Weekly Commentary by Dr. Scott Brown

The Fed’s View
July 19 – July 30, 2010

Federal Reserve Chairman Ben Bernanke will testify on the Fed’s semi-annual Monetary Policy Report to Congress this week. This is usually a big deal for the markets. However, there’s much less suspense this time around. The Fed’s views were already included in the minutes of the June 22-23 policy meeting. Fed officials lowered their projections of near-term growth and inflation, and about half saw the risks to their growth outlooks as tilted to the downside. However, policymakers felt that the shift in the near-term outlook did not warrant stimulus.

The Fed’s central tendency forecasts, which exclude the three highest and lowest forecasts of the five governors and 12 district bank presidents (growth and inflation projections are 4Q-over-4Q, the unemployment rate is the 4Q average for that year):

Economic data were generally on the strong side of expectations in the early spring, leading Fed officials to raise their forecasts of 2010 GDP growth. Recent data have been soft, suggesting a near-term moderation in the pace of growth. The Fed’s longer-term growth outlook has been little changed

Bernanke’s testimony will present the Fed’s view of where things stood at the June 22-23 policy meeting. What’s happened since? Private-sector payrolls were reported to have risen by 83,000 in June – disappointing, but still positive. Retail sales fell 0.5% in June. Core retail sales, which exclude autos, building materials, and gasoline, edged up 0.2%, after falling 0.4% in April and 0.2% in May. Industrial production rose 0.1% in June, but manufacturing activity fell 0.4%. One month does not make a trend. However, these figures are consistent with a more moderate pace of economic growth in the near term. They do not indicate a double dip recession, but they do suggest some increase in downside risks to the growth outlook.

The Fed’s inflation outlook has continued to shift lower. The core CPI rose at a 0.6% annual rate over the first six months of 2010. In June, the Fed saw inflation as “likely to stabilize near recent low readings in coming quarters and then gradually rise toward more desirable levels.” The risk of deflation (a sustained decline in the overall price level) is small. That would depend on a more serious downturn in economic activity (possible, but the odds seem rather small). Still, Bernanke has previously spoken about the need to act swiftly and forcefully to counter the possibility of deflation. Fed officials appear to be divided on the risks and whether further policy efforts would be effective.

Further quantitative easing (purchasing long-term Treasuries or mortgage-backed securities) would seem pointless given that long-term interest rates are already low. Still, the Fed could lower the rate it pays on bank reserves to 0% and also expand efforts to improve securitization of consumer and business debt.

With conventional monetary policy exhausted for a while now and unconventional policy seen as difficult to achieve and of questionable impact, that leaves fiscal policy as the only game in town. Unfortunately, the odds of further fiscal stimulus are low. The economic recovery will likely take a lot longer.

Animal Spirits and the Economic Outlook II
July 12 – July 16, 2010

The U.S. economic recovery appears to have entered a moderation phase, where growth is likely to remain positive in the near term but may not be as strong as was hoped for a few months ago. Recoveries from financial crises take time. This was never expected to be a sharp recovery and improvement in the labor market was projected to be very gradual. Recoveries are never smooth, but it seems clear that consumer and business psychology will play important roles in the near term.

The economic recovery made an important transition in 2010. The recession likely ended in June 2009. That doesn’t mean that everything is wonderful. It simply signals that the overall economy stopped contracting and started to expand again. To many people, it will still seem like a recession for some time. Growth was positive in the second half of last year, but the recovery made an important transition in 2010. That is, growth in the second half of last year and early 2010 was supported largely by the federal fiscal stimulus and a shift in inventories (from a sharp decline to a moderate accumulation). Growth in the first half of 2010 saw less support from these transitory factors and more support from basic demand – consumer spending and business fixed investment. More importantly, the return of private-sector job growth indicates that the recovery has become more sustainable. Still, the economy recovers from recessions in fits and starts – the early stages of expansion are typically uneven across time and sectors.

One of the biggest fears during the economic downturn was that consumers might increase their savings dramatically. Declining stock prices and home values could lead consumers to sock more away for their retirements. Saving more, consumers would spend less – and that lost spending was someone else’s income. If the savings rate were to rise to 8% or 10%, we would have a depression. The savings rate did rise during the downturn, settling at 4.0% in May. However, take the savings data with a grain of salt. These figures are often revised considerably. Savings are not measured directly. They are calculated as a residual (income less taxes and outlays). A few years ago, much was made about negative savings. Revisions now show that savings never turned negative. Still, there is plenty of evidence that households do not save enough. A further increase in savings could dampen the pace of recovery in the near term. Note that annual benchmark revisions to the personal income and spending data will be released on July 30 (quarterly) and August 3 (monthly) – the story could change.

During the heat of the financial meltdown in the fall of 2008, banks cut lines of credit to many small businesses. Bank credit to small firms has not been tightened appreciably in recent months, but it hasn’t gotten easier either. Banks are willing to lend to small firms, but are finding it hard to find good-quality borrowers. Moreover, those businesses that do have good credit generally don’t want to take on additional financial burdens. This is a key concern for Federal Reserve and White House officials. Small firms play an important role in recoveries, accounting for roughly a third of net job growth.

The lack of expansion for small business is limiting the pace of the recovery. Part of this is psychological. Doubtful about the economic outlook, these firms are reluctant to hire new workers. Many cite worries about higher taxes, but this seems more like an excuse. Small firms want to see evidence that the recovery will continue. Stronger underlying demand for the goods or services they produce should eventually lead to expansion, but that’s likely to take some time.

The stock market is a leading economic indicator, but it’s also manic. In the market’s eye, either the economy is booming or it’s falling apart completely. It’s difficult for the market to get a handle on things when the data are mixed, but moderate.

Animal Spirits and the Economic Outlook
July 5 – July 9, 2010

Near-term economic expectations have softened over the last few months and the risks to the growth outlook have become tilted more to the downside. There’s nothing to suggest that a double dip recession is imminent or even likely over the next few quarters. However, the one element that’s hard to get a handle on is psychology. Fears of a double dip could become self-fulfilling if enough firms stop hiring.

The June Employment Report seemed to encapsulate the themes generated by recent economic data releases. That is, the pace of growth appears to have moderated – still positive, but somewhat slower than was anticipated a few months ago. Private-sector payrolls continued to advance in June and the three-month average (+119,000) was respectable, but not especially strong. Prior to seasonal adjustment, private-sector payrolls advanced by 863,000, up by 3.358 million since February. That looks like the kind of (unadjusted) job gains we would see in a normal year, but the pace has been disappointing given the depth of the decline over the last two years.

The unemployment rate fell to 9.5% in June, but the details suggest no significant improvement. The decline was due largely to a drop in labor force participation, which could be a consequence of unemployment insurance benefits running out for some individuals. The employment/population ratio avoids month-to-month peculiarities in labor force participation – it fell further in June (to 58.5%, vs. 58.7% in May, 59.4% a year ago, and around 64% in the late 1990s).

The June jobs report confirms what was widely expected at the start of the year. That is, economic growth was expected to be positive, transitioning to a more sustainable recovery (one supported by an underlying expansion in consumer spending and business fixed investment rather that federal fiscal stimulus and a shift in inventories), but unlikely to be strong enough to push the unemployment rate down by much.

The list of near-term economic headwinds is long: lingering problems in residential and commercial real estate; tight credit, especially for small firms (and some reluctance of creditworthy borrowers to take on debt); the contractionary consequences of tighter state and local budgets; the federal fiscal stimulus ramping down into 2010; the Bush tax cuts expiring at the end of this year; and tighter budgets overseas limiting global growth. On the positive side, long-term interest rates are extremely low, which should provide some support. Thirty-year home mortgage rates hit another record low last week.

One worry is that if the recovery should falter, monetary and fiscal policy may be helpless to counter that. The Fed already has short-term interest rates near 0% – conventional monetary policy is played out. The Fed could resurrect quantitative easing (buying mortgage-backed securities and long-term Treasuries), but what would be the point? Long-term interest rates are already low. There’s clearly scope for more fiscal stimulus, but the public mood is against it and it would be nearly impossible to get anything significant through Congress. The desire to reduce the budget deficit is well-intentioned, but misguided in the short term. As a consequence, the economic recovery may be painfully slow in the quarters (perhaps years) ahead.

The Gulf oil spill had a clear impact on consumer confidence numbers in June and may dampen consumer spending growth in the near term. If households increase savings significantly (which might happen after a drop in the stock market), overall growth will be even softer. Businesses generally remain fearful of what the Obama Administration might do, but Obama has already had difficulties getting things through Congress (healthcare and financial reforms were significantly watered down). The November elections won’t change that outlook, but it could alter perceptions. Normally, gridlock is good for the markets, but there are times when stuff has to get done.

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 our office today.

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