial markets earlier this month suggests that it is not out of the question.

The fact that aggregate bank lending continues to contract, that the Fed is obviously aware of this, and that, according to Tarullo, the European crisis has the potential to aggravate an already existing problem all clearly point toward a more aggressive quantitative easing program than in place.  Actually, what is happening is the Fed is considering a quantitative tightening program:

Meeting participants agreed broadly on key objectives of a longer-run strategy for asset sales and redemptions. The strategy should be consistent with the achievement of the Committee's objectives of maximum employment and price stability. In addition, the strategy should normalize the size and composition of the balance sheet over time. Reducing the size of the balance sheet would decrease the associated reserve balances to amounts consistent with more normal operations of money markets and monetary policy. Returning the portfolio to its historical composition of essentially all Treasury securities would minimize the extent to which the Federal Reserve portfolio might be affecting the allocation of credit among private borrowers and sectors of the economy.

Tarullo also presses for a hawkish fiscal stance:

The United States is in a very different position from that of the European countries whose debt instruments have been under such pressure. But their experience is another reminder, if one were needed, that every country with sustained budget deficits and rising debt--including the United States--needs to act in a timely manner to put in place a credible program for sustainable fiscal policies.

Interestingly, Tarullo seems to suggest that the US response to fiscal problem in Europe should be to tighten US fiscal policy on roughly the same timetable the Fed is looking forward to tightening US monetary policy.

 

To summarize, the Fed believes we are facing another threat to demand, either via financial or real trade linkages, at a time when lending activity continues to fall, suggesting that monetary policy is too tight to begin with.  But the Fed stance is to believe that monetary policy is on the verge of being too loose, and, if anything, planning needs to be made to tighten policy.  At the same time, Fed policymakers also believe fiscal policy needs to turn toward tightening as well. Meanwhile, unemployment hovers just below 10%, nor is it expected to decline rapidly,  and inflation continues to trend downward.

 

All of which together suggests that the Fed's policy stance is seriously out of whack with policymaker's interpretation of actual and potential economic developments.  And I have trouble explaining the disconnect.  

Is the European Crisis a Net Positive for the US?

How will the European crisis feed into the US outlook?  I clearly recall JP Morgan making a recession call in the wake of the Asian Financial crisis, predicting a US recession on the back of a drop in net exports.  While a drop in net exports did occur, domestic growth more than absorbed the impact.  The US recession was delayed until the impact of tighter monetary policy, higher energy prices, and the popping of the tech bubble all came home.

 

I can see a similar pattern of events evolving now. 

 

First off, I think it unlikely that an export demand shock alone is sufficient to push the US economy back into recession.  Menzie Chinn tackled this issue back in 2007, arguing at the time it was unlikely a rise in exports would stave off a recession.  The reverse logic holds as well; US recessions look to be driven by sharp declines in domestic absorption, not exports.

 

That is not to say that slowing exports would not crimp US growth.  The rising Dollar not only stresses US exports to Europe, but China as well.  As Calculated Risk notes, European exporters are now more competitive in China compared to their US counterparts.  Moreover, the falling Euro may delay any eventual loosening of Chinese currency policy, as policymakers fret about the effects of one falling currency, let alone two. 

 

Now, it is perfectly reasonable to be concerned about the implications of falling net exports for growth given the supposed fragility of the US recovery.  The Wall Street Journal reports the Goldman Sachs analysis:

Estimates of how much the government’s spending is actually stimulating growth vary wildly — some economists contend it has no net effect at all. But if you believe the economists at Goldman Sachs, who have spent a lot of time poring over the details, the effect is quite significant: about two percentage points of annualized growth in both this quarter and the last. Indeed, if one subtracts that stimulus effect and the boost from changing inventories — also a temporary factor — there’s been no recovery at all. Growth in the first and second quarters of 2010 would be zero.

One can contrast this with a more optimistic assessment from Justin Weidner and John Williams at the San Francisco Federal Reserve Bank:

In the past, large output gaps, rapid growth of potential output, and real interest rates well below the natural interest rate have contributed to rapid V-shaped recoveries. These factors were much more muted in the recessions of 1990–91 and 2001, leading to U-shaped recoveries. Now they point to a moderate pace for the current recovery, somewhere between the U and V shapes of the past.

Yes, per usual, two economists, three opinions.  In any event, one would have to consider the positive impact of the Greek crisis against any trade drag.  And yes, there are positive implications.  First, the weaker Euro has taken a bite out of oil prices, which fell back below $70 today.  Make no mistake - keeping a lid on oil prices offers continued support for US consumers.  And while we can all dream of a more balanced economy less dependent on household spending, for now it remains the best game in town.  Although Phil Izzo at the Wall Street Journal tried to throw some cold water on the details, the overall trend in retail sales continue to look solid:

 

Consumers have a wind at their backs, unbelievably, and further job growth will only speed them further.  Likewise, the rush to Treasuries is keeping a lid on US interest rates.  And this is coming on the back of already surging demand for US assets.  From Bloomberg:

Global demand for long-term U.S. financial assets strengthened in March to a record as investors from China to the U.K. purchased the most Treasuries since November, a Treasury Department report said.

 

Net buying of equities, notes and bonds totaled $140.5 billion in March, more than double economists’ projections, after net buying of $47.1 billion in February, the report released today in Washington showed. Including short-term securities such as stock swaps, investors abroad purchased a net $10.5 billion, compared with net buying of $9.7 billion the previous month.

 

Signs of a sustained economic recovery, including a rebound in earnings and stock prices, may increase demand for U.S. investments as concerns mount about the sustainability of government debt in Europe, economists said. The world’s largest economy has expanded for three consecutive quarters and added 573,000 jobs in the first four months of the year.

Add a lid on interest rates via a steady surge of capital flows to sustained job growth, and the odds of sustainable recovery look better every day.  Moreover, we are still in a sweet spot with regards to monetary policy.  The Fed was not inclined to tighten policy this year, expecting continued downward pressure on inflation via a persistent unemployment gap.  The European crisis only adds to the willingness of monetary policymakers to hold tight.  No, in the near term, the Fed is not likely to derail the recovery.

 

Of course, the European financial crisis remains a bogeyman via the possibility of financial contagion.  Will the US banking system once again come under assault?  On this point I think we can pull out the "too big too fail" card - images of the most recent crisis remain vivid in policymakers' minds.  They would likely swamp the financial system with cash if the crisis threatened to spread to the US, quickly pulling out all the tools they just put back on the shelf.  And note that the inflows of capital helped the US whether the Asian Financial Crisis despite a few harrowing days on Wall Street (like that little thing called LTCM). 

 

Bottom Line:  The European crisis, by keeping US interest rates in check and oil prices low, may do more to help the US recovery than hurt it.  In the process, however, we would expect the flip side of the resulting capital inflows into the US to emerge - namely, a rising external imbalance.  Arguably, this simply shifts the ultimate adjustment to sometime in the future.  Again. 

Still Unbalanced

The recent flow of data is interesting to say the least.  While headline numbers are generally solid, the underlying story looks shaky.  Shaky enough that disinflationary trends remain firmly entrenched in the US, whereas inflationary risks appear to be growing in emerging markets.  The former suggests the Fed is set to remain on hold, while the latter will push foreign central banks to tighten.  In a perfect world, that combination would put downward pressure on the Dollar and support a shift to a more balanced pattern of growth for both the world in general and the US in particular.  Yet we persistently fall short of a perfect world.  Will this time be any different?  The Greek crisis is saying it won't. 

 

Manufacturing remains a clear bright spot in the economic environment, a point reiterated by the most recent ISM survey.  The headline 60.4 was the strongest since 2004, and the underlying details were solid.  Employment continues to expand, providing at least a modicum of relief for the beleaguered labor market. The inventory drain became apparent, with more firms than not reporting stockpiles as too low.    This suggests further room for manufacturing expansion.  The proportion of firms reporting rising prices edged up again, not unexpected considering the complete lack of pricing power and drop in commodity prices at the low point of the recession.  Note too that the strength in the ISM numbers is consistent with the solid manufacturing report, with a strong gain in new orders for nonair, nondefense capital goods. 

 

Although the positive tenor to manufacturing is welcome, the first quarter read on GDP reveals a more uneven pattern of recovery, and more worrisome, a recovery that looks a little too dependent on US households.  Consumer spending gained 3.6%, contributing 2.55 percentage points to the headline 3.2% gain.  The sustainability of such spending, however, remains in doubt.  Note that spending growth was heavily supported by falling savings rates, while income growth less transfer payment remains stagnant.  This suggests that consumers are once again leveraging up the balance sheets while the deleveraging outside of housing was likely not as deep as initially believed, once bank loan write-offs are accounted for.  In short, it looks like we have come full circle.  The US economy is again excessively dependent on consumer spending, and that spending is fueled by anything but organic income growth.

 

The next largest contributor was  inventories, which add 1.57 percentage points - clearly part and parcel of the manufacturing revival.  Also supportive of that sector was the 13.4% gain in equipment and software category, down from the previous quarter.  But a closer look reveals that category, a small part of overall spending, contributed only 0.83 percentage points to growth, and the bulk of that was information technology; industrial and transportation were basically flat.  Residential and nonresidential structures were both a drag on growth, illustrating the ongoing weakness of both sectors - weakness that prevents a true V-shaped recovery.  Growth, yes, and even sustainable growth.  But growth that leaves the economy limping along, heavily dependent on policies to stimulate consumer spending.

 

With overall investment still falling short of fully supportive of recovery, attention turns to the export story.  And, yes, export growth is supportive.  The problem is the import drag swamped the export push, leaving the external sector a net negative for growth, sapping 0.61 percentage points from the headline number.  This drag throws a wrench into hope that external growth will support the recovery or a rebalancing of global activity.  We need to acknowledge the possibility (likelihood) that outsourcing during the past twenty years has left the US structurally dependent on trade deficits.  Fueling consumer spending simply translates into a substantially offsetting import increase, thereby preventing the external sector from contributing to growth on net.

 

Presumably, what we need is policy supportive of a real rebalancing, in which the US consumer is comparatively subdued, keeping a lid on import growth, while the rest of the world is firing on most cylinders.  And here is where exchange rate adjustment is important.  Faster growth abroad should translate into higher foreign interest rates, which should in turn be Dollar negative.  Part of that story is in play.  From the Wall Street Journal:

Prices across Asia are rising faster than expected, highlighting the region's strong recovery compared with the West and raising the likelihood for tighter monetary policy.

 

South Korea and Indonesia reported higher-than-expected inflation Monday, coming a day after China raised banking reserve requirements in a bid to cool its economy. In a sign that inflation is becoming entrenched, core prices, which exclude volatile food and energy, are ticking up.

Meanwhile, the Fed last week reiterated its commitment to ultra-low rates, which should come as no surprise given the uneven and inventory cycle dependent nature of US growth so far - note that real final sales posted another anemic reading of 1.6% in the first quarter.  There is simply not enough growth to rapidly alleviate stress in the labor market, thereby keeping disinflation in play.  The March read on core-PCE inflation confirmed the downward trend:

 

A declining Dollar is the signal to shift production to US shores and alleviate inflationary pressures abroad (while stimulating such pressure domestically), thereby limiting the need for foreign monetary policymakers  to hit the brakes so fast that they stifle  growth.  There is no such thing as immaculate adjustment; a Dollar decline is critical to this process.

 

It should be a nice, textbook story.  Alas, the US external adjustment is anything but textbook.  The challenges I see to this adjustment:

1. Export supporting foreign policymakers.  Foreign policymakers could attempt to simply shift demand away from internal sources and to the US by raising rates while accelerating reserve accumulation (and sterilizing the subsequent domestic money growth).  Indeed, emerging Asian nations would be hesitant to hobble their exporting industries, more so if China does not first revalue the renminbi. 

2. The Greek crisis.  The Greek drama is obviously far from over; it is not clear that the threat of contagion is even significantly reduced, let alone eliminated. Nor would it be until all the PIIGS committed to a growth sapping fiscal stance, which the Greek public are finding hard to accept.  That stance, while perhaps necessary, weighs against global growth and tends to strengthen the Dollar, slowing the rebalancing process.  Moreover, I find it difficult if not impossible to believe that the impacted nations can adjust without a significant devaluation.  Which suggests the Euro has further to fall.  But it is reasonable to believe that, given the German weight in the Eurozone,  any decline in the Euro would fall short of what is necessary for the PIIGS to fully adjust.  Are we really down to just two choice then?  Either Northern Europe commits to perpetual fiscal transfers to Southern Europe (not going to happen), or the Eurozone shrinks?  Both suggest a weaker Euro, but the latter points to an outright collapse.

3. The size of the Dollar adjustment.  Given the substantial fixed costs of offshoring, it is possible that very large adjustments in the Dollar are necessary to give a lift to importing competing industries in particular.  Policymakers may not have the stomach for such an adjustment, resulting in a slow pace of Dollar decline that the support provided net growth is almost negligible.

4. The dependence of everyone on the US consumer.   Any rebalancing requires the importance of the US consumer to decline from the current 71% of US GDP.  Yet US officials welcome the consumer recovery, and would be hesitant to accept renewed consumer weakness without a clear offset (which they could provide via increase public investment, if they wanted to).   And foreign officials, faced with a political class of exporters dependent on US consumers, would be hesitant to risk angering that constituency with a substantial adjustment (see point 1 above).

These are challenges, and are not meant to imply that adjustment cannot occur.  Only that so far that recovery has seen precious little such adjustment, with net exports subtracting from growth two of the last three quarters.  The combination of tepid US consumer growth, rapid foreign growth, and a steady although not disruptive decline in the Dollar - the combination of factors that present in 2006 and early 2007 - appears difficult to achieve and sustain.  I fear it requires a much more substantial global commitment to rebalancing than we have seen to date.  And that commitment will be sorely lacking given the Greek crisis.  Where the American-led financial crisis forced global policymaker to pull together, the European crisis may push them back apart.