August 31, 2010
IS THERE AN AUSTERITY TRAP?
Bloomberg has a story that suggests that fiscal austerity NOW isn't all it's cracked up to be. Ireland has tightened its belt, but to what end? For the moment, this isn't an encouraging argument for going hawkish.
Yes, some of this story (most of it?) is about the euro. But the euro is really just a gold standard draped in modern fiat currency clothing, as discussed previously.
Meanwhile, according to Bloomberg:
Ireland has been exemplary in its austerity drive. Public-sector salaries have fallen by an average of 13 percent. Taxes have been raised where necessary, but not in a way that will hurt business. The Irish have been willing to tighten their belts and adjust to hard times...
Ireland is doing exactly what it has been told it should be doing. It is following the path laid down for Greece, Portugal and Spain, and doing so with admirable self-restraint and discipline. There ought to be some reward for all that effort. But there is very little sign of it.
The end result:
Credit rater Standard & Poor’s lowered its grading on Irish debt by one level to AA-, stressing the heavy cost of rescuing a banking system struggling to cope with the collapse of the property market. S&P estimates the cost of recapitalizing the banks will be about 50 billion euros ($63 billion). That’s almost a third of the economy.
Ireland now has its lowest rating since 1995. Irish bonds plunged on the news. The spread over German bunds widened to a record.
The Surly Trader called it the "Austerity Trap," explaining: "If you have looked at the credit default swap level of Ireland lately, you would think that they were just as irresponsible as Greece and currently just as risky as Portugal."
THE FED MUST MANAGE EXPECTATIONS
The case for thinking that effective central banking is all about managing expectations is persuasive. There are lots of formal papers arguing for no less, and the numbers confirm that this is indeed how the world works.
As everyone recognizes, aggregate demand expectations have been falling. And rightly so, given the latest news that GDP has been revised down. More of the same appears to be coming, based on economists' falling projections for economic growth, as the chart below shows (courtesy of the Philadelphia Fed's third-quarter survey of forecasters).
The falling trend should come as no shock, considering falling expectations for inflation in recent months. If the market's outlook for inflation continues to fade, so too will the crowd's view that the economy's growth rate will weaken further. If the Federal Reserve ignores the trend, that's a defacto monetary tightening—even at a near-zero nominal Fed funds rate. Expectations have a habit of becoming reality under current conditions.
Why might we disagree? The fear of higher inflation is the standard worry. But that's exactly what's needed at the moment. Not as a long-term proposition, of course, but it's necessary now. That creates new challenges down the road, and perhaps sooner than we think, but it's a secondary issue for the immediate future. The fact that the Fed has yet to raise (or at least stabilize) inflation expectations is testament to the problem. You could argue that inflation expectations are falling because productivity is rising, but that's a weak argument, given the latest report on labor market productivity.
The key unknown is how will the Fed react in the coming weeks and months. Yes, the remaining monetary levers aren't as potent as they were, given the near-zero nominal rates. As such, we can't be sure that they'll be effective. On the other hand, not using the remaining tools runs the risk of giving the crowd a new and potentially potent incentive to continue revising expectations down. The bigger challenge is all the guessing that's swirling about. Will Ben do something? Or not?
Mark Thoma isn't so sure. As he wrote earlier today:
Rereading Federal Reserve Chairman Ben Bernanke's recent speech and measuring it against the incoming data leaves me with a pit in my stomach. I sense Bernanke reveals in this speech he is the proverbial emperor without clothes, short on policy options but long on hope. A last ditch attempt to persuade us that as long as we don't believe deflation will be a problem, it will not be a problem. But he faces the same challenge as did then President Gerald Ford. All hat and no cattle. You need to be ready to back up your talk with credible policy options. While Bernanke outlined possible policy options, reading between the lines makes clear he lacks conviction in the viability of any of those options. Simply put, Bernanke is not ready to embrace the paradigm shift bold action requires.
Until the incoming economic data surprises boldly on the upside and/or the Fed chairman convincingly persuades the market to expect higher (or at least stabilized) inflation, there's a surfeit of uncertainty rolling about. In that case, the market's likely to err on the side of caution, i.e., shun risk, seek safe havens.
August 30, 2010
SPENDING & INCOME RISE IN JULY. YES, BUT...
Disposable personal income (DPI) and personal consumption expenditures (PCE) gained 0.2% and 0.4%, respectively, vs. flat performance in June, the Bureau of Economic Analysis reported today. That's encouraging, as these things go in the summer of 2010. But as usual, the fine print leaves room for debate.
Let's start by looking at recent history in context, as shown by the first chart below. Income and spending rose last month, but nothing's really changed relative to the trend over the past year. Growth is light, compared with pre-recession days. The question is how long it'll stay light? At the moment, the crowd's inclined to err on the side of caution until fresh numbers suggest otherwise, and today's spending and income updates don't do the trick.
One month a trend does not make, but consumers spent more than they earned in July. Higher savings reduces consumption, of course, and that's a risk if the economy isn't growing below trend. But there's a conflict to consider too. On the one hand, higher savings rate are a worry for the economy in the near term, and so today's bounce in consumption is what the bulls want to see. But it's highly likely (if not inevitable) that Joe Sixpack will be saving more in the future to pay off debt and rebalance household balance sheets after the spending binge of past years. As such, to the extent the consumer spends more than he earns today, that implies that future growth in consumption will be lower. There's a price to pay for short-term happiness.
To see a richer measure of the big-picture trend, consider the second chart, which shows the rolling 12-month percentage change for income and spending for the past decade. The trend has turned up since the dark days of 2008/2009, but so far the rebound has been weak, and there's little in the way of persuasive arguments for expecting a material change for the better in the immediate future.
But the case for expecting the economy to muddle through isn't yet lost, or so one economist advised. "All in all, July's report supports our view that consumer spending will continue to recover, albeit modestly, supported by a gradual improvement in labor income," wrote Peter Newland, an economist at Barclays Capital Research via The Washington Post. That's the optimistic outlook, such as it is.
Stephen Stanley, chief economist at Pierpont Securities, echoed that sentiment, telling Bloomberg: "It’ll be a real slog. We’ll see very slow growth, but it’s a far cry from a double dip."
The future for the macroeconomic mystery still depends heavily on the labor market and wages. The good news is that wages are rising, which is critical to fuel ongoing economic growth. The bad news is that the economy's still not adding workers at anything close to a robust pace, although perhaps this Friday's employment report will tell us different. Only the combination of rising employment and rising wages will deliver an end to the challenges that bedevil the business cycle.
Meantime, wages for those who are employed remain in a growth mode, as the third chart below shows. Half a solution is better than none.
The rebound in wages is encouraging, but it's still got a long way to go. The 1.8% rise over the year through last month is a world away from the contractions of the recent past. But we're hardly any closer to the 6-8% annual gains that prevailed before the Great Recession. Deciding how much of a rebound in wages (and job creation) is still the burning issue and it's going to take time to figure out the answer.
MOMENTUM PROFILE FOR THE MAJOR ASSET CLASSES
Momentum isn't everything, but it's hardly chopped liver. You could spend the next several months reviewing the literature published over the past two decades that make a case for showing a little respect for price momentum, or the tendency of prices to continue moving in the same direction relative to recent history. Should you focus exclusively on momentum for managing portfolios? No, of course not. But neither should you ignore it.
Skeptical? Take a look at a newly published summary of the momentum factor by Professor Tobias Moskowitz. a finance professor at the University of Chicago. And here's a recent article on momentum I wrote for Financial Advisor magazine.
Momentum as a risk factor is old news, but it isn't easily explained. Yet it's hard to dismiss it as irrelevant. Yes, there are hazards to consider, including the inevitably for a given direction in momentum to eventually run up against mean reversion—i.e., momentum reverses at some point. Positive momentum always and everywhere gives way to negative momentum, and vice versa. The question is always: When? A very rough rule of thumb is using 12 to 24 months as a benchmark for deciding if momentum is long in the tooth. Some momentum strategies define momentum over the past 12 months as robust. But by 24 months, if not earlier, the strategies jump ship. Much depends on the asset class, of course, along with the economic context and other factors. But this is probably a good place to start a momentum analysis.
The various caveats aside, how do the major asset classes stack up on momentum these days? For some insight, I reviewed ETF/ETN proxies for the major asset classes using data from StockCharts.com. Specifically, I looked at closing prices for 11 ETFs/ETNs as of Friday, August 27 relative to the 200-day moving averages, based on data from StockCharts.com. Some strategists argue that price below the 200-day moving average is a near-term bearish signal; price above this average is bullish.
There are no guarantees, but as Mark Hulbert wrote earlier this year: the 200-day moving average trend strategy is tough to beat when it comes to market timing. Mebane Faber in The Ivy Portfolio comes to a similar conclusion in a detailed study of using momentum signals to manage a multi-asset class portfolio.
As for the latest 200-day moving average profiles, here's what I found:
Funds trading below their 200-day moving average:
U.S. Stocks (VTI)
Foreign Developed Mkt Stocks (VEA)
Funds trading above their 200-day moving average:
Emerging Market Stocks (VWO)
Emerging Market Bonds (PCY)
U.S. Bonds (BND)
Foreign Gov't Inflation-Linked Bonds (WIP)
Foreign Dev Mkt Bonds (BWX)
High Yield Bonds (JNK)
This isn't terribly surprising. Bonds generally have been rising in price, thanks to deflation/double-dip recession fears. For the same reason, stocks have been trading below this average. Risk aversion is alive and kicking.
But there are some quirks. REITs are well above their 200-day moving average while commodities are below.
Given the higher-than-usual uncertainty surrounding the macroeconomic outlook, interpreting this information carries more than the usual risk. Momentum is about trend, but all trends eventually reverse. Momentum can be a powerful short/medium-term signal for tactical asset allocation, but it's far from flawless.
Nonetheless, there's no question about where market sentiment lies. The crowd generally favors bonds and is cautious on stocks (particularly in developed markets), REITs and commodities. The trend may roll on for a time until the economic news inspires thinking differently. Meantime, momentum is king.
August 29, 2010
READING ROUNDUP FOR SUNDAY: 8.29.2010
►After the Fall
Carmen M. Reinhart and Vincent R. Reinhart/working paper presented at Kansas City Fed conference
"Real per capita GDP growth rates are significantly lower during the decade following severe financial crises and the synchronous world-wide shocks. The median post-financial crisis GDP growth decline in advanced economies is about 1 percent."
►Hiring, Manufacturing Probably Cooled on Signs U.S. Recovery Is Stumbling
"Hiring and manufacturing probably cooled in August, showing companies are scaling back as the U.S. recovery shows signs of stumbling, economists said before reports this week."
►The Emerging Markets’ Century
Desmond Lachman/The American (Journal of the American Enterprise Institute)
"A profound, yet little noted, change is occurring in the global economy. It is the relative strengthening of the public finances of the major emerging market economies compared to the crumbling public finances of industrialized countries. This change will likely accelerate the tendency already very much in evidence in recent years for the emerging market countries to gain relative importance in the global economy. It is also likely to carry with it profound political implications for international relations between those countries and those in the G-7."
►The Bubble That Isn't
"Don't worry about a bubble in U.S. government bonds"
►We're Not Going to Double Dip
Donald Luskin/Smart Money
"…I remain convinced we're not in a double-dip recession, and I think stocks should be accumulated at these levels."
►The Yield Spread and the Odds of Recession
"…the relative steepness of today’s yield curve (10-year rate about 2.5 percentage points above the fed funds rate) thus suggests, by itself, that renewed recession is unlikely, despite recent weak economic data. On the other hand, there are reasons to believe that this time things are different (usually a scary phrase). After all, fed funds rate has been pushed down almost to zero and yet the economy no longer appears to be responding. That’s exactly the logic that inspired the SF Fed researchers to try their model without the yield spread."
►U.S. Equities: Scaling Back On Risk
"We have been overweight risk assets relative to Treasurys and cash since early 2009, but it is time to take profits and scale back on risk exposure. We recommend cutting equity and corporate bond allocation to neutral and placing the proceeds in Treasurys. We view this as a tactical shift. We have not abandoned our view that the economic recovery will ultimately be sustained, although growth will be tepid by the standards of past recoveries that followed deep recessions."
►Preparing For The Next Black Swan Is Tough
"Don't expect your favorite economist to predict the next Black Swan. Economists are a "black swan blind species," charges Nassim Nicholas Taleb in the expanded second edition of The Black Swan: Second Edition: The Impact of the Highly Improbable.
August 28, 2010
THE MORNING AFTER BERNANKE'S SPEECH
At yesterday's central banking confab in Jackson Hole, Fed Chairman outlined what the Fed can do to further juice the economy. The initial reaction from the stock market was positive, with the S&P 500 jumping 1.7% on Friday. But in a sign of the treacherous road ahead, the bond market was unimpressed. Bonds sold off yesterday and the benchmark 10-year Treasury Note yield rose to 2.65%, the highest since August 13. Yes, folks, it's going to get complicated from here on out.
The priority, of course, is minimizing the odds of a new recession. The central bank's big guns have already been fired in that pursuit, and so expectations for monetary policy are falling, and rightly so. But there's more to do, if and when Bernanke and company are persuaded that it's time to act (again). As the Fed chairman explained yesterday, the remaining levers include:
1) additional purchases of government debt and other securities to lower long rates.
2) launch a new rhetorical war on the price of money by talking tough on promising (threatening?) to keep short rates low for a longer period than the market anticipates at the moment.
3) reduce/eliminate the already meager 25 basis points the Fed pays to banks for reserves.
4) Hike the Fed's inflation target as a further incentive for banks to lend money instead of sitting on cash.
Based on Bernanke's commentary, buying more debt and talking down long rates are the preferred lines of attack for rolling out a new round of quantitative easing. Cutting Fed funds to zero and/or raising the inflation target, by contrast, are apparently off the table, at least for the moment, according to the Fed chairman. On the higher inflation target option, for instance, he explained:
such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability. In this context, raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets--including inflation risk premiums--would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy.
But dismissing a higher inflation target seems premature at this point. For starters, inflation expectations have been something less than stable lately. As we discussed earlier in the week, the market has been anticipating falling inflation for the years ahead. Scott Sumner lays out the reasoning for raising the inflation target:
Draw a 2% trend line for core inflation from September 2008. We are now 1.4% below that trend line. Shoot for getting back to trend. I know that doesn’t sound like much stimulus, but given the slack in the economy it would actually take pretty fast [nominal GDP] growth to get 3.4% core inflation over 12 months. Or 2.7% over 24 months.
Meantime, there's the question of whether the bond market is set to throw a new wrench into the machine with higher long rates. Ultimately, the goal is to raise interest rates generally, but for the right reason: higher economic growth. The rise in the 10-year Treasury yield yesterday, by contrast, was spurred by worries that the Fed may still be reacting to macroeconomic events rather than making headway on getting in front of the challenge.
Ultimately, it's all about the broad trend, and on that front there's still reason to worry, as the latest data point reminds. Yesterday's news advised that GDP for the second quarter was revised down sharply. The economic numbers generally are still weakening. The double-dip risk isn't yet absolute, but it's rising. Next week we'll have additional information to digest. The highlights:
* Monday: personal income and spending numbers for July
* Wednesday: the first look at the economic trend in August via the ISM Manufacturing Index update.
* Thursday: weekly jobless claims report will be closely watched.
* Friday: the big number for the week is the government's employment update for August.
On the employment outlook, the consensus forecast among economists is a net loss of 100,000-plus in nonfarm payrolls, according to Briefing.com. What more do you need to know?
August 27, 2010
GDP REVISED DOWN TO 1.6% FOR Q2
The U.S. economy grew at a tepid 1.6% annualized real rate in this year's second quarter, the government reported today. That's down from the earlier estimate of 2.4% growth. The revised 1.6% rise is slightly higher than consensus forecast among economists, but there's no getting around this uncomfortable fact: the economy slowed dramatically in Q2, falling to a 1.6% pace from 3.7% in Q1.
Some growth is better than no growth, of course, but today's update is sure to keep the debate going about whether the economy will continue to slow, perhaps to the point of falling into a new recession. By some accounts, the distinction no longer matters. "This is not a recovery," Paul Krugman writes today. Maybe not, but whatever you call the current state of the economy, it could get worse.
Or better? Not likely, at least not anytime soon. But let's also recognize that there was some good news in today's GDP revision, or at least better-than-expected news. That includes the numbers on consumer spending. Personal consumption expenditures rose 2.0% in Q2, slightly higher than the 1.9% rate in Q1. The broad trend in consumption, in other words, is generally holding steady. That's not a bad thing for a sector of the economy that represents more than 70% of GDP.
But the challenge is tied up with expectations for growth in consumption over the next several years. The probability that consumer spending will remain slow, if not dip a bit, can't be written off as unlikely.
“The economy has slowed a bit and will probably continue to slow through the second half,” John Silvia, chief economist at Wells Fargo Securities, told Bloomberg News today. “We’re skating on thin ice, and we don’t have a lot of margin for error.”
The question before the house: Will the various macroeconomic weights on our collective backs break the ice, or allow us to skate tentatively forward until stronger recovery winds begin to blow? No one really knows the answer, but it's getting harder to give the latter anything more than a 50% chance, if that.
THE BOTTOM LINE ON THE RISK OF A DEBT CRISIS
Arnold Kling hits the macroeconomic nail on the head with a very heavy rhetorical hammer:
...it would appear to be quite likely that the United States will
experience a debt crisis within the next two decades, unless the path for fiscal policy changes from what is projected by the Congressional Budget Office. However, international capital markets continue to treat U.S. Treasury debt as a fairly safe asset. One way to interpret this phenomenon is that investors expect the United States to take steps to get its fiscal house in order.
The assumption that the United States will have the political will to stabilize its fiscal position is based more on hope than on recent experience. If the political process continues to enlarge the government’s commitments to spend in the future, investor expectations will change at some point. That change in market perception is likely to be swift and severe.
On the other hand, there's the current problem brewing with a slowing economy. Fiscal stimulus may be politically and economically untenable. That leaves monetary policy as the last, best hope. And on that note, Fed Chairman Ben Bernanke will enlighten us in a few hours. But, hey, no pressure, Ben.
WILL THERE BE A QE2? WILL IT MATTER?
Fed Chairman Ben Bernanke is scheduled to speak today at the Kansas City Fed's annual Jackson Hole conference in Wyoming. Will he outline a new plan for monetary stimulus? If so, will the second wave of quantitative easing (QE2) be bold--bold enough to work? Or maybe he'll just offer the same chit-chat that we've been hearing for months by telling us that the recovery is slowing and that nominal rates will stay low for an extended period.
What's clear is that the crowd is anxious. The fear is that the economy is headed for a double-dip recession. But the market is also confused about what's coming, and what the current Fed policy means. Consider two stories in today's Wall Street Journal. The Ahead of the Tape column opined:
A glance at the stock market lately suggests the prospect of more so-called quantitative easing, or QE, isn't doing much to inspire a rally. If anything, the more the Fed acknowledges the weakening economy, the worse the market responds.
Really? Has the stock market fallen because the crowd doesn't expect QE2 (assuming it's even tried) will work? Or is the selling related to disappointment that a new, bolder round of QE has yet to arrive?
Elsewhere in today's Journal we're advised:
The market is bracing for the possibility of QE2. Market expectations of more quantitative easing, alongside weak economic data, have led U.S. bond yields to fall sharply.
Maybe Ben can clear it all up and set the market straight. Stay tuned.
August 26, 2010
JOBLESS CLAIMS: BETTER BUT STILL HIGH
Today's update on new filings for unemployment benefits brings a reprieve from last week's disturbing surge in new claims. For the moment, we can breathe a sigh of relief. But while the trend has improved, it's still not healthy.
New weekly claims for jobless benefits dropped by 33,000 last week. That's a bigger drop than the crowd expected. Impressive, until you realize that 473,000 workers signed up for unemployment on a seasonally adjusted basis. As the chart below reminds, the trend still leaves us treading water this year. The best we can say (still) is that it's not getting any worse, although that defense looked dead on arrival a week ago.
The case for expecting jobless claims to meander at an elevated level looks compelling, short of arguing that something's about the intervene and provide relief in the way of material improvement in the labor market. Never say never, but there's no obvious catalyst waiting in the wings for the near term. What's more, there's a case for wondering if the labor market is set to weather greater challenges before it enjoys better news. As Bloomberg News reports today,
A slowdown in U.S. business investment may soon hit the job market, further hindering a recovery in the world’s largest economy.
Capital spending, one of the few bright spots in the recovery, declined in July, according to Commerce Department figures released yesterday in Washington. Sales of new homes fell to the lowest level since data began in 1963, another report from the same agency showed, indicating a lack of jobs is crippling housing.
The next round of confirmation (or not) arrives next week, when the government releases the August payrolls report on September 3 (Friday). Meantime, there's still enough of a gray area in the economic numbers overall to see almost anything you want. The safe assumption is that the future looks likely to bring more water torture as the economy remains technically in recovery that otherwise feels like recession. Minds will differ, of course, but more of the same appears to be heading our way.
Minneapolis Fed president Narayana Kocherlakota's recent speech has unleashed a storm of criticism. The offending remark: "To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation."
The punditocracy has attacked this statement, and its implications, charging that the underlying economic logic is "unsupportable," "bizarre" and just plain "wrong," to cite but three dismal scientists.
Perhaps the bigger story is that Kocherlakota is suggesting that the Fed's current monetary policy is actually promoting deflation rather than trying to alleviate it. To be fair, there are some economists, such as Scott Sumner, who argue that the Fed isn't doing enough to provide monetary stimulus. Yes, nominal rates are just about zero, but the Fed can and should do more to minimize the risk of deflation. In other words, the Fed has moved in the right direction, but it hasn't gone far enough. But that's a completely different argument than Kocherlakota's point, which is that the current level of low interest rates will promote deflation. If that's true, then Bernanke and company are engaging in the biggest monetary mistake since the Great Depression.
In fact, the Fed is doing what it should be doing. It's fair to argue that it should be doing more with quantitative easing, even though the ammo is "running low." Kocherlakota's argument, however, is radically different. And maybe I'm going overboard, but taking Kocherlakota's assertion at face value all but indicts the Fed's current stance as reckless (assuming you think deflation would be a bad thing).
Why would the Minneapolis Fed president make such an assertion? Robert Waldmann at the Angry Bear has a theory:
My honest opinion is that he wants to argue for a higher target federal funds rate and he’s decided to present every argument that supports that proposal even if it is half baked, unbaked or negabaked (frozen ?).
Meantime, don't forget that Kocherlakota is an alternate member of the FOMC. In other words, Kocherlakota's thoughts are more than just academic ramblings.
Update: Sumner's post on the Kocherlakota affair offers a timely observation that highlights the macroeconomic stakes and the related challenge for the situation du jour:
...money is a specialized field and I just don’t have much confidence that our decision-makers or the media people who shape the discussion are on top of this issue. We need people who are “fussy” about definitions. Who understand why monetary policy does seem like “magic” to the uninitiated. Every single FOMC voter should have not only a PhD in economics but 20 years of research on monetary policy, monetary theory, and monetary history. Not one, not two, all three areas. It’s that important. (For instance, does Kocherlakota know that the Fed tried Rajan’s exact proposal in 1931, they raised rates by 200 basis points when the economy was weak and rates were very low?)
August 25, 2010
WAITING FOR GODOT...OR BERNANKE
The yield on the 10-year Treasury Note was under 2.5% this morning at one point—the lowest since early 2009 and down sharply from this past April's 4% range. Not surprisingly, inflation expectations are falling too. The market's outlook for inflation slipped below 1.5% yesterday for the decade ahead, based on the yield spread between the nominal and inflation-indexed 10-year Notes. The last time this inflation forecast was so low was July 2009.
Deflation is still a ways off—150 basis points, by the measure of 10-year-yield spreads. But it's not the level per se that's the key worry. Rather, it's the trend. For the last four months, the Treasury market has been telling us that inflation expectations have been falling. Maybe this rising anxiety is wrong. Maybe it's a bubble. Maybe the market's irrational and prices don't matter about the future. Maybe, but maybe not. Unless you're clairvoyant, the trend can't be ignored, at least not entirely.
Clearly, something's up (or down) with inflation expectations. The main reason to think twice before dismissing the market's outlook is that corroboration has been arriving in other economic measures for several months. Yesterday's dramatic fall in existing housing sales is the latest sign that the economic recovery is weakening.
In fact, the drop in home sales provides a timely lesson for divining the future with inflation. One catalyst for the slump in housing sales last month was the expiration for the home buyer tax credit. This one-time stimulus gave the market a boost, or so it seems, but the juice evaporated big time in July.
The lesson is that expectations are a critical factor when it comes to economic rebounds and related matters with prices. It's relatively easy to convince the crowd for a time to spend or to assume that prices will change in a given direction. But if the market thinks the stimulus will soon end, the effect is likely to do little more than borrow future consumption by moving it forward. In that case, today's higher consumption will be paid for with lower consumption tomorrow.
Something similar applies to inflation expectations. If you're trying to raise inflation expectations, or at least stabilize them, the effort must be credible. Quite a bit of economic research tells us no less. To be sure, there's "substantial disagreement" about inflation expectations, as a study from Stanford a few years ago reminds. On the other hand, it's also clear that inflation expectations in various forms provide a fairly reliable clue about the actual levels of future inflation, as shown in a chart from the study that's republished below.
Are inflation expectations always accurate? No, of course not. What's more, there's more than one way to measure the market's outlook on price trends. But given the broad economic backdrop of late, we should be reluctant to ignore the Treasury market's ongoing forecast of falling inflation. This decline isn't an isolated event.
The solution at the very least requires stabilizing the market's inflation forecast. Allowing it to continue falling would eventually lead us into dangerous territory with deflation. Yes, the risk of higher inflation—even runaway inflation—down the road is a threat, and one that we can't forget. And that challenge makes the Fed's job in the here and now all the more precarious. But unless you're willing to overlook the current economic slowdown, inflation isn't a clear and present danger today, nor is it likely to be a pressing concern for the foreseeable future.
If the Federal Reserve has any chance of stabilizing inflation expectations it must do so with a credible policy, which is to say a policy that the market takes seriously. As the housing market's sharp fall reminds, that's not so easy with one-time prescriptions that the crowd recognizes will soon fade from the scene. That suggests that the Fed needs to communicate with the market that it will move heaven and earth to keep inflation expectations from falling any further. Arguably those expectations should target headline inflation at a level that's higher than current ~1.5% outlook for the decade ahead.
Surely no one thinks the central bank should let the market's expectations for inflation fall to 1% or lower. At some point even the inflation hawks will concede this point. The danger is that when they do, it may be too late to arrest the current trend.
Fed chairman Ben Bernanke is scheduled to speak this Friday at Kansas City Fed's annual Jackson Hole conference. This is the next opportunity to lay the groundwork for stabilizing the market's inflation expectations. If not then, when?
Time is running out. The longer the market anticipates that the risk of deflation is rising, the harder it will be for the central bank to dissuade the crowd from this expectation. Remember, too, that it doesn't really matter what actual inflation was last month, or over the past year. The main priority is managing expectations.
The Fed still has enormous power over the market's outlook on general price trends. The question is whether the Fed will rise to the occasion. Don't hold your breath. Indeed, there's quite a bit of internal debate at the Fed these days, as The Wall Street Journal reported yesterday. The "deep divisions" about how to manage monetary policy is unfortunate, but it's reality. No wonder that the market continues to assume that inflation will fall.
Until (or if) the Fed acts convincingly to change expectations—or if economic reports turn sufficiently bullish in the weeks ahead—more of the same is coming: lower interest rates. Momentum is a powerful force in financial markets, just as inertia has been known to dominate central bank decisions at times. This seems to be one of those times.
August 24, 2010
EXISTING HOME SALES TAKE A DIVE
As widely expected, existing home sales fell sharply last month. The expiration of the federal government's home buyer tax credit was probably a factor. Whatever the reason, the news is unmistakably bearish for the housing market, with repercussions for the broader economy as well. As the National Association of Realtors (NAR) advised in a press release accompanying today's update: "Sales are at the lowest level since the total existing-home sales series launched in 1999, and single family sales – accounting for the bulk of transactions – are at the lowest level since May of 1995."
NAR's chief economist, Lawrence Yu, tried to put a positive spin on the dire numbers. “Consumers rationally jumped into the market before the deadline for the home buyer tax credit expired," he said via the press release. "Since May, after the deadline, contract signings have been notably lower and a pause period for home sales is likely to last through September. However, given the rock-bottom mortgage interest rates and historically high housing affordability conditions, the pace of a sales recovery could pick up quickly, provided the economy consistently adds jobs."
That's a lot of speculating about what could go right. What do other analysts outside the real estate world say? Here's a sampling of the chatter. Unsurprisingly, the pundits are quite grim...
►Sales of U.S. Existing Homes Fell in July to 3.83 Million Rate
"'This is a devastating reading on the U.S. housing market,'" said Derek Holt, an economist at Scotia Capital Inc. in Toronto. "'There’s such an inventory overhang, it shows there will be pressure on prices' in the months ahead. "
►Sales of existing U.S. homes fall 27%
Alejandro Lazo/LA Times
"'From our vantage point, the first-time home-buyers credit pulled forward demand -- by definition this is what stimulus measures achieve -- however the issue this time is that there was so little demand to be pulled forward, the credit has left no demand for the summer,' Dan Greenhaus, chief economic strategist for Miller Tabak + Co., wrote in a research note Tuesday morning. 'The result is exactly what we're seeing: a near, if not outright, collapse in housing.'"
►Plunging home sales could sink recovery
"'Home sales were eye-wateringly weak in July,' said economist Paul Dales of Capital Economics. 'It is becoming abundantly clear that the housing market is undermining the already faltering wider economic recovery. With an increasingly inevitable double-dip in housing prices yet to come, thing could get a lot worse.'"
►Home sales plunge 27 pct. to lowest in 15 years
"'The housing market is undermining the already faltering wider economic recovery,' said Paul Dales, U.S. economist with Capital Economics. 'With the increasingly inevitable double-dip in prices yet to come, things could yet get a lot worse.'"
HOW THE OTHER HALF THINKS ABOUT DEFLATION/INFLATION
The case for worrying about deflation, or at least continued disinflation, is fairly compelling, as we noted yesterday. But is deflation fate? No, at least not yet. Much depends on the Federal Reserve's actions in the weeks ahead. There's also the question of how the economy fares. Was the recent slowdown in economic momentum temporary--or the sign of something more ominious for the business cycle?
I'm increasingly persuaded that deflation is still a rising risk, even if it's not destiny at this point. If there was ever a moment to be worried about the D risk, this is it. But there are plenty of strategists who disagree, arguing that inflation and related hazards are the bigger problem. For those who take this view, the implied trade is selling and otherwise avoiding bonds—Treasuries in particular. Of course, that's been a losing trade this year, which is to say that the case for deflation has generally swayed the crowd. Is that simply evidence of irrational exuberance? Or is the fundamental argument for worrying about deflation based on solid ground?
There are no definitive answers in economics when it comes to the future, and so we'll simply have to wait for the incoming data to confirm or reject our analysis. Meantime, let's consider the counter argument to the deflation-is-coming crowd, which includes the Treasury market. What are the inflationistas thinking (or drinking)? For some perspective, here's a small sampling of recent analysis...
►Inflation, not deflation, Mr. Bernanke
"Inflation, not deflation, will dominate the global economy. The deflation scare causes the central banks in the developed economies to sustain a loose monetary policy. It will fuel inflation in emerging economies. Through trade, currency markets, and ultimately inflationary expectations, inflation will hit developed economies."
►Bernanke Must Raise Benchmark Rate 2 Points, Rajan Says
Scott Lanman and Simon Kennedy/Bloomberg
"Raghuram Rajan accurately warned central bankers in 2005 of a potential financial crisis if banks lost confidence in each other. Now the International Monetary Fund’s former chief economist says the Federal Reserve should consider raising rates, even as almost 10 percent of the U.S. workforce remains unemployed."
►The Fed Can Create Money, Not Confidence
George Melloan/Wall Street Journal
"Inflation—or stagflation—remains the more serious danger than deflation."
►A bull market in pessimism
But actual inflationary expectations may not have declined as much as bond markets imply. Inflation-linked bonds are less liquid than their nominal cousins. When investors rush to government debt, they pile into nominal bonds: that is what happened after the Federal Reserve marked down its economic outlook on August 10th and said it would reinvest maturing mortgage bonds in its portfolio into Treasuries. That extra demand squeezes the spread over inflation-linked bonds, bringing down the implied inflation rate…
America’s 12-month core-inflation rate, which excludes food and energy, has fallen from 2.7% in early 2007 to 0.9% in July, but it may be bottoming out. Most of that drop has been because of falling rents, and they now appear to be headed higher again as apartment vacancies start to drop. Core producer prices also rose faster than expected in July. The deep freeze in private borrowing has begun to thaw, too. On August 16th the Fed reported that banks had eased lending standards for small businesses; sales of junk bonds are rocketing.
►Why Quantitative Easing is Likely to Trigger a Collapse of the U.S. Dollar
John Hussman/Hussman Funds
"As one might infer from the content of this week's remarks, my view is that the quick initiation of quantitative easing by the Federal Reserve has significantly changed the prospects for foreign currencies and by extension, precious metals. For the past couple of months, I've observed that deflation risks in response to fresh economic weakness were likely to provoke weakness in the commodity area, even if long-term inflationary concerns were accurate. However, my impression is that the Fed's immediate initiation of quantitative easing may cause investors to take deflation concerns 'off the table.' This is important, because even as we observe economic deterioration, the potential for a "deflationary scare" is likely to be more muted than we might have expected without explicit quantitative easing actions."
►The Nemesis of Long-Term Yields Bottom
Shalom Hamou/Seeking Alpha
"I think that long term rates should soon be bottoming as the undervaluation of long term yield become unsustainable from an option valuation point of view…"
August 23, 2010
INFLATION EXPECTATIONS STILL FALLING
The summer is winding down and so too is the market's outlook for inflation. The 10-year forecast for inflation, based on the yield spread between nominal and inflation-indexed Treasuries, dipped under 1.6% last week—the lowest level in about a year.
That's a disturbing sign for a number of reasons, starting with the recognition that this is supposed to be an economic recovery. The recession technically ended last year, or so many economists opine. If so, inflationary pressures at the very least should be holding steady if not rising. And for a while, that was the trend. Through the end of this past April, inflation expectations were on the march, rising to roughly 2.45%, up from something approximating zero in late-2008, when the financial crisis was raging. But as the chart below reminds, something changed in May and the D risk was on the march once more. The recovery hit a wall of turbulence and the macro outlook has been suffering ever since.
The challenge was compounded earlier this month when the Federal Reserve disappointed the market with a tepid response to deflation's mounting momentum. Since the last FOMC meeting on August 10, the Treasury market's 10-year inflation forecast has fallen by nearly 20 basis points. If the Fed's last FOMC statement was designed to arrest the market's worries about deflation, the effort looks like a failure so far.
But talk is cheap. What of the central bank's actions? Is monetary policy reacting to the rising to the challenge of the D risk? Perhaps. Recent data on monetary aggregates suggest a change may be unfolding as we write. The monetary base (defined by MZM money stock) turned up recently after a period of decline. As the second chart below indicates, MZM has been rising in recent months.
So far, however, the increase in MZM hasn't reversed the year-over-year percentage change. As the next chart shows, MZM's annual pace is still negative, as it's been for most of this year.
No wonder that long Treasuries have been soaring in recent months. The threat of deflation has motivated the crowd to bid up prices on government bonds. The iShares Barclays 20+ Year Treas Bond (TLT), for instance, has climbed nearly 20% since late-April, roughly the start of the current worries over the D risk.
For investors, the burning question is whether the D trade has legs? There's lots of positive momentum to argue in the affirmative. But it'd be a mistake to assume that deflation is a done deal. Yes, the Fed has stumbled and let worries about future prices take a tumble. But the game isn't over. The central bank can still change the market's expectations, but it's going to be harder to gain traction and the clock is ticking. Remember, this is all about managing expectations. Let's not forget that the Fed could, if it was so inclined, push long rates much lower by printing money. There are some very good reasons for why Bernanke and company are reluctant to roll out the nuclear option. But events may be set to overwhelm otherwise cautious thinking on matters of monetary policy.
Meantime, there's quite a bit of risk embedded in the D risk trade, on both sides. It's getting harder to dismiss the possibility that inflation expectations will continue to shrink. At the same time, the easy money in going long government bonds may not be so easy if the Fed chooses to get tough with the deflationary momentum. Since no one is really sure how all this will play out, this is no time to bet the farm, one way or another. We're in uncharted territory. Invest accordingly.
August 18, 2010
A SHORT HOLIDAY...
The Capital Spectator will be MIA for a few days. Back on Monday, August 23.
READING ROUNDUP FOR WEDNESDAY: 8.18.2010
►The Great American Bond Bubble
Jeremy Siegel and Jeremy Schwartz/Wall Street Journal
Ten years ago we experienced the biggest bubble in U.S. stock market history—the Internet and technology mania that saw high-flying tech stocks selling at an excess of 100 times earnings. The aftermath was predictable: Most of these highfliers declined 80% or more, and the Nasdaq today sells at less than half the peak it reached a decade ago. A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds.
► China Reduces Holdings of Treasury Debt in June
China reduced its holdings of U.S. Treasury debt for a second straight month in June while the holdings of Japan and Britain rose...The debt figures are being closely watched at a time when the U.S. government is running up record annual deficits. A drop in foreign demand would lead to higher interest rates in the United States.
►China Hiding Treasury Purchases
Derek Scissors/Heritage Foundation
China’s reported holdings of U.S. Treasury bonds fell sharply again in June and are now almost $100 billion lower than they were in July 2009. The press reports this as meaningful and important. It isn’t. You may have noticed that American interest rates are not soaring; in fact, they’re at historic lows. One reason they’re not soaring is because, contrary to widespread assertions, American interest rates don’t depend on the PRC. The other reason is, over the same period, reported British holdings of U.S. Treasuries rose $265 billion. Why would the UK increase its holdings 273% in 11 months, when the yield on Treasuries is close to zero? The answer: China’s State Administration for Foreign Exchange (SAFE) has an office in London. When purchases are made through that office, they are initially counted as purchases from Britain, not China. SAFE’s goal is to reduce China’s visible dependence on the United States.
►China Doubles Korea Bond Holdings as Asia Switches From Dollar
Frances Yoon/Bloomberg News
China more than doubled South Korean debt holdings this year, spurring the notes’ longest rally in more than three years, as policy makers shifted part of the world’s largest foreign-exchange reserves out of dollars.
►We need more quantitative easing to create jobs
Roger Farmer/FT Economist Forum
Quantitative easing encourages the private sector to create more jobs. As yields on long term assets fall, some of that money moves into equity and newly capitalised firms expand and begin to hire workers. In light of a slowdown in the global recovery, quantitative easing is a programme that should be vastly expanded.
►Bank Of England Admits Being Surprised By Increased Inflation Rate
Staff/All Headline News
Bank of England Gov. Mervyn King admitted he was surprised by the strong inflation rate registered in July. Britain logged a 3.1 percent inflation rate last month, higher by more than 1 percent of the government target of 2 percent.
►Bank of England voted 8-1 for steady policy
The Bank of England's rate-setting Monetary Policy Committee earlier this month weighed the case for further easing of monetary policy as well as tightening before voting 8-1 to make no changes, according to minutes of the meeting released Wednesday.
►Fed’s Bullard Supports Asset Purchases If Inflation Falls Further
Jon Hilsenrath/WSJ's Real Time Economics
The Federal Reserve might need to commence a program of moderate purchases of U.S. Treasury bonds if inflation continues to fall, James Bullard, President of the Federal Reserve Bank of St. Louis, said in an interview with the Wall Street Journal.
Mr. Bullard has become a vocal proponent of asset purchases if the economy continues to weaken and inflation falls further, though the subject is still the source of vigorous internal debate at the Fed and it’s not clear whether it will take this step. At its August meeting, the Fed took a small step in that direction by deciding to reinvest proceeds from maturing mortgage backed securities into Treasury bonds.
“I thought we should be in a position to return to a quantitative easing program if we got further disinflation,” Mr. Bullard said. Quantitative easing is a term central bankers use to describe purchases of assets like Treasury or mortgage bonds by the central bank, which floods the financial system with cash and could help to drive down long-term interest rates and spur growth. Fed Chairman Ben Bernanke has referred to the Fed’s purchases in 2009 as credit easing.
THE ARITHMETIC OF DEFLATION: POSSIBLE BUT NOT PROBABLE?
The president of the Minneapolis Fed, Narayana Kocherlakota, explained in a speech yesterday how deflation is possible but unlikely. Near the end of his talk he provided the setup: "I mentioned earlier that inflation has been near 1 percent recently. These data have led some observers to worry about the possibility of a multiyear period of falling prices—that is, persistent deflation. I don’t see this possibility as likely. It would require the FOMC to make the surprising mistake of ignoring the long run in its desire to fix the short run."
He then went on to explain:
Here’s what I mean. It is conventional for central banks to attribute deflationary outcomes to temporary shortfalls in aggregate demand. Given that interpretation, central banks then respond to deflation by easing monetary policy in order to generate extra demand. Unfortunately, this conventional response leads to problems if followed for too long. The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation. Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.
Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.
To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.
That sounds easy—but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.
While this scenario is conceivable, I consider it to be a highly unlikely one...
August 17, 2010
THE LIQUIDITY FACTOR
In a new interview with Morningstar, Roger Ibbotson explains why liquidity (or the lack thereof, to be precise) should be considered a distinct risk factor in equity investing.
This is an intriguing idea that I analyzed in some detail in the June 2010 issue of The Beta Investment Report. From an investment perspective, the case for carving out liquidity as a separate beta looks compelling, based on Ibbotson's research. Why? Part of the answer is that the liquidity premium has a history of independence from the usual beta suspects, namely: the broad equity market factor, the small-cap factor and the value factor. In other words, stocks with relatively low liquidity are linked to a risk premium that's not driven by the Fama-French three-factor model.
The liquidity premium also seems to explain the mystery of why value stocks have historically earned a higher return than the broad market with lower volatility. As the June issue of the newsletter observed:
Decades of financial research advise that higher return arrives only by embracing higher risk. On its face, value stocks look like a breach of conventional finance theory. The implication: the equity market isn’t efficient and perhaps irrational as well. But parsing equity returns through the prism of liquidity suggests otherwise. To be precise, small-cap value harbors more risk—more liquidity risk.
Low-liquidity stocks exhibit lower volatility, but not because they're less risky. Instead, the low vol is directly related to the fact that they trade less often. In essence, this phenomenon can be summed up by the old Wall Street adage: "It takes volume to make prices move." In fact, studies over the years show this to be true, i.e., higher volume tends to be associated with a higher absolute change in price over time.
In an effort to isolate and capture the liquidity premium, Ibbotson and his firm Zebra Capital Management recently launched a pair of mutual funds in partnership with American Beacon Advisors. It's too soon to say if Ibbotson's research on liquidity has made a successful transition from research to the real world, although this strategy is worth monitoring.
Meantime, take a few minutes and listen to Ibbotson's commentary…
MID-AUGUST PERFORMANCE UPDATE FOR THE MAJOR ASSET CLASSES
Economic anxiety is taking a toll on risky assets so far in August. The mid-month summary for the major asset classes boils down to: bonds are up, stocks, REITs and commodities are down. High-yield fixed income has lost ground on a price basis as well this month through August 16, based on representative ETFs listed in the table below.
The net result is that the Global Market Index (GMI) has retreated by 0.8% month to date in August. GMI, the proprietary benchmark for The Beta Investment Report, is designed as a market-value weighted index of all the major asset classes. Over the long haul, this passive index of everything has done fairly well. That’s no surprise, for reasons I discuss in my book Dynamic Asset Allocation. For the 10 years through the end of last month, for instance, GMI has returned an annualized 4% vs. a slight loss for U.S. stocks (Russell 3000). (For additional perspective, see our latest monthly update of the major asset classes here.)
But in the short term, anything’s possible. This month, a broadly diversified portfolio is suffering, or so GMI’s modest decline suggests. More of the same is probably coming until the crowd receives a higher degree of clarity on the broad economic trend generally and one question in particular: Is a double-dip recession looming, or will the economy muddle through with subpar growth?
We’re still in the latter camp, as we have been all year. But that’s not written in stone, depending on the economic reports in the coming weeks. Indeed, it feels like we’re near closure, for good or ill, on the issue of what’s happening with the business cycle.
Back in January of this year, we were skeptical that the news of a surge in 2009’s Q4 GDP wouldn’t last. As we opined that month, there were still too many weights on the economy that threatened to keep growth low. That view still holds. If anything, the outlook has deteriorated.
Our optimism, if you will, is that we haven’t thrown in the towel yet on the question of subpar growth vs. outright GDP contraction. Much depends on how the next month or two plays out. That includes how the labor market fares through the autumn. Another key variable is the Federal Reserve. At the moment, we’re less than enthused with the central bank’s reaction to recent economic news, as we explained here and here, for instance. The Fed may not be able to keep growth positive at this late hour. But if it doesn’t try harder with more quantitative easing, the odds of a new tumble in GDP look considerably higher.
Even if you expect the economy to remain in a modest growth mode, as many economists predict, the outlook will still be rocky for the economy and for investing. For the moment, the age of diminished expectations is upon us.
August 16, 2010
A FUNDAMENTAL PROBLEM
Is the current wave of risk aversion a speculative affair? No, not at all. There are fundamental drivers that are creating new headwinds for the economic recovery. At the core of the problem is the decline in inflation expectations. In a number of posts back in May we wondered if the then-nascent warning signs were simply noise. Three months later, it's clear that the economy is struggling anew, and for reasons that won't quickly fade.
At the leading edge of this struggle is the downward revision in pricing pressure. Inflation will likely remain low for the foreseeable future, a new IMF study suggests, based on analyzing 25 periods of "large output gaps" throughout the developed world going back to the 1970s. In other words, when an economy's potential output is substantially higher than its current output, inflation is a dim threat for the near term. By most accounts, the U.S. economy's potential output significantly exceeds current production. Expecting this to change soon is expecting too much. That's not necessarily a recipe for disaster, but it's almost certainly a large challenge to robust growth that won't be resolved quickly. As such, the struggle and uncertainty of late will roll on for the rest of year and well into 2011.
That doesn't stop some analysts from arguing that the Federal Reserve should raise interest rates. Perhaps the leading voice for tightening is Thomas Hoenig, president of the Federal Reserve Bank of Kansas City and a voting member on the Fed's FOMC. Hoenig has been the lone dissenting vote on the FOMC for keeping Fed funds low. As Hoenig recently explained:
“In judging how we approach this recovery, it seems to me that we need to be careful not to repeat those policy patterns that followed the recessions of 1990-91 and 2001. If we again leave rates too low, too long, out of our uneasiness over the strength of the recovery and our intense desire to avoid recession at all costs, we are risking a repeat of past errors and the consequences they bring."
But the market disagrees. The inflation outlook (based on the yield spread between the 10-year nominal and inflation-indexed Treasuries) fell to 1.68% last Friday (Aug 13). That's the lowest since last summer. The market might be wrong, of course. Predictions are always risky because there's the possibility that new information could change the outlook. But there are strong reasons for taking the market's forecast seriously and expecting more of what's been unfolding recently to continue in the months ahead.
Indeed, the underlying cause for the falling outlook on inflation is the slowdown in the economy. The smoking gun that's first among equals is the continued sluggishness in the labor market. At the very least, it's hard to argue that the trend in job creation is improving, as last week's disappointing update on initial claims for new unemployment benefits suggests.
The weak labor market is creating headwinds throughout the economy, including the critical arena of lending. As a recent report from the Cleveland Fed shows, business loans are still falling and "the rapid pace of the decline is especially conspicuous when lending growth is compared across past recession-recovery cycles," as a chart from the study shows (see below).
The negative trend of late in the economy will continue to play itself out until a new catalyst intervenes. Ideally, the catalyst would be a large surge in job creation. But that's unlikely anytime soon. A more likely scenario is that at some point the market stabilizes as the crowd becomes comfortable with the new normal.
Meantime, it's a mistake to think that the falling inflation outlook is speculative. As the IMF study reminds, the falling inflation observed in 25 historical instances in past decades had a common denominator: "…weak labor markets and/or high unemployment and falling wage growth." That, of course, describes economic life in these United States today. The one bright spot, so to speak, is that in those 25 historical cases is "the observation that disinflationary pressures within episodes have tended to taper off at very low inflation rates."
In other words, outright deflation usually didn't arrive. Rather, very low inflation persisted in most instances. What might tip low inflation over into deflation proper? Tightening monetary policy could do it. In fact, some measures of the money supply are contracting on a year-over-year basis. MZM money stock, for instance, was lower by 1.5% in early August vs. a year ago. In fact, MZM's one-year percentage change has been negative since March, according to data from the St. Louis Fed (see chart below).
Quantitative easing may or may not be the solution now that nominal rates at just about zero. But it looks like we're still a long way from QE 2.0.
August 14, 2010
SATURDAY READING ROUNDUP: 8.14.2010
►Bank Loans: Still Contracting
Information from various sources suggests that the number of loans that banks are making to businesses continues to fall. The contraction appears to be driven by both supply and demand; banks are extending less credit, and businesses are asking for less. The restriction of credit may be one important factor that is constraining the current recovery, since businesses, especially small ones, rely on bank loans and access to credit to finance their operations, capital expenditures, and growth.
►In a sluggish economic summer, no easy fix ahead
"You can't force people to take out a loan or spend money that they don't want to spend," says Alice Rivlin, who served as the Fed's No. 2 official in the late 1990s.
►Dissenting KC Fed chief says interest rates too low for too long
The U.S. economy is recovering and the Federal Reserve needs to raise interest rates, lest it leave in place a policy that will only fuel future financial imbalances, Federal Reserve Bank of Kansas City President Thomas Hoenig said Friday.
►Economic Growth Prospects Dim in U.S. After Retail Sales, Trade Reports
Prospects for U.S. economic growth took a hit this week after reports showed the trade deficit swelled and consumers reined in spending.
►What Will Happen If the Fed Stops Paying Interest on Reserves?
Banks will try, ultimately unsuccessfully, to get rid of their reserves by exchanging them for T-bills and other safe, liquid, short-maturity assets.
►Beyond the zero lower bound on nominal interest rates
How can monetary policy overcome the zero lower bound on interest rates? This column explores the possibility of negative nominal interest rates, arguing that, for it to work, all reserve nations must agree to protect against using foreign currencies as an alternative means of exchange.
►US 'Virtually Certain' to Fall Into A New Recession: Rosenberg
The US economy is almost certainly headed back into a double dip recession, and economists aren't seeing it because they're using "the old rules of thumb" that don't apply this time, well-known economist David Rosenberg told CNBC.
►Economists in Philly Fed Survey More Pessimistic
A closely watched poll of economists conducted by the Federal Reserve Bank of Philadelphia saw analysts downgrade their estimates of future growth and hiring levels, as well as inflation rates, although the forecasters still put low odds on another contraction in growth.
►Deflation and negative TIPS yields
So really, negative TIPS yields can be taken as a sign that the markets are beginning to price in some brief dip into negative-inflation territory. They’re not a sign that the markets are expecting no deflation.
►Using Productivity Data to Understand Employment Trends
A slowdown in productivity growth is not usually good news, but the dip in U.S. productivity in the second quarter of 2010 may have a silver lining. The 0.9 percent decline in productivity, and the data that underlie it, appear to indicate that the stage is now set for employment growth in the second half of the year...On balance, then, labor market data show an abundant supply of reasonably priced, productive labor, and an exhaustion of reserves produced by recession-driven labor hoarding. The groundwork is laid for employment growth to improve later this year if--and it is still a big if--there is sufficient demand for the output that newly hired workers can produce.
August 13, 2010
A BIT OF GOOD NEWS IN RETAIL SALES, A.K.A. IT COULD HAVE BEEN WORSE
Retail sales posted a modest gain in July and consumer prices advanced as well, delivering some much-needed statistical counterpoints to the deflation-is-fate argument of late. But closer inspection of the numbers leaves plenty of room for debate about the economic outlook. Beggars, of course, can't be choosy and so the numbers du jour are welcome if not exactly cause for celebration.
Let’s start with consumer prices. The consumper price index (CPI) rose 0.3% on a seasonally adjusted basis last month. That's the highest pace since August 2009’s 0.4%. For the weekend, at least, it's harder to argue that deflation is upon us. The latest CPI reading translates into a 1.3% rise over the past year. That’s slightly higher than the previous reading, although the rolling 12-month rate of change for CPI still looks weak, as the chart below suggests.
After stripping away food and energy prices from CPI—leaving the so-called core rate of inflation that the Federal Reserve targets—the pricing trend looks considerably weaker. Indeed, core CPI rose a mere 0.1% last month, well below headline’s 0.3% gain. And for the past year, seasonally adjusted core CPI is up by just 1.0%--the lowest since the early 1960s.
It’s tempting to think that inflationary pressures have merely evaporated and that this is good news for the economy. Indeed, something close to stability on the pricing front is every central bank’s goal. But given the current profile of an economy that appears to be struggling to maintain growth, an unusually low level of core inflation raises questions about the potential for deflation if the economy weakens further in the months ahead.
Whatever concerns are suggested via today’s CPI report, anxiety is minimized somewhat by the news for July retail sales. Last month’s 0.4% jump reverses two straight months of declines. Much of the rise, however, is due to strong auto sales last month, which was reportedly driven by one-time incentives for buyers.
More importantly, the 12-month rolling pace of retail sales is still holding up, as the chart below shows. The annual pace of sales is sure to decline in coming months. Year-over-year comparisons look strong at the moment, but that's largely because last year's readings were unsually depressed. The question is how the trend fares from here on out. Much depends on the labor market, which for the moment is suffering from mediocre growth.
At best, July’s economic profile so far is mixed. Meantime, a fair amount of additional data for July is coming during the remainder of this month and so a complete reading is still up for grabs. For instance, next week brings updates on housing starts and industrial production, followed by July figures for durable goods orders the week after.
Meanwhile, retail sales offer a bit of optimism for thinking that the struggle for growth isn’t lost. It's hardly definitive, but it's all we've got for the moment. But after yesterday’s discouraging news on new jobless claims, it’s clear that the macroeconomic outlook is still cloudy.
One retail sales report certainly doesn't render the last several months of sluggish economic news irrelevant. "There is only one thing that's for sure -- economic momentum has slowed," Jennifer Lee, senior economist for BMO Capital Markets, told AP today.
But given the diminished expectations for the future, one could argue that today's numbers are a turn for the better, if only marginally and relative to pessimistic forecasts. "Consumers are still cautious, but it is not double-dip material," opined Stuart Hoffman, chief economist at PNC Financial Services Group, via Reuters.
Such is the realm of "good news" in the new normal.
August 12, 2010
NEW JOBLESS CLAIMS TREND HIGHER
For months, it was treading water. That was bad enough. But now it’s rising, raising fears that it could go higher still. Today’s update on weekly jobless claims shows that new filings for unemployment benefits rose to 484,000 last week—the highest since February.
On a weekly basis, the change was small—a gain of 2,000 on the week, albeit a rise over a modest upward revision in the previous week’s number. The bigger problem is the trend. As the chart below shows, there’s upward momentum where there was a sideways bias previously. Since bottoming at 427,000 weekly claims in mid-July, new filings have risen by 13% through last week.
In the grand scheme of this series, there’s still reason to wonder if it’s all still statistical noise. Weekly claims are a volatile beast and so next week's number could wipe away months of statistical misery. Yes, anything's possible. In addition, there’s quite a bit of precedent for these numbers to meander and even rise after the end of recessions, so we can't say we're in uncharted territory. But that’s all cold comfort given the recent deterioration in other economic metrics.
It’s been clear for several months now that the markets have been pricing in the risk of new economic weakness and today’s jobless claims report only throws more fuel on this fire. Granted, today’s update doesn’t materially change what we already knew and what we've been analyzing on these pages for months: the economy’s hit a rough patch. Still, it’s hardly encouraging to learn that initial jobless claims are inching higher. Ground zero in the economic problems is the spare level of net job creation, and for the moment the outlook is a touch darker than it was yesterday.
No wonder that risk aversion is the new new thing again. One clue is the sharp rise in the dollar yesterday while gold held its ground. The US Dollar Index gained a robust 1.6% on Wednesday while gold remained flat. As we discussed in May, the dollar and gold tend to move in opposite directions. That implies that when they’re both relatively strong, it’s a sign that risk aversion is on the march. True three months ago, true today.
More so at the moment, in fact. What we didn’t know in May was that the labor market recovery would continue to remain sluggish, labor productivity would fall and costs would rise, and the Fed would disappoint the markets at its August 11 FOMC meeting on the issue of raising the bar for fighting the deflationary winds.
You can argue that brighter days are coming, and that's almost certainly true if you look out far enough. But in the short run the case for optimism has fallen on hard times, and it's not obvious that the trend is set to undergo a miraculous change for the better any time soon.
GROWTH & DEBT, THE CHICKEN & THE EGG
Is high debt a drag on economic growth? Or is a recession born of other catalysts the source for high debt? Inquiring minds want to know.
A research paper by Carmen Reinhart (an economics professor at the University of Maryland) from earlier this year argued that high debt leads to low growth or worse. This study triggered a debate, which I discussed in May. Reinhart and Ken Rogoff of Harvard have responded to the brouhaha with a new update, but one critic is, well, still a critic.
Another skeptic of the notion that high debt impairs growth wrote:
...what I don't like about the analysis is that it only looks at the risk of adding to the deficit, it doesn't compare the risk posed by higher debt to the risk of doing nothing (or worse, contracting the deficit before the economy has recovered sufficiently).
Meanwhile, the Economic Policy Institute recently published a more detailed critique of the earlier Reinhart and Rogoff paper.
But no matter which side you're on, ignoring a huge mound of red ink on a nation's balance sheet requires a special kind of self delusion. "So while the general criticism, that there is no 'magic' level of debt-to-GDP, is a fair one," reminded The Economist's Buttonwood blog, "the Reinhart/Rogoff paper can't be dismissed so easily." Why? Buttonwood explained:
The best way of solving a high debt problem is economic growth. Clearly, however, countries have struggled to grow with a high debt level. So it seems best not to take the risk. As for the deficit/stock argument, governments with a high debt-to-GDP ratio will inevitably be paying a lot in interest payments; either these drive up the deficit or they would crowd out more useful forms of public spending such as roads or education.
August 11, 2010
A QUICK REVIEW OF TARGET DATE FUNDS...
I recently wrote a short take on TDFs for BankRate.com. The moral of the story: these products may harbor more risk than it appears. You can read the story here.
BETTER LIVING WITH DERIVATIVES?
Yes, it's possible. Unless the Dodd-Frank Wall Street Reform and Consumer Protection Act throws a wrench or two into the machine.
In any case, derivatives trading sometimes makes for strange bedfellows. As one family farmer explained today:
On the purchasing side, I also use derivatives to protect myself from swings in the cost of fertilizer, fuel and other staples. In the past two years, my nitrogen fertilizer has ranged from $435 to $685 per ton, and my fuel bills are giving me whiplash. While reading through the Dodd-Frank act these past few weeks, I’ve been wondering: Will the regulations on swaps make it more difficult for me to hedge against market swings in prices for crops and supplies?
According to the language of the law, sometime later this year it will become unlawful to enter into swaps “in excess of such amount as shall be fixed from time to time” by the Commodity Futures Trading Commission. But what will that amount be, and when will we find out? What is meant by “from time to time”?
Luckily, it looks as if the regulations are unlikely to intentionally restrict family farmers like me from trading futures. And the trading commission may carve out special protections for farmers in the next few months as the legislation goes into effect. But that doesn’t mean that I’m not worried about the act’s unintended consequences.
Update: If you're interested in learning more about Dodd-Frank, GrantThornton has a useful overview.
The Federal Reserve recognized that the economic recovery has slowed in recent months, according to the FOMC statement issued yesterday. The central bank also said that inflation has "trended lower in recent quarters" and that pricing pressures are likely to remain "subdued for some time." What will the Fed do to a) help keep deflationary pressures from gaining strength and b) bolster growth? Two things, according to the FOMC announcement. One, it will keep Fed funds at a zero-to-25-basis-point target rate for an "extended period." Two, it will invest the proceeds from its bloated mortgage and agency debt portfolio in longer-term Treasuries to help keep long rates low. The question, of course, is whether this will suffice to offset the downshift in economic momentum of recent months? No one really knows, but the argument that this is enough looks thin.
There are additional quantitative easing steps the Fed could embrace, including a more aggressive effort to lower long rates by "printing money" and buying long-dated Treasuries. It could also stop paying interest on bank reserves, or even charge banks a fee to keep reserves at the Fed. It's not clear how effective such actions would be, but those are tools at the central bank's disposal and it's premature to argue that they're ineffective.
In any case, the stock market certainly wasn't impressed with the Fed's statement yesterday. Equity investors initial reaction was more or less a yawn after reading the FOMC press release. The S&P 500 slipped by around 0.5% on Tuesday. By Scott Sumner's pre-emptive standard for what the Fed needed to accomplish, the crowd's early reaction was a disappointment. "In my view a stock market rise of 2% to 4% would be an indication that the Fed had done something significant, making a double dip recession considerably less likely," Sumner wrote a few days back. We didn't get anywhere near that in terms of an initial vote of confidence in stocks. Strike one.
What about changes in inflation expectations? That's a little better, but just barely. On Monday, the market's 10-year inflation outlook was 1.82%, based on the yield spread between the nominal and inflation-indexed 10-year Notes. A day later, after the Fed had spoken, the inflation outlook was higher by a thin 2 basis points, rising to 1.84%. As the chart below reminds, that's a disappointment too, given the decline in recent months.
Of course, not everyone's worried about deflation or the threat that the tenuous recovery will continue to weaken. There are still some who worry that inflation is a real and present danger now, today--and that the economy is poised to pick up a head of steam. Indeed, some who subscribe to this outlook are voting members of the FOMC, and so one could argue that yesterday's tepid response by the central bank to lean more heavily in favor of growth was a political compromise of sorts. A committee trying to design a horse ends up with a mule.
Maybe the problem is that the published economic numbers that I'm reading hide some emerging trend that favors expansion. Perhaps there are those on the FOMC who see what I can't: an imminent and robust rebound in the broad trend. If so, I wish they'd share their analysis in detail with the rest of us.
Unfortunately, the numbers, at best, speak of mediocrity in the trend, at least the numbers that are publicly available. At worst, it appears that the trend is deteriorating. As such, it doesn't take a great leap of faith to think that inflation and economic activity generally may continue to slow in the weeks and months ahead. Is this destiny? No, not yet, but neither is it beyond the pale.
If ever there was a case for more quantitative easing in an effort to elevate aggregate demand, the time is now. If not now, when? Under what conditions? Isn't the data sufficiently discouraging? Isn't the outlook convincingly soft? Or should we wait for even more discouraging numbers? Then again, if you're expecting salvation in the next round of numbers, the case for doing nothing, or even tightening, looks stronger.
Yes, there's a risk that the Fed may be laying the groundwork for higher inflation if it moves to the next level of monetary stimulus. Of course, that's the point, isn't it? We want higher inflation for the near-term future; we want higher prices, including a rise in nominal GDP. On that, we can all agree (maybe). The debate is over whether this state of affairs is fate via the current level of monetary policy. Or does the trend need additional help?
The full compliment of economic reports argues for the latter, or so it appears to this observer. Unfortunately, the Fed's degree of assistance is open to some debate. The current conditions are relativley unprecedented, and so to some extent we're knee-deep in a grand experiment.
But the numbers looking backward don't lie. For instance, one measure of the money supply is contracting (as defined by the annual percentage change in MZM money stock, calculated as M2 less small-denomination time deposits plus institutional money funds). As the second chart below shows, MZM shrunk by 2% in late July vs. a year earlier. Given the current economic climate, this trend looks inappropriate by more than a trivial amount.
What's the risk of trying to go to the next level of monetary stimulus? Unleashing runaway inflation in the years ahead is the worst-case scenario. Of course, the Fed knows how to control inflation by mopping up excess liquidity, assuming it has the discipline to act in a timely manner. That's not easy, but central banks weren't invented to be country clubs.
Then again, given the central bank's actions of late, we shouldn't assume that Bernanke and company has the stomach for a monetary battle on either the inflationary or deflationary fronts. It's always easier to split the difference and stand on the middle ground. But sometimes monetary policy requires something more. Arguably, this is one of those times.
August 10, 2010
IS THE STREAK IN HIGH LABOR PRODUCTIVITY HISTORY?
If you were looking for one more reason to wonder about the already shaky prospects for a recovery in the labor market, today’s report on second-quarter worker productivity is just the ticket.
Nonfarm business sector labor productivity unexpectedly dropped at a 0.9% annual rate for the three months through June, the U.S. Bureau of Labor Statistics reported today. That’s the lowest reading since the third quarter of 2008, the height of the financial crisis. That’s bad news for labor market. Why? Joshua Shapiro, chief U.S. economist at Maria Fiorini Ramirez Inc., explained via Bloomberg News today: "Slower growth in output will prompt companies to continue to focus on aggressive approaches to cost cutting. This will heighten obstacles to a convincing labor-market recovery."
No one really knows if we're entering a new era of lower productivity. Let's hope not, for the sake of the economy generally and the labor market in particular. But this much is clear: productivity does wax and wane through time and so the risk that productivity may be trending lower for an extended period isn't unprecedented.
For some perspective, consider a brief history of U.S. labor productivity as explained by Harvard economics professor Gregory Mankiw in his Principles of Economics textbook:
Productivity growth varies over time…Around 1973, the U.S. economy experienced a significant slowdown in productivity growth that lasted until 1995. The cause of the productivity slowdown is not well understood, but the link between productivity and real wages is exactly as standard theory predicts. The slowdown in productivity growth from 2.8 to 1.4 percent per year coincided with a slowdown in real wage growth from 2.8 to 1.2 percent per year.
Productivity growth picked up again around 1995, and many observers hailed the arrival of the "new economy." This productivity acceleration is most often attributed to the spread of computers and information technology. As theory predicts, growth in real wages picked up as well. From 1995 to 2006, productivity grew by 2.6 percent per year, and real wages grew by 2.5 percent per year.
The bottom line: Both theory and history confirm the close connection between productivity and real wages.
That's not an encouraging bit of history for the current climate, given the latest reading on productivity. Nonetheless, today's news of slumping productivity isn't fatal, at least not yet, explained The Atlantic's Daniel Indiviglio:
After five quarters of growth, worker productivity fell in the second quarter by 0.9%, according to the Bureau of Labor Statistics. Even though this news sounds bad, there might not be any reason to worry yet. Productivity can't grow as steeply as it has recently forever, so a decline was inevitable. Indeed, economists expected it to fall by 0.4%, so the reported decline was only a little lower. Yet it might have been better if unemployment had declined more before productivity began falling.
True, but there's another catch, as Indiviglio noted:
While productivity's decline isn't necessarily a cause for deep concern yet, the report also indicated that unit labor costs are increasing. That's not good. They rose by 0.2% in the second quarter, making for the first increase in a year.
Rising labor costs, falling productivity and sluggish job growth? That's a toxic combination if—if—it rolls on. The fundamental challenge now is making a convincing argument for why this toxic trio doesn't have legs. Any takers?
August 9, 2010
The Federal Open Market Committee meets tomorrow to discuss monetary policy at its regularly scheduled confab. No one expects a rate hike, of course, but the debate about how the central bank might do more with so-called quantitative easing has the crowd buzzing...
Disappointing growth and stubbornly high unemployment is likely to leave Fed officials with the important task of deciding whether to further bump the economy with a debt-buying program, said James Hughes, a market analyst with CMC Markets. "Whether this happens is still very much up in the air, but the reaction by the major markets could well be an aggressive one. Markets could see the move as a good sign of officials seeing the problem and acting before its too late. On the other hand, a further sign of a stuttering economy could well spook the markets in to a bigger fall for equity markets," said Hughes.
Treasury two-year yields approached an all-time low amid speculation that the Federal Reserve will resume bond purchases this week as it seeks to safeguard the U.S. economic recovery.
►Tim Duy's Fed Watch:
Incoming data give the Fed a green light to ease further. There is frequent chatter from unnamed sources that the Fed can do more and will consider more at this Tuesday's FOMC meeting. The public stance of Fed officials is recent weeks has tended to downplay the necessity for action at this juncture. This combination leaves the outcome of this week's FOMC meeting in doubt. My baseline expectation is that the FOMC statement acknowledges the weakness in recent data, but leaves the current policy stance intact. There is a nontrivial possibility that the Fed either implicitly or explicitly ends the policy of passive balance sheet contraction. I believe it very unlikely that the Fed sets in motion an expansion of the balance sheet.
The Fed should, and probably will change its tune by the fall and fire up the printing presses. Its current stance of watchful waiting in the face of slowing economic growth, inflation cycling below its preferred target rate of 1.7% to 2% and naggingly elevated unemployment strikes some observers as nothing short of mind-boggling. With good reason, these critics are pushing the Fed to adopt the deflation-fighting strategy that Bernanke mentioned in 2002, when he was a newly minted Fed governor. He suggested that the Fed could always buy long-term government bonds and corporate debt to mainline more liquidity into the financial system to counteract incipient deflation.
It goes without saying that rates will remain unchanged at 0.25%. What will be of particular note will be the tone of the language used in the statement especially after Friday’s weaker then expected payrolls data.
It will also be interesting to see if renowned hawk Thomas Hoenig drops his opposition with respect to the “extended period” language. This on its own would certainly give the market something to chew over and suggest that the Fed may well have the appetite to take further measures to stimulate the economy if data fails to improve.
Recent comments by St. Louis Fed President James Bullard at the end of July suggested that there are rumblings amongst Fed members for possible new programs of asset purchases in the event the economy continues to stumble.
The Fed will obviously acknowledge the weaker data since the last meeting in June, but they might view the last two months as a "pause" as opposed to a slowdown. In his recent testimony and his speech last week, Bernanke clearly felt the economy would continue to recover.
►Danske Bank via Pragmatic Capitalism:
Recently, speculation of further easing has intensified. However, we believe that it is premature for the Fed to announce new easing measures at the upcoming meeting. That said, it is quite certain that the assessment of the economic situation will be downgraded following a range of disappointing economic data. Hence, the Fed will continue to communicate that yields will remain exceptionally low for an extended period. It will be interesting to see if Plosser votes against the extended period language again. If not, it will be a dovish sign.
We don’t expect the Fed to launch any major balance sheet initiatives or alter the interest rate on reserves at this week’s FOMC meeting. Few of the operational options open to the Fed would have any substantive effect on financial market conditions, and the FOMC cannot afford to engage in empty symbolism. In the short run, the most important task facing the FOMC is to regain control of its core policy message. Monetary policy is already stimulative, and low but positive inflation rates are likely to allow the Fed to maintain an accommodative stance for as far as the eye can see.
THE DEBATE ABOUT DEMAND
There are economic recessions, and then there are economic RECESSIONS. The latest encounter with the dark side of the business cycle undoubtedly satisfies the later definition. The challenge, then, is figuring out how to convincingly promote growth on a sustainable, meaningful basis. Part of the solution requires deciding what went wrong, which suggests possible responses. On that analytical front, however, the standard advice from the dismal science these days is flawed, argued Nobel Prize winner Edmund Phelps in a New York Times op-ed last week.
"The diagnosis is that the economy is ‘constrained' by a deficiency of aggregate demand, the total demand for American goods and services," wrote Phelps, the author of Structural Slumps and the head of the Center on Capitalism and Society at Columbia University. "The officials’ prescription is to stimulate that demand, for as long as it takes, to facilitate the recovery of an otherwise undamaged economy — as if the task were to help an uninjured skater get up after a bad fall." But the "diagnosis is wrong" and the prescription will "fail," he warned. Phelps went on to explain:
There are no symptoms of deficient demand, like deflation, and no signs of anything like a huge liquidity shortage that could cause a deficiency. Rather, our economy is damaged by deep structural faults that no stimulus package will address — our skater has broken some bones and needs real attention.
For Phelps, there are deeper ills in the economy that aren't easily resolved (if at all) with the standard tools of monetary and/or fiscal stimulus. What does he recommend? His prescriptions include tax-code and regulatory changes that promote business; dispensing credits to companies for creating low-wage jobs; and setting up a program that extends loans for innovation in the private sector.
There's nothing wrong with these ideas per se. In fact, others policy gurus have promoted simliar themes. Former Treasury Secretaries Paul O'Neill and Robert Rubin, for intance, counseled recently that what this country needs most of all at this point is fundamental reform of the tax code.
But it'd be wrong to assume these prescriptions (and others like them) can replace monetary policy as the first, last and best policy tool for managing the economy. There's simply too much evidence that monetary policy is where the action is. Yes, even now--at the zero bound, when nominal short rates are virtually nil.
That doesn't mean that central banks are omnipotent, or that they don't make mistakes—they do, and sometimes big ones. In the grand scheme of money policy, the two main risks of ill-conceived and ill-timed decisions by the Fed and its counterparts around the world: elevating the odds of a slump or planting the seeds of higher inflation. And if the policy is truly flawed at a given point, the economy can suffer both simultaneously. History reminds that one or the other has afflicted the economy from time to time over the decades, and the monetary mistakes engineered by the Fed were almost surely a key reason. But monetary policy can also help, and by more than a little. Even now.
Let’s remember that Phelps won the Nobel Prize for Economics in 2006 for his analysis of the interaction of wages, unemployment and inflation. This might be called the standard view: wages and inflation are positively correlated, with one reinforcing the other until the labor market reaches equilibrium, a.k.a. the point where prices are stable. It's debatable how much influence the standard view has on current Fed policy decisions now, but it's safe to assume that it's a factor of some significance.
Inevitably, the details of the relationship between wages, unemployment and inflation are in a constant state of flux. This is economics, after all. Sometimes the changes are fairly mild and the stakes relatively low, as during the long stretch of low/falling inflation and unemployment—the Great Moderation, as it was called. A good tailwind that promotes positive outcomes never hurts. But that 20-year stretch of nirvana ended in 2008. Figuring out how to navigate the new paradigm that's upon us won't be easy.
In the frenzy to find a quick solution, there’s a temptation to throw out the old rules in the belief that new ideas will save us. But there are limits to reinventing the policy solutions writ large; there are also dangers. Monetary policy isn't a silver bullet, but arguably it's the first among equals in the realm of macroeconomic choices. All the more these days, when high debt levels impose political constraints on using additional fiscal levers to stimulate the economy.
Even now, with Fed funds just above zero, Bernanke and company could do more—much more—to juice growth and/or fight deflation. For instance, the Fed could buy large quantities of long Treasuries. The 10-year Note is currently around 3%. If the Fed was so inclined, it could push that yield to 2%, 1% or even lower by printing money. We can debate if that's necessary or prudent, or how much of a boost it'll provide; but it can be done.
Yes, the ideas of Phelps and others are worth considering (reconsidering) as well. The idea that there are structural impediments weighing on the economy can’t be dismissed. Economist Alex Tabarrok estimates that the high vacancy rate for U.S. housing (which undoubtedly is driven by high unemployment, among other factors) is due to partly (25%) to structural reasons. Another 25% is attributable to “sticky prices,” and 50% comes from weak aggregate demand, he opined recently at the Marginal Revolution blog.
Monetary policy, in other words, is still relevant. In fact, it’s wrong to think that the monetary tools are broken. A stronger criticism is that the Fed hasn’t used its tools as efficiently as it could have. The problem, in short, lies with human error rather than the monetary policy per se. That’s a critical distinction and one worth remembering as macroeconomic policy is reconsidered in the months and years ahead.
On that note, Paul Seabright’s The Company of Strangers: A Natural History of Economic Life offers some perspective (HT: Greg Mankiw’s Blog):
Politicians are in charge of the modern economy in much the same way as a sailor is in charge of a small boat in a storm. The consequences of their losing control completely may be catastrophic (as civil war and hyperinflation in parts of the former Soviet empire have recently reminded us), but even while they keep afloat, their influence over the course of events is tiny in comparison with that of the storm around them. We who are their passengers may focus our hopes and fears upon them, and express profound gratitude toward them if we reach harbor safely, but that is chiefly because it seems pointless to thank the storm.
August 8, 2010
TALKING ABOUT JOBS, GDP & RELATED TOPICS
The July jobs report was a mixed bag, as we discussed on Friday. What does the punditocracy think? A brief sampling...
"If we don't see significant job growth by the end of the year, the economy could be in serious trouble," said Bill Cheney, chief economist at John Hancock.
►San Francisco Chronicle:
"A double dip (recession) is not likely, but not out of the question," said Sung Wohn Sohn, an economics professor at California State University Channel Islands.
"A significant portion [of corporate spending] is going into equipment and software that are bolstering productivity as opposed to gearing up for expansion and job growth in the near term," said economist Lynn Reaser, president of the National Assn. for Business Economics, after analyzing government data on business spending.
The U.S. labor market’s “weak and faltering” recovery doesn’t imply the economy is sliding back into a recession and may instead reflect productivity gains, said Stanford University economist Robert Hall, who heads the National Bureau of Economic Research’s business-cycle dating committee. “So far, there has been no second dip,” Hall, whose group is tasked with marking the start and end of recessions, said in an interview.
Christina Romer, chairwoman of the Council of Economic Advisers said in a White House blog post cautioned not to read too much into any one month's job figures. "We have made substantial progress from the days when employment was declining by 750,000 a month," she said. "But, today’s employment report emphasizes just how important the additional jobs measures before Congress are. …There will likely be more bumps in the road ahead as the economy recovers."
►Investment Postcards From Cape Town:
My estimate of the July GDP-weighted PMI (manufacturing and non-manufacturing) of 52.5/53 fell short of the actual 54.58 as the ISM non-manufacturing PMI surprised on the upside. The latest GDP-weighted PMI is suggesting that US GDP growth in the third quarter could be running at approximately 3% on a year-ago basis compared to my previous estimate of 2% to 2.5%. Coming off a high base, the 3% year on year effectively entails that on a quarter-on-quarter annualised basis GDP growth in the third quarter has slowed to approximately 1% from 2.4% in the second quarter. Yep, the double dip pundits will have a field day despite a steady growing economy!
►The Wall Street Journal:
The discouraging jobs report sets the stage for intense debate at Tuesday's meeting of Federal Reserve policy makers about whether to do more to spur recovery. A key item on the agenda is likely to be whether the Fed should tweak its strategy for managing its $1.1-trillion portfolio of mortgage backed securities so holdings don't shrink in the months ahead. The weak jobs numbers -- evidence that the economy lacks strong growth momentum -- ensure that altering the portfolio strategy gets serious consideration though change isn't a certainty.
August 6, 2010
ANOTHER ROUND OF MIXED NEWS ON THE JOB FRONT
U.S. unemployment remained unchanged at 9.5% and nonfarm payrolls shrunk by 131,000 last month, the government reported this morning. That’s not good, but it’s not quite accurate either once you consider that July is lighter by 143,000 temporary census workers. If we focus on the private sector, nonfarm payrolls rose by 71,000 in July. That’s better, but it’s still well short of what’s needed to convince the crowd that the economy is on a sustainable path of growth worthy of the name.
But let's return to the headline number for a minute. Looking at nonfarm worker totals including government jobs—the standard definition that usually makes the headlines each month—shows a rather grim trend of late, as our chart below shows. For the last two months, job destruction has been deeply negative. Again, most if not all of the loss is due to cutting Census workers loose.
That inspires looking at the trend in non-government nonfarm payrolls of late, which is shown in the second graph below. Clearly, recent activity looks quite a bit better after stripping out the government factor. Payrolls have risen on a net basis for seven straight months. The labor market, in other words, is recovering. The problem is that the recovery has slowed sharply since the spring.
If you’re inclined to see the bright side, there’s an encouraging uptick for July, which posted a net gain of 71,000 private nonfarm payrolls, roughly double the gain in June. Unfortunately, that looks like statistical noise next to the fact that we’re a long way from April’s 241,000 rise.
"The job market has lost steam and remains lethargic," Sung Won Sohn, economics professor at Cal State University Channel Islands, told CNNMoney.com.
Nigel Gault, chief U.S. economist at IHS Global Insight, agrees. As he explained via Bloomberg News today: "To the extent that we have a labor market recovery, it’s a slow one. I don’t see anything to indicate that the third quarter will be better."
The downshift in momentum in the broader economy’s rebound has been obvious for several months and so today’s jobs report doesn’t really tell us anything new. As far back as May we noticed that it looked like risk aversion was rising in the markets. As it turned out, this was an early warning sign that the deflationary winds were blowing harder.
The question now is whether the D risk, having taken a bite out of asset prices and economic momentum over the past two months, is set to recede or rise? For the moment, you can argue either side with a fair amount of persuasion. The July numbers have only just begun to roll in; so far, the numbers are mixed. The ISM manufacturing and services indices suggest that these sectors continued expanding in July: the pace of growth slowed in manufacturing but inched higher for services. Meanwhile, we learned today that same-store retail sales for July rose a "tepid" 2.9%.
The bottom line: the debate about the economy is alive and kicking. Today’s employment report is vague enough to give bears and bulls ammunition to press their respective points. Next week’s light schedule for new economic reports isn’t likely to change anyone’s perspective (the main event: next Friday the government updates the numbers on consumer prices and retail sales for July). The vacuum of uncertainty, it seems, is set to roll on.
FRIDAY'S READING LIST: 8.6.2010
►Retailers don't see back-to-school boost, report spotty sales for July
Cautious consumers translated into spotty sales for national retailers in July, according to data released Thursday, potentially signaling a tough back-to-school season for the industry.
►German Industrial Production Unexpectedly Declines
Industrial production in Germany, Europe’s largest economy, unexpectedly declined in June led by a drop in investment goods such as machinery and trucks.
►2 Top Economists Differ Sharply on Risk of Deflation
When the latest unemployment figures are announced on Friday, all of Wall Street will be watching. But for Richard Berner of Morgan Stanley and Jan Hatzius of Goldman Sachs, the results will be more than just another marker in an avalanche of data.
►Christina Romer, Top Economic Adviser to Obama, to Step Down
Christina Romer, one of President Obama's top economic advisers, plans to step down effective Sept. 3.
►OECD composite leading indicators point to a possible peak in expansion
OECD composite leading indicators (CLIs) for June 2010 point to a possible peak in expansion. The CLI for the OECD area decreased by 0.1 point in June 2010. The CLIs for France, Italy, China and India all point to below trend growth in coming months, whilst the CLI for the United Kingdom points to a peak in the pace of expansion. Stronger signs of a peak in expansion have also emerged in Brazil and Canada, and in the United States the CLI has turned negative for the first time since February 2009. The CLIs for Japan and Russia point to future slowdowns in the pace of expansion but for Germany the CLI remains relatively robust.
►Annual inflation in OECD area falls to 1.5% in June 2010
Annual inflation in the OECD area1 fell to 1.5 % in the year to June 2010 compared with 2.0% in May amid a slowdown in energy price rises. Annual energy inflation slowed to 4.7% in June compared with 11.0% in May. Excluding food and energy, the annual inflation rate held steady at 1.3 % in June for the third consecutive month. Food prices rose by 0.6% in the year to June 2010 compared with 0.5% in May.
►Dogs that didn't bark
Remarkably, for a short period of the general global economic crisis, output was down across the whole of the world economy. This was a risky period for the global economy, which had grown and matured thanks to impressive growth in the volume of world trade, which was itself due in part to years of hard-won liberalisation in trade rules. When the global pie fails to grow, individual countries can only increase their consumption at the expense of others. Zero-sum thinking can take over, leading to mercantilist and protectionist policies.
►The Battle Over the Bush Tax Cuts
Congressional Democrats and Republicans will likely lock horns in the coming weeks over the fate of the 2001 Bush tax cuts. Divided largely along party lines, lawmakers are at odds about whether to extend or repeal more than $3 trillion in tax cuts, which are set to expire at the end of the year. Senior Fellow William Gale weighs in saying it's a complicated and thorny issue.
►When Labor Is Capital: The Limits of Keynesian Policy
In the United States, the economic mystery of 2010 is the persistence of high unemployment, in spite of the application of the stimulus treatment that follows the prescription of the prevailing Keynesian orthodoxy. I wish to offer an alternative to that orthodoxy.
►To spend or not to spend: Is that the main question?
The debate over fiscal policy has reached a fork in the road. One way leads to maintaining or increasing the fiscal stimulus. This column argues that policymakers should take the other path. This would mean phasing out government expenditure while phasing in social protection programs at the risk of a double-dip recession but potentially resulting in a more vibrant economy.
August 5, 2010
PONDERING PROGRESS IN THE MONEY GAME
Is money management getting any better? How would we know? I wrestle with these and related questions in a story just published in the August 2010 issue of Financial Advisor magazine: "Searching For Progress: Financial innovation is under fire. Failing to beat the market is only one reason."
MORE TROUBLE WITH WEEKLY JOBLESS CLAIMS
Today’s update on weekly jobless claims isn’t very encouraging for expecting a big positive surprise in tomorrow’s news on nonfarm payrolls for July. And that's the charitable interpretation. But judge for yourself: the latest number on new filings for unemployment benefits shows a rise of 19,000 last week, bringing the weekly total to 479,000—the highest since early April. The year is more than half over and still no sign of improvement in this metric. So much for a V recovery, at least as far as new jobless claims go.
Yes, this data series has a history of moving sideways and sometimes even rising after recessions, as we’ve discussed. But that’s cold comfort these days, when the labor market is struggling with it’s biggest challenge since the Great Depression. On a number of levels, the losses suffered in the job market are unprecedented since the 1930s. And as the weeks and months roll on without convincing signs of a rebound, it’s getting tougher to imagine that a revival of consequence is imminent. We can debate if the jobless claims trend of late is normal or not, but that doesn't change the fact that the longer this series goes nowhere, the greater the headwinds for growth. Translated: the labor market is, to put it mildly, a key factor in the business cycle, particulary in America where consumer spending is still the dominant slice of the economic pie.
The risk of a double-dip recession may still be slight, in terms of expecting GDP to post losses in the quarters ahead. But if the labor market continues to stagnate, it will feel like a new recession has arrived for the man on the street. Or, perhaps it’s more accurate to say that the old recession never really ended for the average American.
Indeed, today’s weekly unemployment-benefits report tells another troubling story with continuing claims, which tracks the number of unemployed workers who were already collecting jobless benefits. As the trend in this metric strongly suggests (see chart below), there’s no sign of progress here either.
No wonder that investors are rushing back into Treasuries this morning. Until the economic data signals a change in the trend, yields will inch lower, fears of deflation will continue to bubble, and the crowd will be increasingly open to arguments that the “new normal” has legs.
"Treasurys are certainly benefiting from fears that the jobs figure will be another nail in the coffin for the economy as the jobless claims number now implies downward risk to nonfarm payrolls tomorrow," Tom di Galoma at Guggenheim Partners, told MarketWatch.com today. Yes, there’s a counterargument to that view. But at this late date you need numbers to make such a case. For the moment, the necessary stats are MIA.
A BULL MARKET IN SAVING
Seth Fiegerman at MainStreet.com wonders if the U.S. is overdosing on savings. "Americans are getting better with their money, but in the process, we may be undermining the country’s financial recovery," he wrote yesterday.
The inspiration for taking a fresh look at the subject is this week's news from the Bureau of Economic Analysis that the personal savings rate was a relatively high 6.4% in June. That may not sound like much, but it's far above levels posted as recently as 2007, when Americans were socking away less than 2% of their personal income (see chart below). At the time, the extreme preference for consumption prompted worries that America would be overly reliant on foreign financing for the long run (a fear that's now widely accepted as fact and one that's not going to fade away soon). Explaining the country's spendthrift habit in 2007 was challenging in economic terms, leaving one study to label the trend a "puzzle."
But the tide has turned after the Great Recession and Americans have recently been saving the highest share of income in about 20 years, as the chart above shows. Is that good news? Perhaps, although it comes with caveats. As Fiegerman points out, the jump in the savings rate has prompted worries that the trend threatens the growth outlook for the U.S. economy, which is heavily dependent on consumer spending. He framed the challenge this way:
So now we’re faced with an odd dilemma: Should we abandon our good spending practices to help the economy? It’s a matter of what’s more important - your own financial well-being or America’s?
The reality is that individuals don't make spending decisions based on what's best for the country—shocking, isn't it? No one runs out to buy a TV or car because they think they're acting in the national interest. For most folks, consumption fulfills a personal need. A few years back, when disposable income levels were unusually high, or so it appeared, consumers were easily convinced that a trip to the mall was a reasonable choice. But that's harder to rationalize these days.
The reason is because need (or preference) alone isn't the only variable in the spending equation. Another shocking disclosure: the trend in income influences spending habits too. In fact, it probably dominates consumption habits in the long run. But on that score there's reason to wonder if the savings rate is set to stay high or even rise further.
As discussed earlier this week, the latest income and spending update from the government reported that both were unchanged in June vs. May—the "new normal," as some are calling it. A robust recovery in the labor market could intervene for the better, but so far the evidence in favor of salvation from job creation is unimpressive.
The other key factor, albeit a less direct one, that influences consumer spending is the housing market. For most Americans, a house represents the single-biggest financial transaction and so the price trend in residential real estate casts a long shadow on personal spending decisions. No wonder, then, that consumers are saving more in the wake of an extraordinarily steep decline in housing prices. That's a reversal of the long bull market in housing that ended in 2007. It's hardly surprising to learn that consumption was rising while residential real estate prices were climbing at a rapid rate. A relatively low unemployment rate bolstered the trend.
But that was then. Yes, the trend today is better than it was a year ago. For a time last year, housing prices overall in the U.S. were falling by nearly 20% on an annual basis, according to S&P/Case-Shiller Home Price Indices. Today, home prices are rising modestly again, albeit after a period of hefty losses. The change is encouraging if not yet convincing. The latest report for the national S&P/Case-Shiller Home Price Index indicates a roughly 5% rise in prices for the 12 months through this past May, as the second chart below shows.
Given the magnitude of the previous losses in housing, it'll take several years of recovery in residential real estate to be a net plus in terms of convincing consumers to spend more. There's still a glut of homes for sale, courtesy of the crushing losses in residential real estate in recent years. "There's too much supply for the demand that's there," Michael Feder, chief executive of the housing market research firm Radar Logic, told AP this week. "That's not a dynamic in which values go up."
That leaves the job market as the primary catalyst (for good or ill) for influencing consumption habits. By that standard, expecting the personal savings rate to remain elevated looks like a safe bet for the foreseeable future.
August 4, 2010
ADP EMPLOYMENT REPORT: A NET GAIN OF 42,000 JOBS IN JULY
The economy added a modest 42,000 nonfarm private jobs to payrolls in July on a net basis, according to today's ADP employment report. The good news is that this is the sixth consecutive monthly gain. The bad news, as the accompanying press release advised, is that those six months of gains "have averaged a modest 37,000, with no evidence of acceleration." Even an optimist has to concede that the pace so far in job creation has been tepid, at best. Unfortunately, it's easy to think that more of the same is on tap for the foreseeable future. As such, that raises the possibility that the labor market remains vulnerable to a setback.
"The further improvement does show some underlying momentum in hiring," Maxwell Clarke, chief U.S. economist at IDEAglobal, told Bloomberg News. Nonetheless, “we’re still on a rocky road,” he added.
Meantime, the consensus forecast for the government's July jobs report (scheduled for release this Friday) calls for a rise of more than 80,000 private nonfarm payrolls on a net basis, according to Briefing.com. That's better, but not enough to blow fears of the new normal. Of course, the possibility for a positive surprise of some magnitude keeps the bulls bubbling.
Technically, the labor market is improving. But the margin of safety between growth and contraction is still uncomfortably thin. Maybe Friday's update will tell us otherwise.
STILL WONDERING, WORRYING & DEBATING ABOUT DEFLATION
The market's outlook for inflation has been meandering just below 2% since late June, based on the yield spread between nominal and inflation-indexed 10-year Treasuries. The implication: the jury's still out on whether deflationary risks are the real deal or just a figment of the crowd's imagination.
As of yesterday, the Treasury market's 10-year forecast for inflation is 1.87%, down from around 2.45% in late-April. The good news is that we're still a long way from zero, which prevailed in late-2008 during the height of the financial crisis.
Despite the recent anxiety over deflation, one bond manager argues that the D risk still looks improbable, according to a story in yesterday's Wall Street Journal:
A senior fund manager at bond-fund giant Pacific Investment Management Co. said Tuesday it is "extremely unlikely" the U.S. could see Japan-like deflation given that the Federal Reserve has the tools to combat a downward spiral in consumer prices.
But Mihir Worah, who manages Newport Beach, Calif.-based Pimco's $17.87 billion Pimco Real Return Fund, admitted high unemployment and weak consumer spending—which the latest data show was flat in June—pose a risk to his outlook. His comments underscored a point made by Pimco's co-chief investment officer Bill Gross, who said recently "it's an uncertain world that's tipping toward deflation."
Unlikely or not, the demand for Treasuries is still strong, as you would expect if deflation threatens. Buyers at one point yesterday pushed the 2-year Note down to a record low of 51 basis points, according to MarketWatch.com.
In the long run, inflation is still a risk. But that doesn't preclude a bout of the opposite. The challenge is deciding if deflation truly is a real and present danger. Clearly, the risk is higher today than it was earlier this year. At the same time, it's premature to expect a broad-based, persistent decline in prices is destiny.
Scott Colbert, who oversees bond investments at Commerce Trust in Clayton, Missouri, tells reporter David Nicklaus that we can't afford to ignore deflation at this point: "It [deflation] has a higher probability than the new inflationary spiral that other people are talking about," argues Colbert. "There's no one right answer, but it is probably going to take some more monetary stimulus and more nontraditional measures to convince people that the Fed is not going to allow asset prices to fall."
In fact, there are bigger threats to focus on, opines Richard Robb, chief executive of Christofferson, Robb & Co. and professor of professional practice of international finance at Columbia’s School of International and Public Affairs. As he wrote on FT's Economists Forum earlier this week:
If you want to worry about something, I can recommend the US current account deficit. By continuing to run deficits equal to 5 per cent of GDP as the US has averaged over the past six years, in a generation it would transfer assets to foreigners that are equivalent to its entire stock market. A modest depreciation in the US dollar would only be enough to stimulate a J-curve making imports more expensive and having little effect on the deficit. The magnitude of the adjustment is likely to be far more disruptive than what little overall price instability seems to be in store.
Maybe, although it's hard to ignore the fact that a current voting member of the Federal Reserve's Federal Open Market Committee (the group that sets monetary policy) is openly worried about deflation, as he explained in a new research paper. That's a rare warning of the D risk from a central banker in the U.S. Of course, deflation is rare too. And since the Fed can prevent deflation if it's so inclined, it's not yet obvious that the general price trend is set to go negative. But that point raises a different set of questions: Is the Fed willing to engage in a new round of monetary stimulus by, say, purchasing more Treasuries at the long end of the curve? There's a fierce debate on when such actions might start, and if they should start at all.
Deflation may be looming, but not necessarily for economic reasons alone.
August 3, 2010
INCOME & SPENDING IN JUNE: GOING NOWHERE FAST
Today’s income and spending update for June was a whole lot of nothing. Literally. Disposable personal income and personal consumption expenditures were both flat last month vs. May. That’s not terribly surprising these days, but it’s hardly encouraging. Perhaps the best we can say is that it’s more of the same. Or, if you prefer, think of it as the latest installment on the new normal, which Pimco's Bill Gross defines as "deleveraging, reregulation and deglobalization, all of which promote slower economic growth and lower inflation in developed economies while substantially bypassing emerging market countries that have more favorable initial conditions."
The June spending and income numbers are a metaphor for the larger economic trend, which appears to be stuck in neutral, albeit with worries that it could deteriorate into something worse. “Consumers are still hunkered down,” Ryan Sweet, a senior economist at Moody’s Economy.com, told Bloomberg News before the report was released. “The second half of this year we’re going to see slower spending.” Now that we have the numbers in hand, there’s little reason to think otherwise.
Monthly data is statistically noisy, of course, which inspires looking at the longer-term trend. How does that stack up on income and spending? Better in the sense that the rolling 12-month changes on these two measures are above zero, which is more than you can say for the June numbers. But as the graph below shows, the annual pace of change with income and spending looks dangerously close to stagnating as well.
Meantime, saving is back in vogue, today’s report shows. According to the AP:
The personal savings rate rose to 6.4 percent of after-tax incomes in June, the highest reading in nearly a year. The savings rate is now about three times the 2.1 percent average for all of 2007, before the recession began.
While income growth was flat in June, incomes did post solid gains in April and May. But households chose to save the extra money rather than spend it. Higher savings restrain spending in the near term. But the extra resources allow households to repair their tattered balance sheets.
"It is of some comfort that households now appear to have something of a cushion that can be used to pay down debt or support spending," said Paul Dales, U.S. economist at Capital Economics.
What’s comforting for household balance sheets, however, may be more complicated when it comes to prospects for recovery with the business cycle. In a consumer-dependent economy a.k.a. the United States, higher savings has a tendency to translate into lower spending, all else equal. But looking further out, hope still springs eternal. "The rebound in the savings rate is encouraging," Mark Vitner, senior economist at Wells Fargo, explained via CNNMoney.com. "It means that spending is likely to rise more in line with income whenever it grows."
Perhaps, but the basic calculus between growth and spending still hovers over the big picture. As Joshua Shapiro, chief U.S. Economist at MFR Inc., explained via The Wall Street Journal:
It is important to understand that recent consumption gains have been substantially fueled by higher government transfer payments (a source of income that due to its nature is 100% spent) and by impetus from a short-lived bounce in home sales spurred by the now defunct homebuyer tax credit. Neither of these is a sustainable source of spending increases, which ultimately must be financed by private sector job growth and consequent gains in wages and salaries.
TUESDAY'S READING LIST: 8.3.2010
►Seven Faces of "The Peril"
James Bullard, president and CEO of the St. Louis Federal Reserve Bank: "In this paper I discuss the possibility that the U.S. economy may become enmeshed in a Japanese-style, deflationary outcome within the next several years…I emphasize two main conclusions: (1) The FOMC's extended period language may be increasing the probability of a Japanese-style outcome for the U.S., and (2) on balance, the U.S. quantitative easing program offers the best tool to avoid such an outcome."
►A few notes on the GDP revisions
Scott Sumner, professor of economics, Bentley University: "So now we know that the severe recession of 2008-09 began in the third quarter. Since Lehman didn’t fail until the quarter was almost over, there is simply no way it could explain why the recession got much worse during those summer months. What can explain the worsening recession? How about a Fed that refused to cut rates for nearly 6 months after April 2008, despite a steadily falling Wicksellian equilibrium interest rate. A Fed focusing on headline inflation numbers driven up by imported oil prices, not the expenditures on American-made goods and services."
►Stop Worrying About Structural Unemployment
Andy Harless, chief economist, Atlantic Asset Management: "If we’re looking for evidence of an increase in structural unemployment, we need to compare the rate at which openings fill today to the rate at which they filled in the past. When was the last time that there were this many job openings? In November 2008, there were 3.2 million openings but only 4.1 million hires. So job openings are filling faster now than then."
►Fed Mulls Symbolic Shift
Jon Hilsenrath, The Wall Street Journal: "Federal Reserve officials will consider a modest but symbolically important change in the management of their massive securities portfolio when they meet next week to ponder an economy that seems to be losing momentum."
►U.S. Banks Stronger, Still Need More Capital
International Monetary Fund: "The United States financial system is stable, but risks remain and implementing reforms recently signed into law is the next challenge, according to the IMF’s first detailed assessment of the world’s largest financial system."
►Welcome to the Recovery
Timothy Geithner, Secretary of the Treasury (via NY Times):
"We have a long way to go to address the fiscal trauma and damage across the country, and we will need to monitor the ups and downs in the economy month by month. The share of workers who have been unemployed for six months or more is at its highest level since 1948, when the data was first recorded, and we must do more to ensure that they have the skills they need to re-enter the 21st-century economy. Small businesses are still battling a tough climate. State and local governments are still hurting…We suffered a terrible blow, but we are coming back."
►U.S. Deflation Scare: 2003 Repeat?
BCA Research: "There are significant differences between the recent drop in inflation expecations and the 2003 scare: The previous recession was far milder than 2008-09 and was marked by a severe contraction in (non-financial) corporate profits rather than a housing bust and financial crisis. Nevertheless, then as now, the pace of growth seemed to be fading following the initial post-trough bounce."
►Fed Likely to Pass On More Stimulus Amid Signs Economy Weak
Craig Torres and Scott Lanman, Bloomberg News: "Federal Reserve policy makers signaled they will probably pass on providing more stimulus at their Aug. 10 meeting and wait to see if signs of weaker economic growth persist."
August 2, 2010
MANUFACTURING & JOBS: IMPERFECT TOGETHER
Today's ISM Manufacturing Index was a winner in the sense that it showed the goods-producing sector expanded for the 12th straight month. Growth is good, more so than ever at this critical juncture. The crowd certainly understands this. As the AP reported today via the LA Times: "Wall Street reacts favorably to the Institute for Supply Management report, the first major economic indicator for July, sending the Dow up 208 points." It's certainly good news, but does it fall short on the labor front?
U.S. manufacturing output has been climbing for decades, but without adding employees. Consider the Fed's Industrial Production Index. Predictably, it turns down during recessions, and took a hefty fall during the Great Recession; but the the long-run trend is bullish. Industrial production has been expanding for many years.
Now compare the upward bias in industrial production with the trend in U.S. goods-producing employment, as shown in the second graph below.
At best you can say that employment has been moving sideways—except lately. The Great Recession took a hefty bite out of goods-producing employment. But this corner of the labor market had been dropping well ahead of the latest economic contraction. There are many reasons for this, such as offshoring and increased use of technology in manufacturing. Meantime, we should be careful about expecting a robust manufacturing sector (if in fact that's what we have) to contribute much, if anything, to resolving the main challenge still weighing on the economy: a weak rebound in job creation.
JULY WAS HOT, BUT COOLER DAYS AHEAD ARE LIKELY
July was a great month for the major asset classes—prices rose across the board. It was the best calendar month overall for the markets since last November, the last time that all the broad measures of stocks, bonds, REITs and commodities posted gains in a single month. Indeed, the Global Market Index (a passive measure of all the major asset classes) rose 5.7% in July, its best month since May 2009.
REITs were the big winner, posting a 9.7% return in July. Equities weren’t far behind, particularly in foreign markets, in part because of the falling greenback. The 5.2% retreat in the U.S. Dollar Index (the biggest monthly decline in over a year) helped boost the dollar-based returns in stock markets in developed- and emerging-market nations overall. July’s rebound in stocks generally helped claw back a fair amount of the losses incurred after the previous two months of selling.
Is that the all-clear signal? Unlikely. The underlying economic worries that moved the crowd to sell in recent months haven’t gone away. A more plausible explanation is that the fading appetite for risk in May and June went a bit too far too fast.
Unfortunately, there’s still plenty of uncertainty about the macro outlook to keep volatility bubbling in the weeks and months ahead. The odds that everything is set to become hunky-dory is a long shot at this point, even for the most passionate optimist. The economic recovery continues to face numerous challenges, starting with the sluggish trend in job growth. Even so, it’s too early to throw in the towel and declare that all’s lost. The debate about how the Federal Reserve could ramp up monetary stimulus even at the zero bound is one reason to think twice before moving everything to cash and bonds (see, for instance, James Hamilton’s Options for monetary stimulus). Of course, for every positive there’s a negative to ponder these days, including the debate about what the Fed might do at this point, and when. As Paul Krugman writes today in his New York Times column:
It’s true that the Fed has already pushed one pedal to the metal: short-term interest rates, its usual policy tool, are near zero. Still, Ben Bernanke, the Fed chairman, has assured us that he has other options, like holding more mortgage-backed securities and promising to keep short-term rates low. And a large body of research suggests that the Fed could boost the economy by committing to an inflation target higher than 2 percent.
But the Fed hasn’t done any of these things. Instead, some officials are defining success down.
Meantime, there's the argument that relative valuations have moved in favor of stocks. The bulls say that equities are attractively valued next to bonds, which have posted a strong run so far this year. The Barclays U.S. Aggregate Bond Index is higher by 6.5% through July 31. U.S. equities, meanwhile, are more or less flat. And with the 10-year Treasury yield dipping below 3% last week while corporate earnings have recently soared to record highs, some strategists think it's time to raise equity allocations and cut back on bonds.
If your portfolio’s stock weight has dwindled sharply this year, there's something to that argument. But it's not yet obvious that macro salvation is at hand. This Friday's employment report is expected to show that nonfarm payrolls shrunk by nearly 90,000 last month, according to the consensus forecast via Briefing.com. If so, it’ll be harder to dismiss the argument that the labor market’s recovery is sputtering. Indeed, nonfarm payrolls slipped modestly in June and another month of the same would suggest this trend has legs.
In turn, a weak jobs report would fire up the deflation talk. Indeed, by some accounts, the risk is a real and present danger. Deflation isn't just a topic of intellectual curiosity, it's happening, Bill Gross of PIMCO, the giant bond shop, tells the Wall Street Journal.
So, yes, July’s surge in asset prices is welcome news, but it's shortsighted to think that a period of easy gains in everything has returned.