Tim Duy's Fed Watch

The Lost Jobs Opportunity

This kind of chart has always bothered me:

It is not the content or format that worries me. And, to be sure, the magnitude of the labor market damage wrought by the recession weighs heavily on my mind. Moreover, the length of time to recovery seems immense. And, on top of both of these, we effectively reduce our expectations of "recovery" with this chart - recovery should be about capturing the previous trend, not the previous peak.

Despite all this, it has always seemed to me that I was missing some even darker point. I think I finally identified that issue. Consider that the US economy remains about 7 million jobs shy of the previous peak of nonfarm payrolls. At 200k jobs a month - a seemingly optimistic forecast at this point - we regain the peak in about 35 months. We are already (believe it or not) 23 months into the expansion, which means that we recover the jobs lost in this cycle after a 57 month expansion.

Now consider this: The average post-WWII expansion is only 59 months.

If this expansion is typical, then we can expect just 2 months of job growth beyond the previous peak before the next recession hits.

Now suppose that job growth limps along at a monthly average of 150k a month. Then we are 46 months away from the payroll peak, or an expansion time of 69 months. Ten months shorter than the post-WWII average. In other words, even without resorting to an immediate double-dip scenario, we could very well be in recession prior to regaining the jobs peak.

Perhaps we should take some comfort in the fact that the average of the past three expansions is 95 months - which provides some room to grow jobs beyond the peak, but not much in historical perspective. Moreover, given the likelihood that the Fed begins a tightening cycle well before the payroll peak is in sight, and that fiscal policy looks poised to turn contractionary very soon, I have trouble thinking this recovery will be more like the past three (one of which included massive technological change) than the entire post-WWII average.  That said, hope springs eternal.

The very real possibility that we will slip into recession prior to regaining the previous jobs peak casts the current situation in an even darker light than that of Federal Reserve Governor Sarah Raskin.  Not only is the depth and duration of the unemployment crisis immense, but so too are the long-term consequences.  The failure to design a coordinated package of monetary and fiscal policy to engineer a V-shaped employment recovery looks increasingly like a massive lost opportunity.  And with that opportunity now lost, a return to even something sort of like the pre-recession jobs trend seems essentially impossible.

Deflation, Not Asset Price Bubbles

I see Mark Thoma links to Martin Feldstein. I think it is worth quibbling with this statement:

Monetary and fiscal policies cannot be expected to turn this situation around. The US Federal Reserve will maintain its policy of keeping the overnight interest rate at near zero; but, given a fear of asset-price bubbles, it will not reverse its decision to end its policy of buying Treasury bonds – so-called “quantitative easing” – at the end of June

I don't believe this is technically correct - it is not fear of asset bubbles that is the primary driver of Fed policy. To be sure, the Fed is a little more cautious about the potential damage that may result from asset bubbles. Federal Reserve Governor Janet Yellen identified the possibility of such bubbles emerging, and may inded be wary to throw more fuel onto that fire.

That said, the issue of deflation, or, more specifically, lack of deflation, is the primary reason the Fed is likely to hold its ground. I think Federal Reserve Chairman Ben Bernanke made this pretty clear in his most recent press conference. You could argue that any existing inflation is actually the by-product of asset-price bubbles, particularly in commodities, but again, this is not likely the determining factor for the Fed. More likely is that with downwardly rigid wages, a much more severe downturn is likely required to rekindle fears of wage deflation. With the economy even limping along, wage growth will tend to be positive, and that will likely keep deflation at bay, Similarly, a weak labor market imposes the counteracting force, preventing a true wage-price inflation spiral from developing.

In any event, the Fed is out of the game, barring of course the usual suspects - a sharp downturn in activity and/or fresh financial crisis.

UPDATE: I see Mark Thoma also makes the point about inflation driving Fed policy his Maximum Utility blog.

FOMC Reaction

The two-day FOMC meeting ended largely as expected, with the Fed reaffirming the current policy stance.  If you were looking for signs that QE3 is on the horizon, you were sorely disappointed.  If anything, the FOMC statement shifted in a slightly hawkish direction, setting the stage for the next policy move to be a tightening.  The Fed is trying to make it as straightforward as possible – in the absence of clear and convincing evidence that deflation is again a threat, they have nothing else to offer.

The statement itself made clear the Fed interprets much of the current data flow as reflecting temporary factors, either the impact of higher commodity prices or the disaster in Japan.  Interestingly, though, temporary factors alone are not sufficient to explain the slowdown, as the 2012 GDP forecast was downgraded.  Federal Reserve Chairman Ben Bernanke admitted this during his subsequent press conference.  In response to a request for the forecast he brought to the meeting, he suggested that he was on the low side of expectations:

[The] “slowdown is at least partly temporary….can’t explain the entire slowdown…Growth at least in the near term might be a little bit less than we anticipate.”

Still, despite the slowdown, the Fed removed the “employ its policy tools as necessary to support the economic recovery” language, presumably because they have no intention of providing any additional support.  Moreover, inflation trends are no longer “subdued.”  Instead, they see a “subdued outlook for inflation,” another signal that they are not thinking about easing, but instead restraining themselves from tightening now.

As Mark Thoma notes, Bernanke made clear that the shift away from deflation concerns effectively ends the possibility of another dose of quantitative easing.  So what happened to the Bernanke of a decade ago, when he chastised the Bank of Japan for inaction?  Brad DeLong laments:

Those of us Democrats who were happy when Barack Obama reappointed Ben Bernanke as Fed Chair thought that we were getting the Ben Bernanke we knew--the student of the Great Depression and of Japan's Lost Decade dedicated to doing whatever was necessary to stabilize the time path of nominal GDP, up to and including dropping bales of money out of helicopters.

Whatever happened to him?

 My first thought is that we forgot or overlooked the fact that Bernanke is a child of the Bush Administration, which should have been a red flag that he was not all that he was thought to be.  My second thought is that I don’t see Bernanke as terribly out of line with the current Administration itself.  Third, Bernanke made clear in his response to a Japanese reporter that he sees himself as exactly the Bernanke of a decade ago.  His comments then meant that:

 “…a determined central bank can always do something about deflation.”

Like inflation, deflation is a monetary phenomenon, and, as such is within the control of the monetary authority.  He acted on that belief last fall with the Fed’s second large-scale asset program – a policy that had more to do with eliminating deflationary expectations than the path of growth.  Those deflationary concerns have now been replaced by the more traditional inflationary concerns.  To be sure, the growth forecast leaves much to be desired, and the unemployment outlook should arguably be seen as a crisis.  But – and I think this is key – the Fed believes that they have little traction over growth at this juncture.  Thus, additional policy yields no improvement on the employment outlook, but potentially adds to an already uncomfortable inflation tradeoff.

Simply put, from the Fed’s point of view, the balance of risks is clear.  And that means we should expect nothing more from Constitution Ave.

Despite the clear direction from Bernanke, Bill Gross of PIMCO doubled-down on his failed bet that this statement would hint at QE3.  Via Reuters:

Gross, the co-chief investment officer of PIMCO, the world's top bond manager, on Wednesday said on Twitter: "Next Jackson Hole in August will likely hint at QE3 / interest rate caps."

Consider the timeline.  Today, the FOMC and Bernanke himself only further distanced themselves from another dose of easing in this cycle.  That means he need a full 180 degree turn by August, less than two months away.  Consider too that we would need a deflation threat to create such a turnaround.  But, even if commodity prices stabilize, or even decline, the pass-through from previous price increases is still likely to be working its way through the core data.  And it defies belief that, given the current attitude among FOMC members, they would entertain the thought of deflation with such inflationary pressure in the pipeline, even if you believe it to be temporary pressure.

Moreover, any commodity price declines are likely to provide a boost to growth.  Moreover, so too will an easing of Japanese related supply issues.  Which means a reasonable chance that growth looks stronger in comparison to recent weakness.  Not terrific, mind you, but the level is unimportant.   What is important is simply that growth does not deteriorate, and instead improves, however modestly.

All of this argues against Gross’s outlook.  Which means you need a vastly contrarian actual outcome, and it needs to fall into place quickly.  That outcome, as far as I can see, is some combination of a shift to deflation concerns, a dramatic downward shift in the 2012 growth forecasts, or massive financial contagion from the European crisis (best guess on this is that Europe kicks this can down the road for a few months anyway). 

Which, in sum, means to need to ask yourself this question if you are going to jump into the Bill Gross camp:  “Do you feel lucky, punk?”  It seems like an awful lot needs to go wrong in the next few weeks to get QE3 at Jackson Hole.  I am not saying that it can’t go wrong, and if it does I will happily give credit to Gross for his wisdom and insight.  That said, the time horizon is remarkably short, and will shrink rapidly, to generate the kind of change of heart at the Fed necessary to prod officials into another round of easing.  It would seem that financial crisis is the only event that could prompt such a shift in just two months.

Bottom Line:  The Fed believes they are done easing, and policymakers now look toward tightening.  I know, I know – they have said this before, which is reason enough to take their tough talk with a grain of salt.  But the shift in the inflation outlook looks very much to represent the high water mark for policy.  The data will need to dramatically deteriorate to shift the Fed’s focus away from tightening. 

Fed on the Sidelines

The FOMC’s two-day meeting next week is expected to be something of a nonevent.  Caught between a deteriorating growth outlook and higher inflation numbers, it is widely expected that policymakers stand pat.  A consensus view from the Wall Street Journal:

With job gains potentially slowing, housing prices sliding and consumers spending cautiously, officials don't want to tighten financial conditions. This means they will maintain short-term interest rates near zero and keep the central bank's $2.6 trillion of securities holdings from shrinking. At the same time, because inflation has picked up, they're reluctant to embrace new initiatives aimed at boosting growth.

On the growth side, the critical issue is that policymakers believe the second quarter drag is an artifact of temporary factors that will soon fade.  Of course, this was the story last quarter as well, but they seem content to ignore the possibility that a string of temporary shortfalls looks suspiciously permanent.  Indeed, arguably the only thing temporary about this recovery was the one quarter acceleration at the end of the 2010. 

Regardless of GDP downgrades, policymakers positioned themselves to turn a blind eye on growth, keeping focused instead on inflation.  And they are seeing what they were looking for. Core-CPI gained 0.3% in May, likely sending shivers down the spines of hawkishly inclined FOMC members.  This was predictable – the gains in headline-inflation were certain to translate into a temporary rise in the core numbers, which would lead the Fed to downplay the growth slowdown.  Moreover, once the obvious threat of deflation was off the table, so too was the motivation for another round of large-scale asset purchases.  In the absence of a downward spiral in 2012 growth forecasts, obvious reemergence of deflation concerns, or a Europe-precipitated crisis on Wall Street, it seems the Fed is content to move to the sidelines.

That said, speculation the Fed is poised for more hangs over financial market participants.  The latest such speculation comes from PIMCOs Bill Gross, who appears to be covering himself after his ill-timed call to go bearish on US Treasuries.  Via Reuters:

The world's largest bond fund manager said on Twitter late Tuesday: "QE3 likely to take form of 'extended period' language or interest rate caps on 2-3-year Treasuries."

Gross, the co-chief investment officer of PIMCO, the world's top bond manager, also said on Twitter: "Next week's Fed statement will likely stress 'extended period of time' language or even a period of interest rate caps."

Now, the extended period language is considered a given so I don’t see much room to stress it further.  Instead, I see some room to back away from it.  Recall the language itself:

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period. 

I think the reference to “subdued inflation trends” could be questioned in light of actual inflation trends.  Which opens up the possibility for a statement that leans a little more hawkish than expectations.  Not my primary scenario, but one worth thinking about.

As to Gross’ second speculation, that QE3 could come as a cap on 2-3 year rates, I very much doubt it will happen, certainly not next week.  While, as Reuters noted, this idea was floated by then Governor Ben Bernanke in 2002, it would mean an open ended commitment to purchasing those securities, and I can’t see anyone on the FOMC with the stomach for that kind of commitment.  This group looks for nothing more than to avoid commitment, trying to unwind policy as soon as possible.  I don’t see them ready to propose.

Moreover, how much traction does the Fed really have in this region of the yield curve?  The two and three year rates stood at 38 and 70 basis points today.  These assets are already barely distinguishable from cash; dragging them down another 20bp will have little impact at the longer end.  Bernanke already stated the tradeoffs for additional action are not attractive.  I would have to agree if the most they are looking for is a handful of basis points; the policy would have little impact and thus only add to the belief that QE2 has done little if anything to lift the economy.

No, I think you have to move further out on the yield curve to get some traction, and I think the Fed knows this.  The numbers to get traction simply make additional easing a bridge too far.  Joe Gagnon,currently at the Peterson Institute, formerly of the Fed, and formerly my supervisor at Treasury, provides some scope via Rortybomb:

While QE2 had good effects, it was too timid. A QE3 needs to be bigger than QE2 — you want to signal a larger amount. A trillion dollars sounds like a big number, but it isn’t like a trillion dollar tax cut. All it is is a swap of two different assets. Buying one kind, selling another.

Bottom Line:  Both monetary and fiscal policy suffer from the same impediment – the numbers needed to be effective, in both the size of the Fed’ balance sheet and the magnitude of the federal deficit, are so big that policymakers view them as potentially destabilizing, while the magnitude to which they might be willing to commit would leave them open to criticism that their policies are failures.  The obvious fallback position is to embrace the devil you know, which in this case is an economy simply limping along.

More on Geithner, Deficit Reduction, and Expenditure Switching

Zach Goldfarb’s profile on Treasury Secretary Timothy Geithner ignited a firestorm among bloggers with the money quote:

The economic team went round and round. Geithner would hold his views close, but occasionally he would get frustrated. Once, as Romer pressed for more stimulus spending, Geithner snapped. Stimulus, he told Romer, was “sugar,” and its effect was fleeting. The administration, he urged, needed to focus on long-term economic growth, and the first step was reining in the debt.

Wrong, Romer snapped back. Stimulus is an “antibiotic” for a sick economy, she told Geithner. “It’s not giving a child a lollipop.”

Reactions on the shift to a deficit-reduction strategy come from Ryan Avent, Felix Salmon, and Mike Konzcal, among others.  The general view is that Geithner has pushed the Administration into an economically dangerous position, guaranteeing millions remain unemployed, for absolutely no good reason.  The yield on the 10-year Treasury is mired at 3%.  Where is this loss of confidence that is so feared in Washington? 

Salmon gets to the heart of Geithner’s thinking here:

Geithner cut his teeth in a world of bond vigilantes, an era when James Carville said that he would like to be reincarnated as the bond market, because then he could intimidate everybody. And after that, Geithner dealt with a series of international sovereign-debt crises where countries found themselves hammered by enormous bond spreads.

I suspect - guessing, really - that Geithner is very much concerned the US is uncomfortably close to a currency crisis.  Indeed, I think that we were closer to such a crisis in 2008 than many realize:

That kind of shift in asset flows is sort of difficult to dismiss as irrelevant.  The only thing that pulled us out of the fire was the willingness of foreign central banks to accumulate dollar assets to compensate for private outflows, no strings attached (of course, those banks arguably had no choice, as their accumulation of Dollars helped support the imbalances that made a currency crisis possible).  If the IMF had been called upon, they surely would have wanted strings attached, and one such string would almost certainly have been a deficit reduction program.

Crazy, you say?  Look to Greece.

That’s all ancient history.  Now, the goal is to prevent it from happening again.  And that is where Geithner is trying to engineer what a massive expenditure switching program.  That program was thoroughly described by New York Federal Reserve President William Dudley in a speech that was lost in excitement surrounding Federal Reserve Chairman Ben Bernanke’s latest assessment of the US economy.  Greg Ip gives the short version:

To get the federal deficit from its current 10% of GDP to a more manageable 3% will require America to generate additional consumption, investment and net exports equal to 7% of GDP. Since it already consumes too much, that leaves business investment and net exports.

Monetary policy can help achieve this by accommodating the shift in relative prices that rebalancing requires. Mr Dudley notes that surging EME growth has driven up prices of both commodities and their own exports as domestic wages rise. That has driven up headline inflation in America. But Mr Dudley makes the crucial point that this represents a deterioration in America’s terms of trade and thus its standard of living. It is not a generalised inflation problem unless it leads to second-round wage and price catch-up, of which there is no sign. Not only does such a terms of trade shock not call for tighter monetary policy, it is essential to rebalancing. As foreign prices rise relative to American prices, America will export more and import less.

(Note also that Yves Smith linked to the Dudley topic even sooner).  I have tended to think in similar terms – that, over time, the US economy needs to shift away from reliance on consumer spending toward nonresidential investment.  Absent the US consumer, where, you ask, will the demand come from to support such investment?  Increased exports and import competition, both of which are facilitated by a weaker Dollar.

Would such a decline become disorderly?  That is probably what Geithner fears, and his response is that it is less likely to occur, and more easily managed should it occur, if the US fiscal position is stabilized, the sooner the better.  Others, particularly China, must participate as well – hence the push to revalue the yuan.

Obviously, the conundrum here is that this process involves structural adjustment, which involves – you guessed it – structural unemployment.  Which, understandably, raises the ire of left-leaning economists and bloggers.  And we go full circle – how can we accept high unemployment when interest rates are so low?

I am a bit stuck on this issue.  Most mornings I wake up and think the Administration’s focus on deficits is insane.  There have been predictions of a Dollar collapse for a decade.  Should we deny employment opportunities to millions for another decade on the basis of such failed predictions? 

A few months ago, I rushed back to Eugene from a Portland Business Alliance meeting where I was given a lapel pin that read “JOBS.”  While picking up my son from soccer practice, another parent noticed the pin and said “Nice pin.  I wish I had one of those.”  “A pin,” I replied, thinking I have another in my pocket.  Duhhh – dumb economist.  “No, a job,” was the response.  Those are the times you think, yes more stimulus, lots more, now.

And, admittedly, at other times I think the costs of a currency crisis would be very, very high, with a rapid imposition of massive structural adjustment.  Given the possibility of such an outcome, which, I reiterate, was not inconceivable during the recent financial crisis, don’t policymakers have a responsibility to work toward a more balanced pattern of growth? 

In addition to clearly differentiating between the short and long run deficits, I think if you want to meld these to positions into a consistent policy framework, the objective is to support deficit reduction via higher taxes on upper-income groups, those least impacted by the structural adjustment away from consumer spending, while maintaining spending on the social safety net.  Whether this ultimately occurs, or if instead the weight of deficit reduction falls most on those negatively impacted by structural adjustment, remains to be seen.

 

More on the Effectiveness of Fed Policy

Kathleen Madigan at the Wall Street Journal on Wednesday:

Although the Fed is tasked with promoting full employment, there isn’t much the central bank can do at this point to push private businesses to hire….

….Fed policy’s main lever for growth is to prompt people to borrow money. But after the financial implosion, businesses and consumers have little appetite for credit. Indeed, as boomers approach retirement, the U.S. household sector needs to borrow less and save more 

Kathleen Madigan on Thursday:

April’s news on trade was quite good, and U.S. manufacturers can thank the Federal Reserve. But improving growth falls far short of solving all the economy’s problems, especially with job growth…

…the Fed has made a mighty contribution to this situation. “By dramatically increasing the supply of U.S. dollars under its [quantitative easing] programs, the Fed has effectively (and perhaps explicitly) been engaged in a weak dollar policy,” says Millan Mulraine, chief macro strategist at TD Securities. “When combined with the recovery in global demand, the weak dollar has contributed significantly to the enhanced competitiveness of U.S. exports.”

So there is nothing the Fed can do to stimulate the economy on Wednesday, but on Thursday we learn there is another channel by which monetary policy operates, exchange rates.  Madigan still insists there is no way for stronger demand to turn into job growth:

That’s because, in order to be price competitive on global markets, U.S. exporters can’t rely solely on a cheaper dollar. They have to reduce the cost of labor going into production….

….Even with rising foreign demand, the increase in output won’t be followed with a corresponding addition of jobs. Exporters will hire a smaller increase in high-skilled workers who can run high-efficiency machinery or understand complex processing systems.

Here again is the idea that rising productivity is a bad thing.  Not sure why, as productivity growth has supported rising living standards for something like hundreds of years.   The challenge in the current environment is that we are not meeting accelerating productivity growth simply with a sufficient increase in demand.  And that is something policymakers should be able to address.

That said, Madigan starts to get closer:

Such proficiency will command better pay — but bigger wages will be covered by the worker’s better productivity.

I really don’t understand what reason for the “but.”  Higher productivity should generate higher real wages.  Madigan finishes:

High value-added jobs are the type the U.S. needs to maintain its standard of living while competing in world. But the actual number of new hires may not make much of a dent in the unemployment rate.

If some workers have better jobs, and more to spend, doesn’t this then create demand for additional labor in lower productivity growth sectors?

I sense Madigan wants to tell supply and demand side stories at the same time – and the story gets muddled, as can often happen when, graphically, we start shifting two curves at once.  I think it is fair to simply say that productivity growth moves the target for demand growth to accomplish the goal of closing the output gap.  This does not mean that policy is powerless or that productivity growth is bad.  It simply means that demand needs to accelerate at a faster pace to adequately address the unemployment problem.

 

 

 

Output Has Not Fully Recovered

Kathleen Madigan at the Wall Street Journal claims:

In a speech given Tuesday, the chairman discussed the aggregate hours of production workers, which had fallen by nearly 10% from the beginning of the recent recession through October 2009. “Although hours of work have increased during the expansion,” he said, “this measure still remains about 6 1/2% below its pre-recession level.” In other words, labor markets are nowhere near where they were before the financial collapse and recession.

Output, on the other hand, is fully recovered. Real gross domestic product — which at its worst had shrunk 4.1% — surpassed its 2007 peak at the end of 2010 and expanded further in the first quarter of 2011.

True, output has surpassed its previous peak, but this in no way should be the measure by which we determine if output has fully recovered.  Full output recovery would require that activity return to potential output, and by that measure, output recovery remains little more than a fantasy:

See also Mark Thoma's link to Justin Wolfers.  Madigan continues:

The gap between output and jobs is why the economy is in an expansion cycle by economists’ standards — but it doesn’t feel even close to recovery mode for the average consumer.

No, because if the economy were in fact fully recovered, unemployment rates would be at normal levels.  Again, just because output regains its previous peak does not mean the economy has recovered.  More:

Output has surged ahead of labor because of strong productivity. Robust productivity gains are good for profits and inflation outlook, but bad for workers and consumer spending.

This shouldn’t be true – higher productivity is absolutely not supposed to be bad for workers.  It is supposed to allow for higher real wages, higher standards of living.  But when aggregate demand falls short of that necessary to compensate for productivity growth, the economy remains mired in persistent disinflationary state, with high levels of unemployment.  To solve this, something needs to boost aggregate demand.  Not the Federal Reserve, claims Madigan:

Although the Fed is tasked with promoting full employment, there isn’t much the central bank can do at this point to push private businesses to hire.

It’s not that policymakers have no appetite for a third round of quantitative easing. It’s that another round probably isn’t going to help.

The Fed is not powerless, even at this juncture.  Arguably, they have not even attempted to ease in line with that required to boost activity further.  As Jim Hamilton points out, the numbers involved in QE2 should have been expected to have only a modest impact.  The Fed could also raise inflation expectations.  And I have always felt the Fed’s repeated insistence that their actions were only temporary helps ensure their policy will be less effectual than would otherwise be the case.  Why should banks expand lending when they know the Fed is only going to mop up excess reserves and jerk up the short end of the yield curve the first chance they get?

That the Fed chooses to not take a more aggressive stance should not be confused with the inability to offer additional economic support.  And by no means should we trick ourselves into believing that output is fully recovered.

Clear Message From the Fed

We received a pretty clear message yesterday – if you are looking for additional monetary stimulus, you need to find a new hobby.  Not going to happen.  Yes, we know we have said this before, but this time we are serious.

Fed officials simply believe the weakness in the first and second quarters of this year is largely transitory, the impact of commodity prices and tsunami-related supply disruptions.  In other words, nothing to see here, move along.  The Wall Street Journal had the story time and time again today.  Chicago Federal Reserve President Charles Evans, on his growth downgrade:

So I’ve taken some steam off the underlying sustainable rate that we were looking at and we’re pushing that growth out into the second half of this year. But we’re still of the mind that these are relatively transitory phenomena, that the recovery is still going to be continuing to take place and build.

Atlanta Federal Reserve President Dennis Lockhart:

The regional Fed president, who is not a voting member of the monetary policy-setting Federal Open Market Committee, added Tuesday that he is “frustrated” with the pace of economic recovery.

Still, the string of disappointing economic data “is no reason to panic” as “recoveries rarely play out smoothly.”

In fact, given the litany of unforeseen events–ranging from the Japanese earthquake and Middle East conflict to the weak domestic housing market–Lockhart said the U.S. economy has shown “pretty impressive resilience.”

And Federal Reserve Chairman Ben Bernanke:

U.S. economic growth so far this year looks to have been somewhat slower than expected. Aggregate output increased at only 1.8 percent at an annual rate in the first quarter, and supply chain disruptions associated with the earthquake and tsunami in Japan are hampering economic activity this quarter. A number of indicators also suggest some loss of momentum in the labor market in recent weeks. We are, of course, monitoring these developments. That said, with the effects of the Japanese disaster on manufacturing output likely to dissipate in coming months, and with some moderation in gasoline prices in prospect, growth seems likely to pick up somewhat in the second half of the year.

Did they make it clear enough?  DON’T PANIC!  It is all under control.  Interestingly, Bernanke further suggests that not only will they do no more, no more can be done: 

The U.S. economy is recovering from both the worst financial crisis and the most severe housing bust since the Great Depression, and it faces additional headwinds ranging from the effects of the Japanese disaster to global pressures in commodity markets. In this context, monetary policy cannot be a panacea. Still, the Federal Reserve’s actions in recent years have doubtless helped stabilize the financial system, ease credit and financial conditions, guard against deflation, and promote economic recovery. All of this has been accomplished, I should note, at no net cost to the federal budget or to the U.S. taxpayer.

The last line should erase any doubt the Federal Reserve is now under the sway of political pressure.  Note also Bernanke’s long defense of the Fed on the issue of commodity prices – clearly he is getting grief on this point.  Would he even be willing to chance that he is wrong?

But not only is monetary policy out of the question at this juncture, he also argues that fiscal policy should be off the table as well:

The prospect of increasing fiscal drag on the recovery highlights one of the many difficult tradeoffs faced by fiscal policymakers: If the nation is to have a healthy economic future, policymakers urgently need to put the federal government’s finances on a sustainable trajectory. But, on the other hand, a sharp fiscal consolidation focused on the very near term could be self-defeating if it were to undercut the still-fragile recovery. The solution to this dilemma, I believe, lies in recognizing that our nation’s fiscal problems are inherently long-term in nature. Consequently, the appropriate response is to move quickly to enact a credible, long-term plan for fiscal consolidation. By taking decisions today that lead to fiscal consolidation over a longer horizon, policymakers can avoid a sudden fiscal contraction that could put the recovery at risk. At the same time, establishing a credible plan for reducing future deficits now would not only enhance economic performance in the long run, but could also yield near-term benefits by leading to lower long-term interest rates and increased consumer and business confidence.

Bernanke sees the threat posed by excessive short-term fiscal consolidation, but offers no suggestion that perhaps more short-term stimulus is still needed – that to close the output gap, fiscal authorities need to move more spending from the future to the present.  But given the expansion of the balance sheet, I think Federal Reserve officials fear this road, as it creates the impression of deficit monetization.   So, no stimulus, monetary or fiscal.

Finally, Dallas Federal Reserve President Richard Fisher noted:

The central banker noted consumers and firms are still traumatized by the economic and financial difficulties of recent years, and that’s part of why growth levels are still struggling. But he does expect activity to pick up: “The next half of the year will have better growth than we’ve seen recently,” Fisher said. “It’s not going to be robust” and he expects to see a “jerky motion” to activity.

The description of a recovery that is jerky and lacking robustness brings to mind something Greg Ip said last week:

Still, I was recently reminded by someone who lived through Japan’s lost decade that America is qualitatively, if not quantitatively, following the same script. That means we will often think robust, above-trend growth has begun, only to see it snuffed out by the inexorable post-bubble deleveraging. Japan offers another sobering lesson: its policy flexibility was heavily circumscribed by politics. Bail-outs, deficits and quantitative easing were no more popular in Japan than in America today. Japanese officials are far too polite to say “I told you so.” But they could.

And it is worth noting that while we think about “a lost decade” over the next ten years, the past ten years was already a lost decade for many:

 

Bottom Line:  Federal Reserve officials accept the economy at face value – growth is slower than they would like, unemployment higher than they would like, but policymakers, fiscal and monetary, believe they are pretty much out of bullets.  Unless the economy slips badly, don’t expect any more from us.  Which leaves the rest of us hoping – against hope, if recent history is any guide – that the economy regains its footing in the second half of the year. 

 

 

 

Circling the Drain

It is beginning to look like the economy is circling the drain.  To be sure, I hate to make too much of one report, but the May employment report comes at the end of a series of bad reports stretching back to nearly the beginning of the year.  There looked to be solid hope the recovery was on a better track as 2010 drew to a close, and that momentum appeared to carry through into January.  But then we hit a wall.

What wall?  Theories abound.  Temporary weather and tsnumai induced disruptions for one, but we should be trying to look through such short term events.  The crisis in Europe, although to be honest I don’t think this is having much of an impact on the decision making of the average US citizen or firm.  I tend to think the rise in commodity prices, particularly oil, was the primary culprit, as consumer spending faltered and businesses struggle to pass increasing costs onto consumers.  But what it really comes down to is that we have only had one good quarter in this recovery, and that simply was not enough to provide sufficient resilience to the sheer number of shocks the economy has weathered this year.

And let’s face it, even with that one good quarter, forecasters were still looking forward to a protracted recovery.  That, however, did not stop the policy environment from turning remarkably contractionary.  The debate in Washington quickly turned to how quickly to cut the deficit, how quickly to withdraw monetary stimulus.  All with the goal of assuaging the invisible bond vigilantes, who have apparently been helping drive the 10 year Treasury yields back down to 3%.  The turn toward contractionary policy - and monetary policy arguably turned contractionary when Fed policymakers questioned the wisdom of continuing QE2 - is surely one of the shocks that hit the economy.

Will the Fed respond with anything more?  Well, if Federal Reserve President Richard Fisher is any indicator, the answer is no.  From the Wall Street Journal:

The Federal Reserve has done enough to spur economic growth and new steps to boost the economy aren’t warranted, Richard Fisher, president of the Federal Reserve Bank of Dallas, said in an interview with The Wall Street Journal.

His comments come amid speculation in financial markets that the Fed might decide to begin a new round of Treasury securities purchases following economic reports that suggest a slowing U.S. economy. “One would be very hard pressed to argue that we need to provide more,” Mr. Fisher said. “The Fed has done its job.” If the economy needs additional stimulus, he added, “it is going to have to come from someplace else.”

True enough, no surprise here.  Fisher is known for his efforts to undermine the efforts and credibility of the Fed, fueling the hard money frenzy.  More interesting are the thoughts of Federal Reserve Vice Chair Janet Yellen:

The shift toward riskier assets is a normal channel through which monetary policy supports economic activity. But taken too far, this dynamic has the potential to facilitate the emergence of financial imbalances. For example, with interest rates at very low levels for a long period of time, and in an environment of low volatility, investors, banks, and other market participants may become complacent about interest rate risk. Similarly, in such an environment, investors holding assets which entail exposure to greater credit risk may not fully appreciate, or demand proper compensation for, potential losses. Finally, investors may seek to boost returns by employing additional leverage, which can amplify interest rate and credit risk as well as make exposures less transparent….

…The Federal Reserve is fully engaged in monitoring financial markets for potential imbalances and developing the tools necessary to carry out that task. These ongoing efforts include attempting to recognize early signs of misaligned valuations in asset markets and increases in leverage. At present, we see few indications of significant imbalances, and the use of leverage appears to remain well below pre-crisis levels. That said, I've noted some recent developments that warrant close attention, including indications of potentially stretched valuations in certain U.S. financial markets and emerging signs that investors are reaching for yield. Should broader concerns emerge, I believe that supervisory and regulatory tools, including new macroprudential approaches, rather than monetary policy, should serve as the first line of defense.

Two asset bubbles in ten years has definitely made an impression.  If Yellen is already seeing the potential for imbalances, would she be willing to throw more gas on the fire with another round of QE2?  To be sure, she makes it clear that monetary policy is a last resort to dealing with financial imbalances.  But I think that can be inferred as an aversion to tightening policy to address the imbalances; should you ease if you suspect those imbalances are growing?  I am still wrapping my mind around this, as I would have expected Yellen to support additional easing.

I also go back to Federal Reserve Chairman Ben Bernanke’s speech in August of last year, in which he raised doubts about the effectiveness of additional quantitative easing:

I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed's balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high. The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool. However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.

More recently, in his press conference, Bernanke expressed confidence that QE2 had in fact worked.  Will the evolution of activity this year cause him to reassess his confidence?  Might he conclude that QE2 was not particularly effective?  We know he already thought the tradeoffs for additional easing were less favorable than last fall, thus he set the bar high for additional action.  If he comes to believe that policy was not effective, that bar obviously only goes higher.

Complicating this story is the possibility the Fed may worry that another round of quantitative easing will only push investors back into the same riskier assets that undermined the recovery.  Also from the Wall Street Journal:

The effectiveness of the Federal Reserve‘s controversial policy of buying government bonds to boost the U.S. economy is being hurt by the high oil prices it helped bring about, a former senior official at the U.S. central bank warned Wednesday.

Vincent Reinhart, who headed the Fed’s monetary-affairs department until 2007, is set to tell a House hearing that quantitative easing, or QE, played a role in the rise and volatility in oil prices seen over the past nine months, which differs from the mainstream view at the central bank.

“The Fed gambled that the benefits of the stimulus of QE to financial markets would offset the adverse effects of oil price developments. Whether that gamble pays off is yet to be proven,” Reinhart will tell the Committee on Oversight and Government Reform.

To be sure, the Fed has denied a link.  But let’s consider the psychology of the market.  Everyone had the same expectations of what would occur if the Fed engaged in additional easing, basically that market participants would largely rally around the inflation play, and thus funnel money into equities, commodities, and foreign currency.  Indeed, right now one reason strategists fear abandoning equities is the potential monetary response to current data. 

It is likely the case that these flows cannot have a permanent impact on the spot price of key commodities such as oil where storage is difficult and expensive, but even a temporary surge can have disruptive effects in a weak economy.  And I think that Felix Salmon made a convincing case that such temporary impacts are real.  Moreover, as has been proven, even a temporary surge will raise inflation fears on Constitution Ave.  The interplay between market participants, commodities prices, and Fed policy looks quite complicated, fitting with Bernanke’s concern that “one risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions.”

So where are we now?  Watching and waiting.  At this point, there seems to be reluctance on the part of Federal Reserve officials to extend the large scale asset purchases.  Putting aside the possibility that the events in Europe turn even more ugly, I don’t think they will seriously consider such a move until 2012 forecasts begin to deteriorate.  For now, watch carefully for Fedspeak that speaks to the forecast – whether or not officials continue to see the current challenges as temporary.  And look for concern that additional asset purchases would have no impact, or a reiteration of Bernanke’s concerns that the tradeoffs are less favorable.  We are caught between rhetoric and reality - while the Fed may believe no more is coming, the history of this cycle is that more easing has always been needed.

Paris, Las Vegas

With the Euro as high as it is, this may be the closest I get to the real thing for awhile. Just a quick trip - probably the only vacation, and very likely the only kid-free trip this year - to see Garth Brooks, a Valentine present from my wife.