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Weekly Commentary by Dr. Scott Brown

“A High Degree of Uncertainty”
July 21 – July 25, 2008

In his monetary policy testimony to Congress, Fed Chairman Ben Bernanke presented an economic outlook characterized by “a high degree of uncertainty.” In the minutes of the June 24-25 meeting of the Federal Open Market Committee, most Fed policymakers viewed the outlook for both economic activity and price pressures as “very uncertain.” The timing and magnitude of future policy actions was “quite unclear.” So if the Fed doesn’t know what’s going to happen and what it’s going to do policy-wise in the months ahead, what hope is there for investors? To project the future, one has to assess the current situation and map out the risks that lie ahead.

First, let’s be clear. There’s no clear sign that the economy has entered a recession. The major monthly indicators (nonfarm payrolls, industrial production, real business sales, real personal income) are trending flat or slightly lower, but real GDP rose at a 1.0% annual rate in the first quarter, and we may see double that for the second quarter (advance estimate due July 31). There’s some chance that annual benchmark revisions may change that view, but as it stands now, there has been no sharp decline in overall economic output.

That isn’t to say that people aren’t hurting. Clearly, household budgets have been squeezed by higher food and energy prices. It’s harder to find jobs, especially good ones. The housing correction is ongoing. Credit has gotten tighter despite the Fed’s aggressive rate cuts earlier this year. It’s not a “mental recession,” as Phil Gramm, former congressman and John McCain’s campaign co-chairman, recently put it (before his remarks, in which he also said we’ve become “a nation of whiners,” Gramm was thought to be in contention to become Treasury Secretary in a McCain Administration). However, the overall economy is not as weak as it is typically portrayed in the media.

Of course, that doesn’t mean that things can’t get worse. Crude oil prices fell last week, but could move higher again ($129 oil is nothing to celebrate – energy prices will remain a major restraint on growth – but it’s better than $147). Credit conditions are still far from normal and could get worse over the near term (the Fed and the Treasury’s signal of support for the GSEs was intended to prevent broader problems in the credit markets). The housing correction is still far from over and an adverse feedback loop (lower home prices leading to more foreclosures, and even lower prices, etc.) remains a significant worry. The first half of the year was characterized by weakness in new hiring – the second half could see a rise in actual job losses (as opposed to the seasonally adjusted job losses of 1H08). In short, there are a lot of bad things that could happen.

A month ago, the Fed increased its rhetoric on inflation. Bernanke spoke of a need (in coordination with the Treasury) to stem a further decline in the dollar. Import prices have accelerated. The price index of Chinese imports rose 4.8% y/y in June. Pipeline inflation pressures remain elevated and there is greater flow-through to the wholesale level. However, core inflation at the retail level remains low. The price index of consumer goods ex-food & energy rose 0.1% in June (up 0.2% y/y and a -0.1% annual rate in the first half of 2008). Inflation expectations are higher, but this has yet to translate to the pressures in the labor market. Wage increases remain moderate. In addition, slow economic growth should help contain inflation pressures in the near term. The Fed has toned down the inflation talk. However, should labor costs pick up, the Fed would be more inclined to raise rates to keep inflation contained.

Note that the minimum wage, after rising 70 cents a year ago, will rise another 70 cents to $6.55 on July 24 (and another 70 cents on July 24 next year). The inflationary impact of this increase should be minimal. Many states (22 out of 50) have minimum wages that already exceed the new federal level and average hourly earnings ($18.01 in June) are far higher.

Some have blamed speculators for driving up commodity prices. That’s a lot of bunk. However, clearly a lot of money has flowed into commodity funds in the last year or so – and commodity funds buy commodities. This may be similar to the late 1990s, when equity fund inflows helped drive the stock market higher. Eventually, the longer-term fundamentals of supply and demand should dominate. Hence, oil prices could fall further (remember, crude oil was below $90 per barrel in mid-February).

Stability in food and energy prices would lead to improved consumer purchasing power over time, providing support for consumer spending growth. Declines in food and energy prices would bring a consumer spending recovery even closer. An improved growth outlook would lead to concerns about potential wage inflation – and remember, the Fed sets monetary policy on where it thinks the economy will be in 6 to 12 months. Hence, the Fed could end up raising rates quickly if the economy shows signs of improvement.

The economic outlook always has some degree of uncertainty and the picture gets more clouded precisely when clarity is needed most. At present, there are a lot of moving parts, with the price of oil being key. The base-case scenario is sub-par economic growth in the near term and a gradual recovery. The Fed will remain watchful as to which course the economy leans toward.

A Deteriorating Job Outlook
July 7 – July 18, 2008

The June Employment Report was not drastically different from expectations. However, the details, as well as other labor indicators, suggest a worsening in the near-term job outlook. Higher oil prices are a major problem for the economy, reducing consumer demand and squeezing corporate profits. For the most part, the fist half of the year was characterized by a reduced pace of new hiring. The second half of the year is likely to be characterized more as a period of job destruction.

There are clear seasonal patterns in the job market. The start and end of the school year causes a huge fluctuation in government jobs. However, private-sector jobs also show a strong seasonal pattern. The end of the holiday shopping period brings large-scale employment declines in January. Firms typically add to payrolls in the spring. However, unadjusted payrolls flatten in the second half of the year. Between January and June, the U.S. economy added 2.712 million jobs (prior to seasonal adjustment). That may sound like a lot, but over the same period last year, 3.839 million jobs were added. The seasonal adjustment turns the January-June payroll change to -362,000 (vs. +517,000 last year). The last time we had such a weak spring hiring season was during the 2001 recession. In that year, job losses picked up in the second half.

This year, there are a variety of problems for the economy. The housing correction is ongoing. Credit conditions have tightened. Higher food and energy prices are squeezing household budgets. The housing and credit problems seemed likely to slow the expansion significantly, but not end it. Higher oil prices, on the other hand, are a much bigger problem. Tax rebates have helped, but not much. The personal income and spending data for May, which are subject to revision, showed about 85% of the income increase was saved.

The weaker job market implies a decline in labor input into the economy. The index of aggregate private-sector hours fell 0.6% y/y in June. There’s really only one recipe for growth. Output is simply the amount of labor input times the productivity of that labor. That means that output growth is the sum of the growth rate in labor plus the growth in the labor productivity. The economy can still expand if labor input is declining, but not if labor input is falling faster than productivity growth. Note that productivity growth jumped in the early stages of the current expansion, yielding moderate growth in GDP even as the economy continued to shed jobs (the recession ended in November 2001, the economy didn’t start adding jobs until the second half of 2003).

High oil prices have added to input price pressures. Import price inflation is up. Inflation expectations have risen. However, there’s little inflation from the labor market, nor are wage gains about to match headline inflation any time soon. The Fed has to look ahead to the eventual recovery. That probably won’t be until 2009, but policymakers needs to plan accordingly.