Downgrading Optimism

`In the wake of yesterday’s Federal Reserve press conference, at which Fed chairman Bernanke lowered growth expectations for the U.S., the Treasury market’s inflation outlook slipped to roughly the lowest level so far this year. Neither the Fed’s forecast for GDP or the latest inflation outlook was radically different, but the trend is worrisome. The implication is that while a recession isn’t imminent, the economy appears to be headed for a murky period of growth that’s sufficient to keep us out of a new cataclysm yet too slow to offer much in the way of repair and recovery.

Yesterday we learned that the Fed thinks the U.S. economy will grow by 2.7% for all of 2011, down from the previous 2.9% estimate. That’s in line with downgrades from other predictions, including the IMF’s recent forecast. We also learned yesterday that there are no immediate plans to launch a new round of monetary stimulus to follow QE2, which is scheduled to expire this month. Meanwhile, Bernanke admitted he and his colleagues at the central bank were somewhat perplexed by the slowing economy of late. As he explained,

We don’t have a precise read on why this slower pace of growth is persisting. Some of the headwinds that have been concerning us, like the weakness in the financial sector, problems in the housing sector, balance sheet and deleveraging issues, may be stronger and more persistent than we thought.

The sight of the slow but steady decline in the market’s implied inflation outlook isn’t helping. It’s premature to draw any hard and fast conclusions here, but the slow drip downward over the last two months implies more trouble ahead, if only on the margins. Using the yield spread between the 10-year nominal and inflation indexed Treasuries as rough guide, the market’s inflation prediction touched 2.19% yesterday, as the chart below shows. The optimistic view is that this is merely a rate that’s unchanged from levels in late-2010. Fair enough. But it’s the trend that’s distressing. Falling inflation expectations are not helpful at this point, especially at these levels under current macro conditions. Some hard line inflation hawks argue otherwise, but the numbers aren’t on their side.

For an economy that appears to be struggling anew, a slow but sustained decline in the inflation outlook isn’t healthy and it may signal even tougher days are coming. Granted, if this outlook stabilizes in the low-2% range, that would be productive. But it’s not obvious that this is the case, at least not yet.
Yes, the latest consumer price inflation report was mixed, with a hint of pricing pressures on the march. But this is a backward-looking number vs. the Treasury market’s forward-looking forecast. One or the other is misleading us, but we don’t know which one. In due course, however, we will have clarity, and perhaps soon.
Meantime, what is conspicious is that the economy continues to suffer from deleveraging on a number of fronts. “We can expect a continuation of deleveraging for many years to come,” warns Comstock Partners. The firm goes on to explain,

The U.S. stock market will not be able to rise in a sustained manner if we are correct in believing that U.S. households will continue deleveraging for the next few years to as many as 10 more years. The key is that household debt will have to decline to the levels of the 1950s, 1960s, and 1970s of 50% of GDP and 65% of PDI. That would mean the weak consumption will continue and that should lead to disappointing economic growth. The average annual growth in consumption over the last 50 years was about 3.5%, but only 0.6% over the seven quarters since the recovery started. That is the lowest growth rate since the Great Depression.

That’s a pessimistic outlook, although it’s not so easily dismissed, even after two years of a formal post-recession recovery. Apparently the Treasury market isn’t inclined to disagree that the glass is half empty. The demand for money, in other words, is still quite strong. In fact, it’s strong enough to inspire purchasing Treasuries at unusually low yields despite recent signs that headline inflation is inching higher. Normally, a CPI report showing inflation moving higher would inspire selling bonds, which would raise yields. But these still aren’t normal times. The fact that money is still flowing into Treasuries, despite the approaching end of QE2, is a reminder that the macro outlook is muddled, at best.
The hope is that the current slowdown is temporary, triggered by various blowbacks of late. Bernanke offered some support for that view in his comments yesterday. But no one’s really sure how this all plays out, particularly over the next few months. But with hefty deleveraging still unfolding, the implications for what’s coming don’t look particularly mysterious. Or is it different this time with the painful work of deleveraging? Don’t count on it, as Reinhart and Rogoff warn.
In any case, the future will continue to arrive one data point at a time. The next clue, which is a critical one, appears later this morning via the weekly update on initial jobless claims. At issue is whether the recent surge in claims was a one-time event or the start of something more ominous. Last week’s report offers reason for cautious optimism. Let’s see what today’s number brings.