Weekly Commentary by Dr. Scott Brown
Looking Ahead To 2009
December 15 – December 19, 2008
The year 2008 was a tough year for the economy and a punishing year for investors. Looking back, it seems like a bad dream. Who could have imagined all the major institutions that have failed, been bought out, or were taken over by the government? We appear to be in the worst recession in more than a quarter century. Indeed, the current downturn has already exceeded the average length of recessions experienced since World War II. There’s hope for improvement in 2009, but the economic outlook is very much uncertain.
It’s often said that economic forecasters were put on Earth to make weather forecasters look good. The science of economic forecasting is well-advanced, just as it is in weather forecasting. However, the nature of the problem is a lot more difficult. There are simply too many interactions and the rules are constantly changing.
Psychology plays a large part. In past episodes, we worried that recessions might be a self-fulfilling prophecy. Fearful about the future, consumers retrench. The reduction in spending is a loss of someone else’s income. Businesses, worried about a lack of future demand for their products, would be less inclined to make capital expenditures. A chain reaction then ripples across the economy. However, it’s often unclear why some periods of softness turn out to be temporary, while others develop into something more serious.
Clearly, it’s not just perceptions about the future that influence growth. The economy is largely driven by credit. No loan growth, no economic growth – that was the lesson of Japan’s lost decade. The collapse of the housing bubble and the ensuing problems in the credit market have been the major factors in the current downturn. Normally, the Fed can move to counter tighter credit. Yet, as we saw during the 1990-91 recession, it often takes some time before the credit markets begin to turn around. In comparison, the current difficulties are large compared to the real estate hangover in the early 1990s. It will likely take a lot longer to get back to normal. However, policy efforts have been significant and more efforts are expected in early 2009. Treasury has worked to recapitalize the banking system. However, banks may still be reluctant to make loans even if they have the capacity.
The current situation differs from previous episodes in the collapse of the shadow banking system. Bank lending has been well regulated and mortgage problems were not a devastating issue directly. However, there had been a growing market for debt outside of the banking industry. Auto loans, student loans, mortgage loans, small business loans, and so on, were securitized and sold to investors. The market for these securities has collapsed completely in the last few months. Securitization has been an important source of credit for the economy. Without it, there will be fewer loans available. The Fed has stepped in to fill the gap, temporarily buying large amounts of agency debt, mortgage-backed securities, and asset-backed securities. These purchases aren’t meant to be an ongoing Fed function. The Fed will have to back out of these markets at some point, and that could prove to be difficult. However, by not participating, the Fed would risk a deeper and longer-lasting downturn.
Big problems require big solutions. The Fed is likely to announce further efforts to unfreeze the credit markets in 2009. Foreign central banks are likely to make similar moves. At this point, few investors seem willing to take credit market risk. Last week, the Treasury auctioned off 4-week bills at 0% and 13-week bills at 0.005%. Bill yields fell below 0% in market trade. Some of this extreme risk aversion may be due to the calendar. If so, risk taking should begin to return in 2009. If not, the Fed will have to do a lot more.
It’s worth pointing out that this is a global recession. We aren’t alone in these troubles and how different countries respond will dictate how they recover. In past recessions, the U.S. has benefited from stronger growth abroad (which helps our exports). However, we’re all on the same page now. The dollar benefited in 2008 from the perception that as bad as the economy is in the U.S., it will likely be worse elsewhere. U.S. policymakers are typically quicker to respond to problems and policy efforts tend to be more significant. That isn’t always the case, of course. Indeed, in shifting TARP funds to recapitalize the banks, Treasury was simply following the lead of the U.K. The U.S. economy is also more flexible. It’s easy to fire workers here (as we see all too clearly in the current situation), but that means that firms will be more able to hire new workers when things eventually pick up (although that could be many months away).
Currently, we seem to be in the chain reaction phase of the downturn. Thus, it’s difficult to say how severe the current downturn will be and when the economy will bottom out. A lot depends on the credit market, but Fed efforts to fill in for private-sector shortfalls in the supply of credit should pay off at some point.
In any downturn, the Fed should do the heavy lifting. However, massive fiscal stimulus will also arrive in 2009. As with the Fed’s quantitative easings, fiscal policy efforts aren’t going to be permanent and some care will be needed to keep an eye on long-term goals (such as deficit reduction). With a little luck, these efforts should help support economic growth by the second half of the year. A full economic recovery will take a bit longer.
Fed Policy Outlook – New Territory
December 8 – December 12, 2008
Federal Reserve officials meet next week to set monetary policy. With the Fed funds target rate currently at 1.00%, policymakers are running out of room to cut. There’s no point in the Fed “saving its ammunition.” However, the Fed may be reluctant to take the target all the way to zero. At next week’s meeting, or perhaps not too far after, the Fed is likely to lay the groundwork for quantitative easing. This is new territory for the Fed.
The Federal Open Market Committee began the current easing cycle in September 2007, when the Fed funds target rate was 5.25% – not especially high by historical standards. The Fed cut rates by 100 basis points by the end of last year and another 225 basis points by the spring. According to Fed Chairman Bernanke, “by way of historical comparison, this policy response stands out as exceptionally rapid and proactive.” However, financial instability increased in September and the FOMC cut by another 100 basis points in October (the October 8 move was an unprecedented coordinated cut with five other central banks). With inflation looking like a credible threat, some criticized the Fed’s rate cuts. However, in hindsight, the Fed’s action seems well-timed. Inflation did advance into the summer months, but has begun retreating, due largely to falling energy prices.
Since October, the effective Fed funds rate has averaged 0.39% – well below the 1% target rate. This begs the question, would another 50 basis points taken off the Fed funds target rate qualify as an ease?
There may be some good reasons not to cut the target rate to zero. The Fed began paying interest on reserves in October (currently equal to the Fed funds target rate). Theoretically, the change was supposed to help set a floor on the actual funds rate. However, that hasn’t been the case. One factor, according to Fed Chairman Bernanke, is that some large suppliers of funds, such as Fannie Mae and Freddie Mac, are not eligible to receive interest on reserves and are willing to lend overnight federal funds at rates below the target.
According to the October 30-31 FOMC meeting minutes, some FOMC members argued that the Fed “had limited room to lower its federal funds rate target further and should therefore consider moving slowly.” However, other Fed officials felt that “the possibility of reduced policy effectiveness and the limited scope for reducing the target further were reasons for a more aggressive policy adjustment; an easing of policy should contribute to a beneficial reduction in some borrowing costs, even if a given rate reduction currently would elicit a smaller effect than in more typical circumstances, and more aggressive easing should reduce the odds of a deflationary outcome.” In other words, when you’re in a war, there’s not point in keeping your powder dry.
Still, the Fed is running out of room to cut. Nominal interest rates cannot fall below zero. However, as Fed Chairman Bernanke has indicated, “there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions.” One of these is quantitative easing.
Quantitative easing is not a well-defined term. In traditional monetary policy, the central bank controls credit through the price of credit (the interest rate). In a quantitative easing, the focus is on the quantity of credit. According to Bernanke, “the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities,” with the hope of influencing their yields, “thus helping to spur aggregate demand.” The Fed’s decision (announced on November 25) to buy up to $100 billion in GSE debt and up $500 billion in GSE mortgage-backed securities falls under that category. Last week, Bernanke said that “it is encouraging that the announcement of that action was met by a fall in mortgage interest rates.”
Over the last year, the Fed has made significant efforts to improve liquidity and to shore up specific segments of the credit markets, such as commercial paper and asset-backed securities. These may be loosely considered to be forms of quantitative easing.
Looking back on this year, the Fed has done a lot to resolve the current financial crisis. The fact that credit conditions have not improved much does not mean these steps were in vain. Rather, conditions would likely have been worse if the Fed hadn’t acted. In addition, it takes some time for these efforts to have a full impact. More efforts are likely to be made in 2009. Big problems require big solutions, and the Fed will deliver them.
Deflation, Inflation, the Fed, and the Gov’t
November 24 – December 5, 2008
Minutes of the October 28-29 policy meeting showed that some Fed officials were worried about deflation. On the other hand, a number of financial market observers have worried that, through expansionary policies, the Fed and the government may be fueling future inflation. Why is deflation a worry, and what can the Fed do about it? Looking further ahead, what is the risk of renewed inflation when the economy eventually recovers?
Deflation refers to a general decline in the price level of goods and services (as opposed to disinflation, which is a decline in the inflation rate). There is big difference between short-term deflation (a brief decline in prices) and long-term deflation (a sustained rate of decline in the overall price level). The U.S. economy has experienced deflation in the past, but not in a very long time. When we speak of “deflation,” we are usually talking about the long-term variety, such as occurred in Japan in the 1990s or in the Great Depression. Currently, the deflation we see appears to be the short-term variety, fed by an unwinding of the prices of energy and other commodities. Nevertheless, there is fear that the weakening global economy could generate a more severe and longer-lasting decline in the price level. The odds of a more significant deflation are still low, but are somewhat higher than a few months ago.
Why is deflation a bad thing? In deflation, consumers are better off postponing purchases. Why should I buy now, when what I want will be cheaper in a month or two? Hence, consumer spending will be a lot weaker. Borrowers will have to pay back loans in dollars that are worth more than what was borrowed, so they become reluctant to borrow. Returns on business investment will be in lower-valued dollars. Hence, firms will be reluctant to expand. Overall growth will be weaker – and weak growth will help push prices down further – leading to a deflationary spiral.
The Fed faces a major problem in fighting deflation. It cannot lower rates below 0%. There is no scope for traditional monetary policy to stimulate the economy. What can the Fed do? Milton Friedman suggested that the monetary authority could simply drop money from a helicopter. More realistically, the Fed can bypass credit intermediaries and lend directly to consumers and businesses. Such quantitative easing is already being done to some extent at the Fed. For example, through the Commercial Paper Funding Facility (CPFF), the Fed purchases unsecured and asset-backed commercial paper directly from eligible issuers. At some point, the Fed could purchase Treasury securities, mortgage backed securities, or even corporate bonds.
The government can also assist in fighting deflation though stimulus efforts. John Maynard Keynes jokingly suggested that the Treasury could place money in old bottles and bury them in disused coal mines, leaving it to private enterprise to dig them up. Realistically, more thoughtfully planned stimulus would be effective in boosting overall growth to the point where deflation is no longer a problem. Spending on the transportation sector, such as the repair of roads and bridges, would take some time to implement. Tax cuts are another form of fiscal stimulus. Barack Obama promised lower taxes for the middle class, and these are likely to be pushed through quickly by the new administration and Congress.
This raises the question of whether monetary and fiscal stimulus will eventually lead to higher inflation when the economy recovers. That’s not a big worry. There is currently plenty of slack in the global economy and it will be some time before we see inflation fueled by strains on resource utilization. Commodity prices are retreating and there’s no inflation coming out of the labor market. The money supply has increased rapidly, but the velocity, or turnover, of money has decreased. Should a miracle occur, and the economy recovery more rapidly than anyone expects, the Fed can begin to remove its monetary policy accommodation. The government can scale back as well – in fact, other than the middle class tax cuts, most government stimulus efforts will be designed to have a limited shelf life (the idea is to get the economy through a tough patch, prime the pump, but not create permanent make-work projects.
While serious deflation is a low risk, it is a possibility. The bigger worry is the slowdown in global growth. Efforts to support economic growth through monetary and government efforts will continue both here and abroad. These efforts should support growth by the end of the year. However, the global economy remains in panic mode for the near term. Things will get worse before they get better, but they will get better.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
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