Tim Duy's Fed Watch

Ahead of a Busy Week

Policymakers are increasingly stuck between a rock and a hard place.  It is likely the recovery remains intact, but at a pace that will fall short of policymakers expectations.  Just how far short?  That is the key question.  In the absence of a fresh financial crisis, in my mind the most likely outcome is that the US economy limps along not unlike the path in the wake of the 2001 recession.  Recall that what ultimately pulled the economy off its feet earlier this decade was the housing bubble.  There is likely no bubble to pull us out this time.

 

And an economy that just limps along will put both monetary and fiscal policymakers in a tight position.  With interest rates already at rock bottom, monetary policy options of any significance are limited unless the Fed is ready to pump up the money supply via either a commitment to higher inflation or the targeting of long term interest rates.  And on the fiscal side, policy is limited by deficit fears.  Lacking a clear downward turn in the economy, there is no willpower for large scale stimulus.  Which means this:  An economy that limps along is on a certain path to a lost decade if policymakers remain incapable of decisive action.

 

Last week was light on data which, as Calculated Risk opined, may have provided support for equities markets.  No chance of "no news is good news" this week.  The economic calendar is full, with an important update on the US consumer with Wednesday's release of the Retail Sales report.  Note the Wall Street Journal ran a cautionary tale on retail sales last Friday:

Consumers aren't stepping up spending at the pace many retailers expected just a few months ago, raising the specter that stores will be stuck with piles of unsold goods later this year.

 

This dimming retail picture is part of a larger downshift in growth occurring across the economy. Consumer confidence slumped last month and the job market remains weak. On Thursday, the Federal Reserve reported consumer borrowing fell in May, another sign that they are wary about their finances.

 

All this bodes poorly for the kind of snapback in spending many stores anticipated only a few months ago. Last year's holiday sales were strong and many retailers expected robust growth to continue through this year, fueled in part by pent-up demand for washing machines and clothes that weren't bought during the recession.

The "robust growth" retailers were looking for was reflected in the trend as recently as April:

 

Pent-up demand released as job losses came to an end supported that stronger trend - a trend that likely pleased policymakers, as it provided hope that the previous trend could be reached within the scope of current policy.  But there might have been less pent-up demand than retailers expected.  The May sales drop pulled retailers back closer to the pre-recession trend:

 

 

We can even question the sustainability of that trend given weak job growth and declining consumer credit.  In any event, the anecdotal evidence presented by the WSJ suggests we should expect the June data to track more closely to the lower trend.  Would growth just below expectations be enough to force a policy shift more than an ongoing commitment to ZIRP?

 

While the Retail Sales report will be especially important, plenty of other interesting data will be in play.  Tuesday we get the May International Trade report.  Note that the Obama Administration is counting on exports to fuel the US recovery.  Note too that they appear to have forgotten about imports; on net, the international sector has reduced GDP the past three quarters.  Will it continue to do so?  If the external deficit continues to widen, watch for pressure to extend the renminibi's pitiful advance.  On that topic, note that China's trade surplus rose again in June - interesting, given the Chinese statement:

With the BOP account moving closer to equilibrium, the basis for large-scale appreciation of the RMB exchange rate does not exist.

Also in the line up are a host of data on the manufacturing sector, with Industrial Production, the Producer Price Index, and regional reports from the New York and Philadelphia Feds on the docket for Thursday.  We are looking for more evidence that the pace of the manufacturing recovery is fading as producers need to rely on final demand, not inventory correction, to fuel new orders - consistent with the drop in the new orders component of the June ISM manufacturing report. 

 

Finally, the big focus of the week might not be Retail Sales, but the Consumer Price report set for Friday.  Any signs of increased disinflationary pressure will weigh heavily on Federal Reserve policymakers, increasing the divide between those who are dead set against further action, a position held most formidably by Kansas City Federal Reserve President and serial FOMC dissenter Thomas Hoenig  and more pragmatic policymakers.  The question remains:  How much disinflation would the Fed be willing to tolerate before they pull out the stops on asset purchases - policy that will look a lot like debt monetization.

 

Simply put, what we are looking for is data to define what is shaping up to be a disappointing second half relative to excessive expectations formed as the economy lifted itself off the recession floor. Market participants are waking up to the reality that the recovery is falling far short of the fabled V.  Policymakers are beginning to realize the same.  Surprising it has taken so long for this realization to sink in.  The pace of growth has never been sufficient to rapidly eliminate the gaping output gap.  Compare the growth in real final sales over the past three quarters to that of the mid 1980's:

 

 

Excluding inventory dynamics, the pace of activity is falling far short of that necessary to fulfill expectations of a rapid snap back to trend.  Paul Krugman reports:

But based on public reporting, like the Ryan Lizza article on Larry Summers — which reads rather differently now that we know how things are really working out, or more accurately not working out — it looks as if top advisers convinced themselves that even in the absence of stimulus the slump would be nasty, brutish, but not too long….So all policy needed to do was meliorate the worst, while we waited for the economy to recover spontaneously.

Policymakers may try to place the blame at the feet of Europe:

The president suggested that troubles in Europe have led to “skittishness and nervousness on the part of the markets and on the part of business and investors.” In brief remarks, the Fed chairman pressed the need to take a global outlook. “I think, very importantly, we also talked a lot about the international context. What’s happening around the world in emerging markets, in Europe affects us here in the United States, and it’s important for us to take that global perspective as we discuss the economy,” Bernanke said

To the extent that Europe is a drag (and at least one Fed official suggests it isn't, and note that lower interest rates a fueling a mini refinancing boom), quite frankly, it is only icing on the cake.  The lack of a V-shaped recovery was baked into that cake from day one, a story that Calculated Risk, for example, has reiterated multiple times.  The basic of components of that story remain the same:  The lingering impact of financial crisis, the ineffectiveness of monetary policy at the zero bound, and the lack of recovery in the housing market.  One does not need to turn to Greece to explain the relative weakness of this recovery. 

 

In short:  This week will be data rich.  Will that data paint a picture of an economy limping into the second half of 2010, growing, but not swiftly enough to return output to trend and lift rapidly lift employment?  Such an outcome should pressure policymakers into additional action.  But short of an outright double-dip, will we get anything more than a token policy response?  My concern is that policymakers will view a retrenchment in growth as a natural "pause," simply a delay on the path the strong rebounds that have traditionally followed deep recessions.

What is the Threshold For More Fed Action?

Yesterday's Washington Post article suggesting the Fed was moving closer to additional policy action left me somewhat puzzled.  It left out a critical piece.  What is the threshold for additional action?  Particularly any action of significance?  Recent Fedspeak suggests the threshold is pretty high - financial crisis high.  Otherwise, any action is likely to be more window dressing than anything else.

Neil Irwin at the Post claims:

Top Fed officials still say that the economic recovery is likely to continue into next year and that the policy moves being discussed are not imminent. But weak economic reports, the debt crisis in Europe and faltering financial markets have led them to conclude that the risks of the recovery losing steam have increased. After months of focusing on how to exit from extreme efforts to support the economy, they are looking at tools that might strengthen growth.

Note the rhetorical claim suggesting this article is sourced by "top Fed officials."  But the only officials cited are St. Louis Fed President James Bullard and Boston Fed President Eric Rosengren.  No one from the Board, interestingly.  To be sure, Bullard is an intellectual heavy hitter.  But Bullard can be difficult to read.  He talks.  A lot.  But with Bullard, the Post reduces his quotes to pretty pedestrian stuff:

"If the economic situation changes, policy should react," James Bullard, president of the Federal Reserve Bank of St. Louis, said in an interview Wednesday. "You shouldn't sit on your hands. . . . I think there's plenty more we could do if we had to."

Surprising.  I have to imagine that Bullard provided a lot of good quotes.  And Irwin doesn't appear to challenge Bullard to explain how much the economic situation needs to change to prompt a policy change.  But, luckily,Bullard gave an interview to Reuters at the end of June, and reporter Mark Felsenthal gave us a little more to work with.  Yes, this is not new news.  Just new for the Post.

 

For me, the Reuters piece had three main takeaways.  First, Bullard and his colleagues underestimated the likelihood of a jobless recovery:

"We just started getting our job growth going three months ago, and then all of sudden we get a kind of a weaker number," said Bullard, who is a voter this year on the Fed's policy-setting panel. Nonfarm payrolls added a disappointing 41,000 private sector jobs in May, denting hopes for a speedy recovery.

Second, and related, the Fed actually believes we are experiencing a typical post-war recession in which output rapidly returns to trend:

Setting aside worries raised by softer economic indicators and Europe, the Fed continues to envision a moderate recovery, Bullard said.

 

"We would expect ... at some point start to gradually withdraw the accommodation and then things would continue to recover, and then eventually we would get back to normal," he said.

Does the Fed really fail to realize that the only reason the US economy returned to "normal" after the last recession was attributable to a housing bubble that was unsustainable?  A topic for another time.  Finally, the threshold for meaningful additional action is very, very high:

However, if the economy takes a decisive turn for the worse, the Fed would have to consider further stimulus, probably buying more Treasury securities to ease financial conditions, Bullard said.

 

"If things got really bad in some dimension and we were back in crisis mode, I think the FOMC wouldn't hesitate to do more if we had to, but I don't really think that that's the situation we're in right now," he said.

Note:  "back in crisis mode."  Note:  "ease financial conditions."  Nothing like  "to ease the pain of unemployment."  Did Bullard say the same thing to Irwin?  We don’t know, because Irwin falls back on plain vanilla quotes. 

 

Putting the pieces together, it appears the Fed is beginning to realize that economic activity will not bounce back rapidly, but there is little meaningful they are willing to do unless they are in crisis mode.  And that analysis is based largely on interviews with a single Fed official.  Other Fed officials appear even less likely to act.  From Bloomberg over the weekend:

Two Federal Reserve policy makers differed on the strength of the U.S. consumer in Nikkei newspaper interviews, amid evidence that the recovery in the world’s largest economy is slowing.

 

Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, said consumer spending is “moderately strong” and along with business investment will help sustain the recovery, the Japanese newspaper quoted him as saying. Richard Fisher, president of the Dallas Fed, cited “cautious” households as a reason for a growth to cool in the second half.

 

The remarks reflect debate on the durability of the economy after reports last week showed private-sector payrolls rose less than forecast in June, consumer confidence slumped and manufacturing growth slowed. Fed officials last month retained a pledge to keep record-low interest rates for an “extended period” and signaled Europe’s debt crisis may harm growth.

 

Lacker said he was comfortable with the current level of interest rates, according to Nikkei. Later this year it will be a “legitimate question” whether to drop the ‘extended period’ language and “think about raising rates,” the newspaper reported him as saying.

 

Fisher said any tightening of monetary policy “depends on the course of the economy,” according to the report. He said on June 4 that while it’s not time for central bankers to tighten policy, they may be “getting closer” as the economy further expands this year.

Goodness, over the weekend, both Richmond Fed President Jeffrey Lacker and Dallas Fed President Richard Fisher were still looking forward to tightening policy.  Of course, Fisher, similar to Bullard, likes to talk.  Indeed, Fisher looks closer to Kansas City Fed President Thomas Hoenig:

Hoenig, 63, has been the sole policy maker to dissent this year from decisions of the Federal Open Market Committee, objecting four times to its pledge to keep interest rates at a record low for an “extended period.”

 

He also said the central bank should dispose of assets accumulated while fighting the crisis “as reasonably as we can, as quickly as we can.” While he has proposed raising the target for overnight loans among banks to 1 percent by September, Hoenig said in the interview that the timing “can be debated.”

 

Fisher indicated there’s little more the Fed can do after cutting interest rates to a record low in December 2008 and pumping more than $1 trillion into the financial system through asset purchases.

“We ought to be very careful about not going too far,” he said. “Interest rates are zero. It’s not the cost of money that’s the issue.”

One can only imagine what kind of crisis would prompt Hoenig for additional action.  Something that would rapidly deteriorate to the guns and gold portfolio.  Still waiting for someone from the Board to speak.   Wait, yes they did.  Fed Governor Kevin Warsh gave a rousing speech:

The Federal Reserve should be wary of the short-term allure of further asset purchases, said Fed governor Kevin Warsh on Monday. In a speech in Atlanta, Warsh set a high bar for his support of further asset purchases, saying he would need to be convinced the benefits of the purchases would outweigh the costs of "erosion of market functioning, perceptions of monetizing indebtedness, crowding-out of private buyers, or loss of central bank credibility."

Which gets to the crux of the issue.  Realistically, to generate significant impacts at the zero bound, the Fed is going to have to commit to policies that look a lot like debt monetization.  We are nowhere near that stage.  Indeed, after two decades, the Bank of Japan is not there.  Sure, maybe the Fed commits to a long term ZIRP (pretty much there already), buys mortgage backed assets to offset maturing securities, or, as a temporary response to a fresh crisis, expands the balance sheet a bit.  But commit to a higher inflation target?  Target long bond rates?  Those actions likely require sustained, massive purchases of US Treasuries - a bridge too far to cross for policymakers who view central bank credibility as a one sided game.  The only real policy error is inflation.  Anything else is interesting, but not important.

Why is the American Jobs Machine Broken?

The June employment report was decidedly weak, and serves as the latest blow to the V-shapers - if any are even left.  It once again left me feeling that something is very, very wrong at the heart of the American economy, something that is much more structural than cyclical.  Consider too that US policymakers appear completely unable to adequately address the latter problem, now hampered by fear of deficit spending and the threat of the invisible bond vigilantes.  Yet the structural challenges are even more daunting, and I fear that the Washington establishment is simply incapable of the paradigm shift necessary to address these challenges. 

 

Only one word describes the American labor market outcome of the last decade - abysmal.  Not only is job growth well below trend, but the quality of jobs is in question.   The jobs deficit is even more striking considering the supposed gains in productivity over the past 15 years.  Job growth should not stagnate.  Resources - including labor - released via higher productivity are supposed to be channeled into expanding sectors.  Moreover, productivity growth is supposed to yield improved economic outcomes via higher real wages.   Yet as spencer famously shows, labor's share of output has been steadily decreasing since the early 1980s.  This downward trend was interrupted by gains evident during the tech bubble of the mid-1990s.  Apparently, only during that brief, shining moment of generational technological change did the productivity story work as we believe it should, at least since the early 1980's.

 

Why has the American jobs machine failed so spectacularly?   This should be the most pressing issue facing economists and policymakers.  Are either up to the task?

 

Yves Smith directs us to an intriguing piece by Andy Grove, former CEO of Intel.  Rajiv Sethi follows up and summarizes:

The piece is long, detailed and worth reading in full, but the central point is this: an economy that innovates prolifically but consistently exports its jobs to lower cost overseas locations will eventually lose not only its capacity for mass production, but eventually also its capacity for innovation...

I think the Yves-Sethi conversation is remarkably important, and should lead one to reexamine the importance of the manufacturing sector.  I admit that in past years I tended to dismiss the manufacturing sector, seeing its relative decline as simply a transition to more productive knowledge-based work.  Alan Blinder, discussing the potential for offshoring services sector jobs, claims:

The relative shrinkage of the manufacturing sector in the US (and elsewhere) from about 30-35% of total employment then to under 10% now was somewhat painful, especially in places where manufacturing was concentrated; it fostered some protectionist sentiment and some protectionist measures, and it induced a variety of other ill-considered policy responses. But, broadly speaking, the adjustment did not precipitate any major economic or social convulsions. This experience suggests that a similar-sized labour force adjustment can, once again, be handled by the market system – with some help from government.

If Groves is correct, then Blinder's conclusion regarding the lack of "major economic or social convulsions" too readily dismisses the very real consequences of manufacturing's decline, and likewise underestimates the impact of further offshoring of service sector jobs.  The loss of manufacturing capacity in the Groves scenario critically impacts the potential growth of the nation.  I think there is a tendency to downplay the relative decline in manufacturing jobs because we do not often distinguish between two stages of the decline in manufacturing.  The first stage was a relative decline as service sector job growth exceeded that of manufacturing.  The second stage, beginning in the early 1980s was a relative and absolute decline in manufacturing jobs:

 

 

Breaking it down into durable and nondurable manufacturing:

 

 

 

 

Note that nondurable manufacturing employment enters sustained decline in the mid-1990's, compensated initially by employment in the durable sector, but that sector too began what looks like permanent declines in 2000.

 

Making the story more intriguing is the downward trend in manufacturing capacity growth.  Consider the long term trend:

 

The downward trend is clear, despite the surge in capacity during mid to late 1990's.  The average growth by decades:

 

	Average Y-o-Y Growth
1950-1969	4.58%
1970-1979	3.37%
1980-1989	2.24%
1990-1999	4.55%
2000-now	1.46%

Note that a number of trends all begin in the 1980s.  Absolute manufacturing declines, the rise of persistent trade deficits, the decline in labor's share of output, growing income inequality, and the Great Moderation.  That the combination of these trends is coincidental seems unlikely.  More unlikely given that the capacity surge on the 1990s gives rise the improving economic conditions for the population as a whole, at least when view through spencer's metric of the proportion of output going to labor. 

 

If manufacturing is critically important to driving trends of national well being, an exploration of the decline of that sector is crucial.  But that exploration almost always leads back to a very difficult place - international trade.  And every right minded economist and policymaker knows unequivocally that free trade is good, and to even question that assumption makes one an ignorant heretic who has never heard of Smoot-Hawley.  Therefore, the examination ends.  Manufacturing's decline simply cannot be a problem if it is consequence of international trade because everyone knows international trade is good.

 

Just as everyone "knew" that the increased liquidity offered by exotic financial instruments and the free flow of capital was unequivocally good.  But that is a different story.

 

Indeed, the establishment will defend any assault on free trade with a simple, seemingly unassailable story:  NAFTA was followed by the 1990s jobs boom in the US even as the current account deficit widened.  Therefore, free trade does not have net negative impacts.  Winners and losses, yes, but the former outweigh the latter. 

 

I have told that story myself.

 

Such a story, of course, denies the importance and unrelated rise of information technology - a once in a generation tectonic shift that, ironically, vastly accelerated the offshoring of manufacturing capacity the following decade.  But even more importantly, it fails to acknowledge that while free trade produces net positive effects, that process can certainly be upset by the deliberate manipulation of currency values.  And make no mistake, those values have been manipulated.  There can be no other excuse for the massive buildup of official reserve assets in global central banks.

 

I don't think it is a coincidence that the absolute decline in manufacturing accelerated in the wake of the US strong Dollar policy, which provided the freedom for China to pursue an aggressively mercantilist economic strategy, perfecting what Japan's policymakers began in the 1980s.  Thus I don't think the pernicious hollowing out of America's industrial base is simply the result of comparative advantage.  I grow increasingly convinced that the disappointing economic outcomes of the last decade are the culmination of decades of industrial neglect.  That economists have dismissed industrial decline with a story of high value knowledge-based workers, a story with specific relevance to the tech boom of the 1990s but that is now defunct.  And I am increasingly convinced that these trends have been largely dismissed by the economics community because acknowledging them would cast doubt on value of free trade, failing to recognize that currency manipulation was turning free trade into a zero-sum game. 

 

In short, I have become a heretic.

 

 But what then is the appropriate policy response?  Unfortunately, we are held captive by fears of a debilitating trade war.  Sethi and Smith debate the issue:

Neither Grove's diagnosis nor his proposed solutions will persuade those who are convinced that protectionism of any kind is folly. I am not entirely convinced myself, and suspect that he may be underestimating the likelihood (and consequences) of cascading retaliatory actions and a collapse in international trade. But the argument must be taken seriously, and anyone opposed to his proposals really ought to come up with some alternatives of their own.

---

Update (7/4). In an email (posted with permission) Yves adds:

 

On the one hand, you are right, any move towards protectionism (or even permitted-within-WTO pushback against mercantilist trade partners) could very quickly get ugly. But the flip side is I wonder if we have a level of global integration that is inherently unstable (both for Rodrik trilemma reasons, international economic integration with insufficient government oversight creates political problems, plus the Reinhart/Rogoff finding that high levels of international capital flows are associated with financial crises). If so, we may have a short run (messiness of reconfiguration) v. long term (costs of really big financial crises) tradeoff.

 

This is a good point. The purpose of my post was to highlight Grove's analysis of the symbiotic relationship between innovation and scaling (which I think is both interesting and valid), and to challenge those who are opposed to his reform proposals to explain how they would deal with the situation in which we find ourselves. Passive tolerance of mass unemployment, widening income inequality, and withering innovative capacity is not an option. 

There may be an additional implication for fiscal policy.  Declining rates of industrial capacity investment suggest that maintaining full employment requires acceleration in other sectors.  In the last decade this was accomplished via the redirection of investment capital to housing and consumer spending with a related debt bubble.  The unsustainability of that approach is now evident.  Thus, if willingness to invest in industrial capacity remains weak, we can expect that that the government sector will need to fill the gap for much longer than many believe.  In short, if domestic investment is limited not by negative animal spirits, but by a rational fear that such investment will rapidly be rendered obsolete by the mercantilist policies of other nations, then government investment becomes ever more important. 

 

Bottom Line:  Something more than cyclical forces is weighing on the American jobs machine.  Here I have tried to extend the Grove/Smith/Sethi discourse with additional focus on absolute declines in manufacturing jobs and distressing declines in capacity growth rates.  These trends may be critically important in understanding the dismal performance of US labor markets. If they are in fact critical, they raise serious questions about US trade policy - questions that few in Washington want to address.  Given the extent to which manufacturing capacity has already been offshored, those questions go far beyond the recently announced tiny shift in Chinese currency policy.  Simply put, accepting the importance of manufacturing capacity and the possibility that offshoring has had a much more deleterious impact on the US economy than commonly accepted would requrie a significant paradigm shift in the thinkink of US policymakers. If you scream "protectionist fool" in response, then you need to have a viable policy alternative that goes beyond the empty rhetoric of "we need to teach better creative thinking skills in schools."  That answer is simply too little too late.