Tim Duy's Fed Watch

On Pins and Needles

Here we are, one month into the second half.  Expectations, or, perhaps more accurately, blind hope, is that the back half of 2011 is better than the first half.  We can only hope this is true. The revised GDP data reveal the US economy flirted with recession in the first six months of the year, raising the real concern that we are at stall speed.  We need those confidence fairies sooner than later – because it looks like fiscal and monetary policymakers are still on the sidelines.  Worse, in the case of the former, near, medium, and long-term policy are all looking contractionary at the moment.

Will the economy tumble into recession, or simply continue to limp along?  Bets are all over the place at this point.  Optimists are looking for a stronger second half as the temporary factors (Japan, oil price shock, etc) fade, giving a boost to at least one sector, autos.  Karl Smith sees room for optimism in the manufacturing survey data – we will see the ISM number this morning for further insight.  Rebecca Wilder, however, sees weakness in the high frequency data, although the most recent initial claims numbers fell below 400k.  That said, Brad DeLong noted unusual seasonal effects in past Julys, and 2011 could be the same.  Bloomberg sees trouble signs in container shipping rates:

Plunging rates for chartering container vessels that carry sneakers, furniture and flat-screen TVs may signal a U.S. consumer slowdown and losses for shipping lines in what is traditionally their busiest time of the year.

Fees for hiring vessels have fallen 9.3 percent since the end of April, according to the Howe Robinson Container Index, which tracks charter rates for a range of vessels. Last year, the index surged 56 percent in the period, as lines added ships on demand from U.S. and European retailers restocking for the back-to-school and holiday shopping periods.

“The troubling part is that charter rates are falling in the peak season,” said Johnson Leung head of regional transport at Jefferies Group Inc. in Hong Kong. “Sentiment among consumers and retailers isn’t very strong.”

I think you can tell a story of growth in the 2.0 to 2.5 percent range in the second half of this year, consistent with the low-end of consensus.  Weak, weak, weak relative to the depth the recession – too weak to push down unemployment rates, perhaps too weak to prevent joblessness from increasing.  As far as faster growth is concerned, I am still held up by the issue that the last two expansions were tied up in massive asset bubbles.  What will provide that wealth-effect source of demand this time around?  What will take its place?  It certainly isn’t fiscal stimulus.  If not, then what?

Moreover, while all eyes where on the debt-ceiling debate, the European debt crisis continues essentially unabated.  So while the US economy is dragging itself into the second half at stall speed, it faces the certain shock of fiscal contraction and the increasingly likely shock emanating from Europe. 

Where is the Federal Reserve in the midst of this turmoil?  Out of sight.  Well, not entirely, San Francisco Fed John Williams offered conditional support:

Looking ahead, we at the Fed will keep a very close eye on incoming data and adjust our policy as needed to work towards our two policy goals. If the recovery stalls and inflation remains low or deflationary pressures reemerge, then we may need to keep our very stimulatory policies in place for quite some time or even increase stimulus. On the other hand, assuming growth picks up and inflation doesn’t fall too low, then at some point we’ll need to start gradually removing stimulus.

We need to see both low growth – in the second half of the year, the first is irrelevant – and a reversal of recent inflation trends.  Note the GDP revisions where not kind on that front:

Chicago Federal Reserve President Charles Evans would be willing to push for additional stimulus, again, dependent on the third quarter growth numbers – see the Wall Street Journal.  Still, he would be more likely to ease even in the face of recent inflation trends, as he sees those as largely transitory.  Note the same article highlights the opposite view of Philadelphia Fed President Charles Plosser.  He expects stronger growth, and is looking to tighten policy ASAP.

Richmond Federal Reserve President Jeffrey Lacker sees more easing as simply inflationary:

This circumstantial evidence suggests that the additional monetary stimulus initiated last November raised inflation and did little to improve real growth. Last year, raising inflation was a desirable policy objective, but that clearly is not the case today. Given current inflation trends, additional monetary stimulus at this juncture seems likely to raise inflation to undesirably high levels and do little to spur real growth.

I suspect Federal Reserve Chairman Ben Bernanke is not far from this outlook as well.  And, finally, we also have the wisdom of St. Louis Federal Reserve President James Bullard:

Now, “you’ve got rising inflation, and headline inflation is pretty high compared to a year ago. It could even go even higher,” Bullard said, noting “in that case you have be very circumspect” about doing more to help the economy, even in the face of anemic growth.

Sounds like a no vote to me.

Bottom Line:  Pins and needles time for the US economy.  The general expectation is for a stronger second half – but how much stronger?  Seems like a lot of swords are still hanging over our heads to expect much more than anemic growth.  That said, monetary policymakers expect something better and won’t budge either way until the tea leaves become clearer.  And even if growth surprises on the downside, the inflation issue remains.  Just can’t see monetary policy shifting in such an environment.  The growth/inflation nexus needs to make a clean break one way or the other to prompt Fed action. For market participants, the mix of growth, inflation and policy is in something of a perverse sweet spot.  Consider that corporate profits have held strong – revised upward even – helping sustain equity markets. Not sure that this should change in the absence of outright recession. Indeed, Wall Street is ready to ignore weak data, instead expected to rally hard this morning on the news that a debt-ceiling solution is at hand.  Meanwhile, the Fed is effectively sidelined by weak growth, keeping interest rates low and freeing investors from imminent tightening fears.  Impending fiscal contraction only locks in that outlook. And inflation is sufficiently high such that the Fed won’t loosen policy.  No need to fret about that for the time being, and instead just enjoy the ride. 

Contemplating the Futility

I think many are in a contemplative mood this evening, seeing that after all the drama of the past month, it looks like the Democrats, with the full faith and leadership of President Obama, will cave almost completely to the Republicans.  We could have done this weeks ago.  On the Democratic side of the aisle, some might hope the White House can retain some leverage regarding the timing of the next debt ceiling vote and the expiration of the Bush tax cuts, but given President Obama's lack of negotiating skill, this is the very thinnest of hope. On the Republican side of the aisle, I imagine the the relief is joyous - imagine, holding the economy hostage and walking away the victors!  Just a day after looking set to tear each other apart, no less.

Four thoughts come to mind: 

• The debt-ceiling has been proven to be a very effective weapon, simply because there exists a non-trivial contingent of Republicans willing to push the button, but not a single Democrat.  With that dynamic, the Republican goal of dismantling the social safety net looks achievable.  They only need to chip away at it one debt ceiling at a time.  
• Obama's attempt to stabilize the political system by moving to the center has failed utterly and completely.  The problem for Democrats is that Obama's "center" keeps moving to the right. Obama thought that as he co-opted Republican positions, such as Romney care, he would gain Republican support.  Instead, he pushed the Republicans even farther right as the only way to differentiate themselves from Obama.  Then Obama thinks he needs to meet in the new "middle" - and hence we get a deficit deal with no revenue triggers, but only after a near-debacle that leaves the rest of the country, if not the world, shaking their heads.  Will this episode bring sanity?  No - expect the Republicans to move further right in the next debate.
• Is it futile to vote Democratic?  Seriously, it is obvious now that your vote will deliver the same policy outcomes should you choose Democratic or Republican - but by voting Republican (at least on a national level), you also get the satisfaction of being on the winning team.
• Finally, it is utterly unbelievable that we are about to pursue an obviously contractionary policy course when the White House is held by a Democrat and in the wake of a GDP report that vividly illustrates the weakness of the economic recovery.  Yet here we are.  Team Obama must believe that deficit reduction worked in the 1990's, and thus should work now.  Would a Republican president have seen the unemployment rate and the pace of growth and thought the odds of reelection where greater with a debt ceiling plan that couples long-term cuts with near term stimulus?  

While considering the madness of the situation, one has to make an effort to find peace.  With that in mind, I again offer up the simplicity of summer, with a picture I tentatively call "Bee Pollinating Pumpkin Flower #25":

Summer Garden

A little stress release from debt ceiling worries - the status of my garden.  This year I got off to a slow start, largely due to a seemingly endless winter in the Pacific Northwest.  But as August approaches, things are looking up.  Tomatoes are starting to set nicely:

Beans of various varieties and timings are coming up.  You can't see in this photo, but another row of pole beans is coming up in the back (the handful already up the trellis were part of an earlier failed crop; the seeds rotted in the wet weather):

Winter squash is taking over half the garden:

Made something of a miscalculation - letting the blue hubbards vine up the fence:

I will need to provide some heavy duty support as they get bigger.  The vine above has six fruits already set, and they all look viable.  I should have put the hubbards are the other side, where I put the small sugar pumpkins.  Some of the corn is starting to flower:

Something I haven't tried in the past - garlic and shallots:

Finally, a reminder of the best crop of peas I have managed, a product of our extended winter:

 

 

 

From Outside the Beltway

Tracking the debt ceiling debate has been something of a monumental task - there are simply too many pieces in motion at any given time.  Perhaps even more of a challenge given that it is an insider's game, and I am well removed from that game  Indeed, from my perch the only thing that looks certain is that whatever happens will be unambiguously bad for the economy.  We are simply looking at degrees of bad – fiscal contraction in the range from mild to severe.  The latter – a severe contraction – will almost certainly result if federal spending needs to be slashed beginning next month to maintain servicing the debt, thus preventing defaults to one group of creditors while defaulting on promises to another – the general US public. 

One view is that the consequences of failure are so severe that failure is not an option.  Thus, we are simply watching a political spectacle unfold that will ultimately be resolved.  In other words, you can sleep peaceful dreams throughout the weekend.

I wish I could be that confident.

Here is my view from the other side of the continent:  My fear is that this optimistic assessment fails to sufficiently acknowledge there are two battles.  One between Democrats and Republicans, and the other within the Republican party itself.  And any outcome that is acceptable to Democrats is internally corrosive to Republicans.  So internally corrosive that compromise with Democrats is a monumental if not impossible challenge. 

Consider Paul Krugman’s analysis:

There’s actually a simple way to resolve the debt ceiling crisis: non-crazy Republican leaders could support something like the Reid plan — which is, let’s be clear, a huge victory for the right and defeat for progressives — and pass it with limited GOP support and overwhelming Democratic support. Situation resolved.

This would, however, probably be the end of these Republicans’ political careers. And the answer is, so?

If you believe that default will quite possibly be a catastrophe — and leading Republicans probably do believe that — their unwillingness to take the action I’ve just described means that they are risking America’s future rather than pay a price in their personal political careers. That’s cowardice on an epic scale, even if it’s the kind of behavior we take for granted nowadays.

On the surface, the Reid plan looks like an overwhelming defeat for progressives, but a look deeper suggests that it arguably puts the Democrats in a much stronger position in 2012.  Ezra Klein:

Democrats are going to lose this one. Whatever deal emerges to raise the debt ceiling, we can be pretty sure it won’t include revenue, it won’t include stimulus, and it will let Republicans pocket a trillion dollars or more in cuts without offering anything to Democrats in return.

It’s difficult to see how it could end otherwise. Virtually no Democrats are willing to go past Aug. 2 without raising the debt ceiling. Plenty of Republicans are prepared to blow through the deadline. That’s not a dynamic that lends itself to a deal. That’s a dynamic that lends itself to a ransom.

Yet Democrats will have their turn. On Dec. 31, 2012, three weeks before the end of President Barack Obama’s current term in office, the Bush tax cuts expire. Income tax rates will return to their Clinton-era levels. That amounts to a $3.6 trillion tax increase over 10 years, three or four times the $800 billion to $1.2 trillion in revenue increases that Obama and Speaker John Boehner were kicking around. And all Democrats need to do to secure that deal is -- nothing.

The Reid plan raises the debt ceiling by enough to clear the next election, sufficient to take it off the plate next year.  Which leaves the Administration holding the leverage – that’s a nice little tax break you have there, you wouldn’t want something to happen to it, would you?

If the Republicans are able to keep the debt-ceiling debate alive, however, they at least have some hope of holding onto some leverage in 2012, keeping the debt-ceiling/revenue/spending dynamic in play.  After all, as Klein noted, a greater proportion of Democrats believe the debt ceiling is meaningful – which provides the Republicans with leverage.  If the Republicans give up the debt ceiling now, they lose that leverage when it comes to the election year tax debate.

In other words, if the Republicans cave and give the Administration enough rope to raise the debt ceiling either all in one swoop or piecemeal over the next 20 months, continuing the Bush-era tax cuts becomes a more difficult game, as they simply expire without the signature of President Obama. 

And, if the Republicans do cave, the internal politics become unbearable.  As Krugman noted, some political careers may end.  But it is worse than that – I think it throws the party into turmoil as the Tea Party contingent digs in their heels and forces the party to move much, much farther to the right ahead of the 2012 election, while Obama gets to move to the center.  All of those “pledges” not to raise taxes or raise the debt ceiling come back to haunt the party all next year. 

In the meantime, the Administration can’t cave and make a deal that brings the debt-ceiling debate back to life before the elections.  Why?  I suspect the Administration is mollifying Congressional Democrats with the promise that tax revenues will take a front seat next year, once the leverage of the debt-ceiling is removed.  If the Administration caves, the election-year debate is not as favorable for the Democrats and, perhaps worse, gives the Republicans time to regroup.  The whole fight was for nothing – Congressional Democrats will be enraged.

It seems that, although there is a lot of griping that the Administration and/or Congressional Democrats have messed up big time, the Democrats are really squeezing the Republicans hard.  Perhaps too hard, some might say, as a non-trivial contingent of Republicans are just that sort of crazy that makes them think not raising the debt ceiling won’t be that bad (the relative calm in financial markets only further bolsters such faith).  And they will viciously attack any Republican who sides with a Democrat plan.  Leaving it a real possibility that Congress can't pull together a solution unless Democrats cave on the timeline.  Which they can't do - which means they, or the Administration, must be willing to put the US economy at risk.

And this is where is gets even more interesting – how many eggs is Obama willing to break to make this omelet?

Brad DeLong, for instance, wonders why the Administration can’t use technical fixes to ignore the debt ceiling limitation.  Or why not just invoke the 14^th Amendment?  I think the answer is that Obama believes he can manage the pain – make it clear that he will abide by the wishes of a Republican-controlled House and not breach the debt ceiling, but the country will have to live with the consequences.

The trick here is to ensure the blame for the ensuing slowdown falls relatively harder on Republicans  And the survey data suggests this is exactly what is happening.  By this mechanism, the Republican party is torn apart by public opinion.

So, it seems to me the Administration has the Republicans in a heads I win, tails you lose situation.  They will have to eat something that tastes very, very bad, and as a consequence, bear tremendous pressure from either the inside and the outside.  Either way, Obama ends up looking like the reasonable centrist who can keep his party in line.  To pull it off, Obama just has to be willing to endure the pain of a further economic slowdown, hoping to make it up on the other side.  And note this – it seems this Administration is willing to bear a remarkable amount of pain.  Notice the unemployment rate lately?

All of which leaves me thinking there is a very nontrivial chance the debt-ceiling question does not get resolved by August 2.  But I admit that this is just my West coast, outsider view that has emerged from studying the news stream of East coast insiders, and will be happy to see the expected compromise emerge over the weekend.

 

Is Structural Change the Primary Challenge?

Given that thoughts of high structural unemployment continue to emerge in Fed thinking, the topic bears ongoing scrutiny.  Especially so for me personally, as I have long seen the need for structural shifts that address the US current account deficit - but should such adjustments require persistently high unemployment rates?  Some affirmation of my general story comes via David Altig, who recently posted this chart:

Note the shift in relative growth patterns – less consumption, more investment, and net exports at least a less negative drag.  This seems consistent with a shift away from the externally supported pattern of household consumption so evident in the past decade.  And in discussing the general disappointment with the strength of the recovery, Altig says:

The undeniable (and relevant) human toll aside, the current recovery seems so disappointing because we expect the pace of the recovery to bear some relationship to the depth of the downturn. That expectation, in turn, comes from a view of the world in which potential output proceeds in a more or less linear fashion, up and to the right. But what if that view is wrong and our potential is a sequence of more or less permanent "jumps" up and down, some of which are small and some of which are big?

The implication is that perhaps we are closer to potential output than is widely believed.  Now, before you roll your eyes, as I am inclined to do, note the CBO estimate of potential output is not the only estimate.  Menzie Chinn reminds us of the variety of estimates of potential output, some of which suggest that, at the moment, the output gap is actually positive. 

Why might we believe that potential output has suffered some sizable, negative downward shock?  Altig did not provide an explanation, but one can find the same idea in the most recent FOMC minutes:

Others, however, saw the recent configuration of slower growth and higher inflation as suggesting that there might be less slack in labor and product markets than had been thought. Several participants observed that the necessity of reallocating labor across sectors as the recovery proceeds, as well as the loss of skills caused by high levels of long-term unemployment and permanent separations, may have temporarily reduced the economy's level of potential output (italics added). In that case, the withdrawal of monetary accommodation may need to begin sooner than currently anticipated in financial markets.

“Several” means a nontrivial contingent.  Notice the two, distinct explanations.  One is a structural change story – the economy needs more IT workers, and less retail staff, but the latter cannot easily become the former.  I cannot entirely dismiss this concern, as it is consistent with my own thoughts of how the US economy should evolve. 

The second point is also not easily dismissible, at least in its entirety.  Left leaning economists have worried that a protracted period of high cyclical unemployment could induce an increase in structural unemployment – that those workers out of the labor market for two years become essentially unemployable at anything remotely like their previous wages. Maybe not even two years of unemployment, perhaps just a day.  See Ryan Avent here.

The standard argument against the structural change story is to turn to the data itself and recognize that job losses have been widespread throughout the economy.  Thus, while some structural change is happening in the background, the primary issue at hand is really a demand shortfall.  See Brad DeLong here.  Moreover, one should expect increasing wage differentials.  But Federal Reserve staffers have had trouble identifying such effects.  From a good overview on Bloomberg:

Mary Daly holds up two charts containing 33 bars that all point down. They show eight industries getting hit equally hard after the 18-month recession ended in June 2009, suggesting that much of the past two years’ high unemployment is broad-based and should dissipate as the economy improves.

Daly is among researchers throughout the Federal Reserve system -- from San Francisco to Philadelphia and the board in Washington -- who are scouring data, examining models and gleaning anecdotes to determine why the jobless rate has remained stuck around 9 percent or more since April 2009. Most are reaching the conclusion that any long-term, structural shifts in the labor market aren’t significant enough to keep the U.S. from returning to a pre-crisis unemployment level of 5 percent to 6 percent by about 2016.

“If we were mis-measuring the natural rate of unemployment, I would expect to see rapid wage growth in some sectors offset by wage declines in others,” said Daly, 48, who heads the Federal Reserve Bank of San Francisco’s applied microeconomic research department. “I don’t see that. I see pretty uniform patterns across all sectors.”

I don’t quite see why if the structural shifts are not significant that is should take until 2016 to get unemployment back down to a normal range, but we will put that aside for the moment.  The main point to the story, however, is that it is challenging to find the impacts of very large structural change in employment or wage data.  Not that there are no effects:

The availability of extended unemployment benefits may have increased joblessness by as much as 0.8 percentage point and should have only a transitory effect as they expire and economic conditions improve, according to a January paper by Daly and San Francisco Fed researchers Bart Hobijn and Robert Valletta. Daly puts the natural rate at 6.25 percent and predicts it will fall to as low as 5.5 percent in five or more years.

Let’s give the benefit of the doubt to the structural change side of the story, and say the natural rate is at 7 percent.  That still leaves over 2 percentage points of unemployment, and, currently, that number is moving in the wrong direction.  Hence this is why overall wage growth remains weak (another factor suggesting fears that we are close to potential output are overblown).

Also arguing for a largely demand side explanation to the current weak employment numbers is what looks like a pretty obvious link between asset bubbles and full employment over the last decade.  As long as households had a mechanism to support demand, achieving full employment was not a problem.  If not households, then why can’t another form of demand fill the gap?

If I were to look for a sign that potential output has been breached, I would turn my attention to the trade deficit, which very much suggests domestic absorption exceeds domestic capacity.  The challenge, however, is that a significant trade deficit still exists along with high unemployment.  I would be happier if the trade deficit only coincided with low unemployment, which would suggest strains in satisfying domestic absorption with internal resources.  In my opinion, this curious state of affairs is the consequence of allowing foreign central banks to manipulate the value of the Dollar to obtain a trade advantage, which in turn has created significant imbalances in global patterns of production and consumption (I wouldn’t fool myself with the belief this has anything to do with seeking greater investment returns).  This, though, brings us back full circle – we should expect patterns of activity to shift to further support export and import competing industries, which almost certainly entails a reduced contribution from consumption and an increased contribution from net exports.  We have the former, but I believe the impact of the latter has so far been insufficient to push the structural change along.  As to why that is not occurring more quickly, I will hand the microphone over to Michael Pettis.

The interesting footnote here is the role of the fiscal deficit.  Additional fiscal spending could reduce unemployment, but would it come with a wider trade deficit?  I think it would – meaning that a portion of additional stimulus would bleed out overseas.  And this, I think, is one reason the Administration is comfortable with risking the consequences of additional fiscal contraction.  Instead, they look for fiscal policy to support the rebalancing story, and thus maintain the confidence of foreign investors.  (That and I get the sense they are trying to recreate the mid-90’s, which seems unlikely given that it was a very different economy.) 

All of which leaves me with these thoughts:  While not discounting the probability that some structural factors are at play, the primary challenge facing the US economy is insufficient demand.  Optimally, I think the best solution to this challenge is that demand emerges from the external sector – and here I mean NET exports, export and import competing industries.  This source of demand would support needed structural change, ultimately for the good of the US and global economies.  This adjustment requires a relatively complicated expenditure-switching story on a global basis.  I don’t know how to avoid such a story.  Barring this outcome, one falls back on fiscal policy, which can surely do the job, but risks maintaining the current pattern of global imbalances.  And perhaps such concerns are overblown; after all, so far the fears of a Dollar/current account crisis have not emerged.  Indeed, despite the ongoing debate in Washington regarding the debt ceiling, it looks like foreigners (central banks?) continue to acquire US Treasuries.

In the end, I take something of a middle road.  I don’t think we need sudden withdrawal of fiscal stimulus, although that appears to be what is happening.  More appropriate would be near term expansion of fiscal stimulus sufficient at least to support the social safety net while allowing for an expenditure-switching story to build.  But perhaps there are just too many moving pieces in such a plan to allow it to actually come to fruition.  My fallback then is that we should not allow the reality of economic pain to take precedence over only imagined externally generated crisis.

Is This More Than a Bump In the Road?

Data has not been kind in recent weeks, sending second quarter forecasts tumbling below 2%.  But that is not all; third quarter forecasts are heading lower as well.  Ryan Avent questions this rush to judgment:

Meanwhile, early forecasts for third quarter output growth are being revised down. That seems premature to me; the third quarter has only just begun and it still seems likely that low petrol prices and a recovering Japan, among other things, may buoy American output.

This is a good question – do we have enough data to appreciably alter estimates of the third quarter?  As Avent notes, the quarter is only two weeks old, and at least a few temporary factors are already in reversal.  Once these factors clear, hesitancy to hire new employees should dissipate. 

Alternatively, will the slowdown in the first half of the year trigger a cascade of weakness that will drag down the latter half as well?  If so, it is appropriate to lower third quarter estimates.

To get a sense of how a fairly simple model might be tell us, I dusted off the simple four variable vector autoregression (VAR) I used back in February to look at the impact of commodity prices.  I updated the data and used the model for two forecasts, one with that sample ending in 4Q10 and a forecast starting in 1Q11, labeled For1.  The second sample incorporates the next quarter of data, with the forecast beginning in 2Q11, labeled For2.  The impact of the weaker than expected first quarter and the higher than expected gain in commodity prices has a significant impact on the forecast through 2012:

The model’s estimate for the second quarter shifted down to 2.7% - which, interestingly, was just about the 2.6% consensus forecast in the June 2011 Blue Chip release.  The impact of the commodity price shock extends the growth decline into the third quarter of this year before activity slowly –very slowly – begins to recover.

One might wonder if the US economy could really linger at growth rates well below 2 percent for 3 or 4 quarters without tipping over into an actual recession. Moreover, it is worth considering that such a forecast leaves the US very vulnerable to negative demand shocks such as thought that might occur if the Europeans don’t get their act together.  Not to mention the antics of their counterparts on this side of the Atlantic.

How do these forecasts compare with those of the June Blue Chip forecasts?  I think it is interesting to look at the averages of the top and bottom ten forecasts: 

In contrast to the simple VAR model, both the top and bottom forecasters expected first half weakness to be temporary, with growth rebounding in the second half.  The “smart” forecasters knew what the “dumb” model didn’t – that temporary factors were dragging down the first half.

Now those same forecasters worry the model wasn’t so dumb after all, and thus need to bring down the third quarter.  The commodity price hike was simply more severe, with more persistent impacts, than initially expected. 

The bottom 10 forecasters see growth settling in at 2.5% by the end of 2012, not far below the simple VAR – they follow different paths to get to the same place.  By contrast, the optimistic group is looking at growth rates of 3.9% at the end of 2012, apparently using models and judgment not dissimilar to our friends on Constitution Ave.

I suspect that if I continue this analysis, the simple VAR will almost always tend to be near the consensus (about the midpoint of the top and bottom averages) 4 to 8 quarters out, sliding between the top and bottom forecasters as the data evolves.  Reconciling the model and forecasters in the near term, however, is a bit more of a challenge.

Bottom Line:  My judgment is not too far from Avent’s – temporary factors are at play.  My simple model, however, is telling me that those temporary factors have more persistent impacts than my judgment initially expected.  Critically, although oil prices have eased, gasoline prices remain near recent highs, and this looks to be having a significant impact on consumer attitudes.  Moreover, there are two big negative risks in the final half of this year, European debt crisis and US fiscal contraction.  Overall, I would agree with forecasters leaning on the side of caution and shade down my expectations for the second half while hoping the error is in Avent’s favor.

Households Are Still Deleveraging. Or Not.

Calculated Risk reviews a David Leonhardt New York Times article and notes:

In addition, household debt as a percent of income, remains very high and household deleveraging is ongoing. That is why so many companies identify their number one problem as "lack of customers"…

The picture looks like this:

How much deleveraging is left remains a mystery.  Just to the pre-2000 trend, or even farther?  Or is the process pretty much over?  Steve Matthews at Bloomberg recently wrote a story full of anecdotes and quotes from those who believe we are very far along on the deleveraging story.  Some examples:

 …“The financial situation of the household sector has improved far faster and far more than everyone thought it would two years ago,” said James Paulsen, chief investment strategist for Wells Capital Management in Minneapolis. “People are still locked into the view that consumers are facing record burdens, and they are not. There has been a change that is sustainable and durable.”…

…“The household deleveraging process is much further along than is appreciated,” said Mark Zandi, chief economist at Moody’s Analytics Inc. in West Chester, Pennsylvania. “This is evident in the rapid improvement in credit quality. ‘Zombie consumers’ is a mischaracterization of the state of the American consumer.”…

… Dean Maki, chief U.S. economist at Barclays Capital Inc. in New York, says the growth in credit reflects an underlying optimism, part of a virtuous cycle. As a Fed economist in 2000, he published research that concluded “high debt burdens are not a negative force” and the debt-income ratio isn’t reliable in predicting spending…

The picture that tells this story is this: 

Household financial obligations – the ongoing service costs – have plunged since the beginning of the recession.  By this view, it is not the level of debt relative to income that should be the concern.  Instead, we should be looking at the cost of financing that debt.  And that cost steadily decreased since the 1980s as interest rates fell, allowing households to steadily increase their debt levels while financing costs were constrained.

For me, I can see both sides of this story, but keep coming back to this chart:

If household are trying to deleverage their way back to a net worth position of 470% of GDP, I imagine the period of deleveraging is only just beginning.  Consider years of cutting debt while hoping asset values rise sufficiently to pull you out of the post-bubble hole - all the while a mediocre economy ensures building assets is difficult at best.

But aside from the deleveraging question, another takeaway from the last chart always rattles in the back of my head: It sure looks like asset bubble-induced surges of net worth were critical in maintaining full employment during the past decade.  And we aren’t coming close to filling that hole with other spending.  Which is why we keep getting this picture:

and this picture:

 

A Nod to QE3?

Financial markets warmly embraced a perceived opening by Federal Reserve Chairman Ben Bernanke, jumping sharply on news that QE3 was still on the table.

But QE3 was never off the table to begin with.  It was simply that the bar to QE3 was very, very high. And I have to agree with Calculated Risk; I don’t see that Bernanke lowered it any today.  The key sentence from the Congressional testimony:

On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support.

Note the two conditions – persistent economic weakness coupled with deflation risks.  The latter was a focus when the Fed initiated QE2, with the lack of such risks guaranteeing the Fed would cease asset purchases at the end of June.  Bernanke made clear the focus on deflation in his most recent press conference. 

Are we seeing signs that such deflationary fears are emerging?  Not yet, at least not based upon the kinds of market and survey based indicators the Fed is watching:

 

I would be looking for inflation expectations to plunge well below 200bp to trigger Fed action, like we saw last fall.  Nor is it evident in the actual inflation data:

 

Absent a jarring negative shock, it seems difficult to believe the Fed could forge a consensus to ease further given the recent inflation path.  Without a clear risk of deflation, it seems any additional asset purchases (or other easing efforts) would not make it through the FOMC.

Of course such a risk could not emerge quickly – the debt ceiling charades and the European debt crisis stand out as big tail risk events.  Not really hard to tell a story that more action would be necessary under either scenario.  But it shouldn't be a surprise that the Fed would be ready to step in and support financial markets if such events occur.

And don’t forget that Bernanke made clear another story:

On the other hand, the economy could evolve in a way that would warrant a move toward less-accommodative policy.

He doesn't lay down any specific data markers for tightening.  In short, policy could tighten, could loosen.  They are stuck on hold, waiting and watching the evolution of the data.  But absent deflation risks, easing policy further seems very, very unlikely.

Bottom Line:  Looking for more from the Fed?  Then look to conditions that sharply raise the risk of deflation.  And note that the FOMC minutes suggest the Fed is not really looking in this direction, instead focused on the commodity-induced inflation shock passing through the economy.

A Divided FOMC

The FOMC minutes were simply fascinating.  The discussion of the economic situation was markedly downbeat, even before the latest employment report, yet the final outcome of the meeting – the FOMC statement and Federal Reserve Chairman Ben Bernanke’s subsequent press conference – seemed to clearly indicate that, barring an outright return to the threat of deflation, the Fed saw its job as done.  How can we reconcile these two positions?  Presumably the faction leaning more toward additional easing is relatively small, while the majority believes either they have already gone too far or that further policy is ineffectual.  Bernanke seemed to place himself in the latter category during the press conference.  Is that really where he stands?  This apparent divergence of views on the FOMC will bring extra attention to Bernanke’s testimony today on Capitol Hill.

 Begin with the economic situation as seen from Constitution Ave.  A host of “temporary factors” are weighing on the economy:

 … including the global supply chain disruptions in the wake of the Japanese earthquake, the unusually severe weather in some parts of the United States, a drop in defense spending, and the effects of increases in oil and other commodity prices this year on household purchasing power and spending.

Still, better times are on the horizon:

Participants expected that the expansion would gain strength as the influence of these temporary factors waned.

I wouldn’t sigh too loudly just yet.  It is reasonable to believe that some of these impacts are indeed temporary.  For example, Bloomberg reports the Bank of Japan see good progress toward normalizing production conditions:

 “Japan’s economic activity is picking up with an easing of the supply-side constraints caused by the earthquake disaster,” the central bank said in a statement. Increasing output has resulted in an “upturn” in exports, and household and business sentiment has improved, it said.

 Toyota and Honda said last month they plan to add thousands of workers in Japan as they increase production. Toyota, the world’s largest automaker, said domestic plants were running at 90 percent of planned levels in June, up from 50 percent in April and May, when output was depressed by a shortage of parts from suppliers.

 That said, as Bernanke earlier explained, temporary factors are not all that are in play:

 Nonetheless, most participants judged that the pace of the economic recovery was likely to be somewhat slower over coming quarters than they had projected in April.

Why the downgrade?  The list is long:

This judgment reflected the persistent weakness in the housing market, the ongoing efforts by some households to reduce debt burdens, the recent sluggish growth of income and consumption, the fiscal contraction at all levels of government, and the effects of uncertainty regarding the economic outlook and future tax and regulatory policies on the willingness of firms to hire and invest.

As if this is not enough, the risks are all downside risks:

Moreover, the recovery remained subject to some downside risks, such as the possibility of a more extended period of weak activity and declining prices in the housing sector, the chance of a larger-than-expected near-term fiscal tightening, and potential financial and economic spillovers if the situation in peripheral Europe were to deteriorate further.

Lions and tigers and bears, oh my. Then comes the disappointing jobs numbers:

Meeting participants generally noted that the most recent data on employment had been disappointing, and new claims for unemployment insurance remained elevated. The recent deterioration in labor market conditions was a particular concern for FOMC participants because the prospects for job growth were seen as an important source of uncertainty in the economic outlook, particularly in the outlook for consumer spending.

Note that this was before the most recent employment report.  The situation has only deteriorated further.  Indeed, the sharp downturn in employment growth is something of a mystery if the primary factors weighing on the economy, primarily the Japanese tsunami, are widely believed to be only temporary.  Firms should be willing and able to look through such disruptions.  Simply a heightened sense of caution as the memory of the recession still lingers?  Or are the back-to-back weak employment reports indicating a more permanent downward shock to growth, perhaps a cascading effect from the commodity price shock that will not be easily relieved unless the shock reverses itself.

Additional risks to the outlook were seen in the European debt crisis and the possibility the US debt ceiling may not be raised (I sure hope Calculated Risk is correct on this one).  Given the general downbeat tenor of the discussion, it is tough to see how they did not open the door further for additional easing.  Why not?  Policy is held hostage to inflation fears:

Most participants expected that much of the rise in headline inflation this year would prove transitory and that inflation over the medium term would be subdued as long as commodity prices did not continue to rise rapidly and longer-term inflation expectations remained stable. Nevertheless, a number of participants judged the risks to the outlook for inflation as tilted to the upside. Moreover, a few participants saw a continuation of the current stance of monetary policy as posing some upside risk to inflation expectations and actual inflation over time.

On the other side were those that argued there were no indications inflation expectations were becoming unanchored, nor would this be likely when labor costs were subdued.  Then comes the paragraph that truly reveals the divergence within the FOMC:

Participants also discussed the medium-term outlook for monetary policy. Some participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate and if inflation returned to relatively low levels after the effects of recent transitory shocks dissipated, it would be appropriate to provide additional monetary policy accommodation. Others, however, saw the recent configuration of slower growth and higher inflation as suggesting that there might be less slack in labor and product markets than had been thought. Several participants observed that the necessity of reallocating labor across sectors as the recovery proceeds, as well as the loss of skills caused by high levels of long-term unemployment and permanent separations, may have temporarily reduced the economy's level of potential output. In that case, the withdrawal of monetary accommodation may need to begin sooner than currently anticipated in financial markets. A few participants expressed uncertainty about the efficacy of monetary policy in current circumstances but disagreed on the implications for future policy.

The group suggesting the need for additional stimulus appears to be relatively small.  A more significant group looks at recent data and concludes we overestimated the amount of slack in the system (despite meager wage gains).  An apparently nontrivial contingent sees structural issues driving potential output lower, even if only temporarily.  And then there are those that are not confident that policy has much impact at this juncture – which implies either do nothing or the next thing they do has to be really, really big.  And I doubt there is much support on the FOMC for something really big.

And note that although the group open to additional stimulus caught the attention of the press, it appears they too would wait until it becomes clear that both labor markets remain weak and inflation returns to low levels.  I would add that Bernanke raised the stakes further – inflation expectations need to threaten to become unanchored on the downside, a real fear of deflation like last fall.  He seems to believe that additional policy would be ineffectual at boosting growth further, and should be reserved for moderating financial disruptions and maintaining inflation expectations.  It should be interesting if today he reiterates his point that in the absence of deflation, the tradeoffs of additional policy are not very attractive.  If he recants this view, it would signal that he is moving toward additional policy sooner than later.  I don't expect such a change.

So what’s the bottom line here?  On one hand, the “watch and wait” mode could be viewed as understandable given the multitude of temporary factors in play.  That said, temporary factors aside, the overall tenor of the meetings appears to have been very depressing.  There is a clear sense the economy is firing on only a handful of cylinders, yet FOMC members cannot completely explain why.  And perhaps more importantly, it appears members are operating without consistent theoretical or empirical frameworks.  They all seem to be looking at the same set of data through very different lenses.  There is no agreement that policy has been effective or ineffective.  There is no agreement if inflation risks are high or low.  There is no agreement if structural impediments are real or imagined.  Given the lack of agreement, it is difficult to see how policy does anything but remain in a holding pattern until a clearer picture emerges.  Good news for those worried the Fed would soon tighten.  Ongoing weak job reports practically guarantees the Fed will not step on the breaks.  Bad news for those looking for more.  Until the inflation fears shift back to deflation fears, there looks to remain strong resistance to additional asset purchases.

 

On That Capital Flow Fallacy

Yesterday Paul Krugman chastised the White House over this quote from President Barak Obama’s press conference:

I do think that if the country as a whole sees Washington act responsibly, compromises being made, the deficit and debt being dealt with for 10, 15, 20 years, that that will help with businesses feeling more confident about aggressively investing in this country, foreign investors saying America has got its act together and are willing to invest. And so it can have a positive impact in overall growth and employment.

Krugman adds:

OK, so that’s the confidence fairy at the beginning. But the “foreign investors” thing is actually worse.

Think about it: U.S. interest rates are low; there’s no crowding out going on; we are NOT suffering from a shortage of saving.

I think it is worth trying to understand the Administration’s position in light of this morning’s trade release, which revealed an unexpected surge in the trade deficit.  The deterioration was in both the petroleum and non-petroleum balances, nominal and real.  I imagine the numbers will be another ding to the second quarter GDP forecast, although on net trade is still poised to make a significant contribution to growth.  So far, in real terms, the trade deficit for Q2 remains improved relative to Q1.

Still, the deficit was $50.2 billion, an outflow which requires an offsetting net inflow.  Annualized, this amounts to $600 billion a year of inflow, although note the decline in oil prices should take some of the pressure of the nominal deficit over the next couple of months.  I think it is protecting this inflow that concerns that White House.

The counter-argument is that that global investors appear to have plenty of cash to pour into the US, yielding very low interest rates.  Under such circumstances, it is counterproductive to fret about the need for foreign investment.  Indeed, that foreign investment, in the form of central bank dollar accumulation, has been a net drag on US demand, supporting the evolution of unsustainable patterns of trade.

It seems if you view the US as a sufficiently large country that the external accounts are simply a residual, the tail of the dog, so to speak, you tend to dismiss their relevance to policy making.  This strikes me as essentially a closed economy view.  On the other hand, persons working in international finance tend to have a less innocuous view of the external accounts, where sudden stops of capital in this “residual” have massive and destructive effects on the domestic economy.   In such cases, the tail wags the dog.

Of course, Obama’s chief economic advisor, Treasury Secretary Timothy Geithner, cut his teeth on financial crises, and thus I suspect this puts him in the latter group.  And where Geithner goes, Obama follows.

I have gone back and forth on this issue.  I don’t think I am alone in viewing the gaping and persistent US current account deficit as a potential disaster waiting to happen.  At the same time, it seems that nations most likely to suffer from current account/currency crises are those with some mix of overvalued exchange rates, inability to print domestic currency, and high levels of foreign currency denominated debt. 

The US is free of these issues.  We can print our own currency, our debt is dollar-denominated, and US authorities are not actively strengthening the currency (such actions are directed by foreign central banks).  Under such circumstances, my tendency is to think that excessive focus on the confidence of foreign investors would tend toward inappropriately tight policy given the current economic environment.  Indeed, discouraging foreign central banks from accumulating Dollar assets would be the appropriate policy, especially as we are experiencing a significant current account deficit at the same time output is well below potential.

I should add this is not meant to imply that investor confidence (and not just foreign investors) is irrelevant.  I admit to a nontrivial concern that even for the US, the tail does wag the dog. But the much-feared Dollar crisis continues to elude us.  It appears that reasonable economic stewardship prevents those fears from being realized – with reasonable meaning acting to prevent economic collapse.  I think this means to push the concern for deficits a few years into the future, but having a credible plan in place to tackle the issue at that juncture.

With this in mind, I would not court disaster, by, for example, calling into question the sanctity of US government debt or putting the nation at risk of a major economic contraction in the second half of this year.  I think it would be appropriate for foreign investors to fundamentally reassess their confidence in US asset in the face of such recklessness.  Yet Republicans appear willing to take just such a risk to hold to the “no new revenues” pledge. 

Indeed, we are now closer than I would have imagined to the ultimate test of the “expansionary austerity” argument because, come August 3, fiscal policy will quickly become very austere.  And somehow I don’t think this will boost investor confidence, neither foreign nor domestic.  Indeed, foreign investors may then be the least of our worries.