Weekly Commentary by Dr. Scott BrownThe “Twin” Deficits, Once Again
November 16 – 20, 2009
The federal budget deficit and the trade deficit are often referred to as the “twin” deficits. They’re not twins exactly, but they are related. The current account deficit, the widest measure of the trade gap, was cut in half in the recession, but now appears to be widening again. The federal budget deficit reached a record in FY09. The two deficits will play an important role in the economic recovery and the trade imbalance may become a bigger long-term problem for the U.S.
The current account deficit rose to a record $215 billion in 3Q06, over 6% of Gross Domestic Product, or $2.35 billion per day. The net trade dollar outflows don’t just sit there. They come back as net capital inflows and perhaps in weaker form (the net trade outflows match the net capital inflows and the dollar moves to equate the two). The current account deficit narrowed sharply in the recession, falling below 3% of GDP, as global trade collapsed. The good news is that the global economy is recovering, and along with it, world trade. The bad news is that the current account deficit is widening again. The 3Q09 current account data won’t officially be reported until December 16, but we have initial estimates of the trade deficit in goods and services for 3Q09, which is most of the picture.
The dollar has been weakening over the last several years and the current account deficit has likely played a big part in that. A rising current account deficit means that net capital flows must rise accordingly to keep the dollar stable. The drop in the current account deficit over the last several quarters means that smaller net capital flows are required. Data available through the second quarter show that net capital inflows also fell sharply in the recession. However, there was some increase in the demand for dollars through the Fed’s swap lines with other central banks (effectively, troubled assets abroad were denominated in U.S. dollars, and efforts to defuse the situation contributed to an increase in the demand for dollars).
Another way to think about the net capital surplus (and in turn, the current account deficit) is the difference between national borrowing and national savings. The U.S. does not save enough or tax itself enough to fund business investment and the government. It relies on borrowing from the rest of the world. There’s nothing inherently wrong with this. It’s like borrowing money from a bank. The questions are, are you using the borrowed funds appropriately, are you able to make payments, and is the lender willing to roll over existing debt? In taking a personal loan from a bank, it’s a lot different if you use the money for a vacation as opposed to a college education. In the late 1990s, the U.S. had a rapid pace of business fixed investment, and those investments (mostly technology) paid off in the form of increased productivity. We were better able to service external debt. In recent years, the U.S. has borrowed money to fund war efforts in Iraq and Afghanistan and the Medicare prescription drug program, and to cut taxes.
The federal government ran a $1.417 trillion deficit in FY09, although the national debt rose by $1.885 trillion (the difference is that more money flowed into Medicare and Social Security trust funds than was paid out). Less than half of the $787 billion fiscal stimulus appeared in the FY09 deficit. The bulk of the increase was due to the recession and the financial rescue. Still, half of the fiscal stimulus will show up in FY10. Furthermore, under existing law, the budget deficit is expected to settle into a range of 3% to 3.5% of GDP after the economy has recovered and the temporary spending has faded.
Campaigning for office, Barack Obama placed a strong emphasis on deficit reduction, but once in the White House, the depth and severity of the recession forced him to place that on the back burner. The last thing you want to do in a recession, or fragile recovery as the case may be, is to raise taxes, but taxes will have to be raised eventually to address the budget situation.
The Young And The Restless
November 9 – 13, 2009
The economic data have been mixed in recent weeks. That’s something that typically happens in the early stages of a recovery, but it’s a big problem for the stock market. In equities, it’s all or nothing. Either the economy is booming or it’s falling apart completely. There’s no middle ground – but that’s where we are now. We did learn a few new things last week about the state of the labor market and what the Fed will be considering as its endgame approaches.
The unemployment rate jumped to 10.2% in October (vs. 9.8% in September), a larger increase than expected. However, much of the surge in the unemployment rate was for teenagers (which went from 25.9% to 27.6%) and young adults (which went from 14.9% to 15.6%) – that could reflect problems with the seasonal adjustment – or perhaps state budget strains are limiting the number of seasonal jobs available. Prior to seasonal adjustment, the number of unemployed teenagers and young adults actually fell. As anyone who has gone to college knows, there are many part-time jobs around and students count on those jobs for spending money or to make ends meet. In the current recovery, those jobs have become increasingly scarce. The unemployment rate for those aged 25 years and over edged up to 8.7% (from 8.6% in September and 5.3% a year ago).
The job market difficulties for teenagers and young adults was apparent before the October numbers. Going forward, we may see policy efforts geared more directly toward job creation, but in the meantime, state and local budget pressures are likely to restrain job growth for the young.
Nonfarm payrolls fell by 190,000 in October. The decline was a bit larger than expected, but figures for the two previous months were revised lower. The pace of job losses has clearly moderated relative to the beginning of the year (payrolls average more than a 691,000 monthly decline in 1Q, vs. a -188,000 average over the last three months) and weakness has grown more concentrated within specific industries. Average weekly hours held steady at a low level in October. That’s discouraging. Normally, an increase in hours precedes an increase in new hiring. However, the hours data tend to be revised. Furthermore, hours did improve in manufacturing (overall hours and overtime hours). Productivity growth surged again in the third quarter, as firms did more with fewer workers. That hints that we may see some new hiring ahead.
Another encouraging sign was the increase in jobs in temporary help services, now up three months in a row (the October increase was the only “significant” pickup since the recession began, according to the BLS). A rise in temp help jobs would indicate that hiring is likely to improve.
As was widely expected, the Federal Open Market Committee refrained from raising short-term interest rates last week, and policymakers signaled again that short-term interest would likely not be raised for some time. There was some speculation that the Fed could abandon is “extended period” language, replacing it with something similar, but spelling out more directly would conditions will lead to a Fed tightening. The Fed listed three conditions that would justify unusually low interest rates for an extended period. All of them are already incorporated in how economists view the Fed, but the listing of these conditions will make it easier for the financial markets. First, the Fed would have to see some increase in resource utilization rates – that means a lower unemployment rate. The second conditions is subdued inflation trends – that means core inflation would have to move significantly higher. The third is stable inflation expectations – as long as consumers and businesses expect low inflation, inflation is unlikely to be a problem. The Fed would have to work harder to wring higher inflation expectations out of the system once they become embedded. Now all we have to do is sit back and wait.
The Federal Reserve Outlook
November 2 – 6, 2009
The advance estimate of third quarter GDP growth provided conclusive evidence that the recession is over. However, the recovery is still expected to be gradual, fragile, and insufficient in the near term to generate much improvement in labor market conditions. Fiscal policy will provide further support into the early part of 2010, but will turn lower later next year, effectively acting as a drag on overall GDP growth. Hopefully, the private sector will be strengthening enough at that time to offset the drop-off in fiscal stimulus. If not, a second smaller stimulus package may be needed. However, amid concerns about the federal budget deficit, the political environment is likely to be resistant to the idea of further fiscal stimulus. That leaves the Fed to do the heavy lifting.
The Fed has a dual mandate, maximum sustainable growth and low inflation. However, over the long term, there is really only one goal. By keeping inflation low, the Fed will generate optimal economic growth. Consumer price inflation has turned negative over the last year, reflecting the unwinding of last year’s energy price increases. Measures of core inflation, have drifted lower. The Fed has long had an implicit inflation target of 1% to 2%. However, a few Fed officials have indicated that a 2% to 2.5% range may be more appropriate, giving the Fed more room to cut rates in a weak economy.
Of course, the Fed isn’t worried about past inflation. The focus is on keeping future inflation low. While inflation is a monetary phenomenon, it appears through pressures in resource markets. With unemployment near 10% – and expected to remain there for some time – wage pressures are not going to be an issue. The Employment Cost Index rose just 1.5% in the 12 months ending in September, and productivity growth appears to have remained very strong. Capacity utilization remains low. So, you’re not going to see inflation pressures due to production constraints.
Commodity prices are a different story. A strong global growth outlook (over the next 10 to 20 years) should generally lead commodity prices higher. However, it takes a huge increase in commodity prices to have much of an impact at the consumer level. Oil is a special case, being pervasive through the economic system, and its price (relatively steady now) remains a major wildcard in the economic outlook.
In addition to pressures in resource markets, the Fed also considers inflation expectations in its inflation outlook. The price of gold has risen in recent weeks, but gold is not the inflation hedge it once was. The spread between inflation-adjusted and fixed-rate Treasury securities suggests that the market does not expect inflation to be a problem over the next several years. Should inflation expectations begin to rise, the Fed would likely tighten sooner, all else equal.
There has been growing speculation that the Federal Open Market Committee may alter the wording of its policy statement on Wednesday. The Fed will not signal that short-term interest rates are headed higher anytime soon, but it may jettison the phrase that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period,” replacing it with something similar, but sounding less like a commitment. One alternative would be to spell out the conditions that would lead to a Fed rate hike.
Looking ahead, the Fed seems unlikely to raise short-term interest rates until the second half of next year, but it depends. If bank lending begins to improve and the economy appears on more solid footing, then taking the foot off the accelerator floor would be an appropriate response.
However, the fiscal stimulus will fade in the second half of next year and into 2011. The Bush tax cuts sunset at the end of next year. With fiscal policy working in the wrong direction, Fed policy will be responsible for keeping the recovery going.
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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