No Need To Change Policy Now
June 22 – July 3, 2009
The arrival of a few “green shoots” has led to calls for an end to stimulative fiscal and monetary policy. Some say that the Fed needs to start unwinding its accommodative policy now to prevent future inflation. Others suggest that the economy is beginning to recover on its own and doesn’t need the large fiscal stimulus and the higher deficits that entails. Such talk is foolish.
The Consumer Price Index fell 1.3% in the 12 months ending in May. Technically, that’s deflation, a decline in the overall price index. However, it’s not the type of deflation we worry about. The decline in the CPI reflects an unwinding of energy prices. This isn’t a deflationary spiral, where falling prices lead to weaker demand, which pushed prices down even more. The median CPI, which measures the middle of price changes (half of the weighted components rise more, half rise less), rose 2.1% year-over-year (my calculation, the Cleveland Fed has it at 2.4%).
Inflation is likely to remain low over the intermediate term due to the large amount of slack in the economy. With elevated unemployment, the labor market, the widest channel for inflation pressures, is unlikely to generate sharp increases in wages. With capacity utilization in manufacturing at record lows (the lowest since 1948, when they started collecting the data), we won’t see production constraints driving up prices anytime soon. Commodity prices, however, are a wildcard. The strong global growth story is still with us, postponed for a while due to the global slowdown. Oil prices are well off their lows and could head a lot higher. Yet, as we’ve seen over the last several years, higher gasoline prices are more of a restraint on growth than a catalyst for higher inflation. Another worry may be expectations. Spreads between inflation-adjusted and fixed-rate Treasuries suggest that deflationary fears have dissipated. However, there’s no indication of substantially higher inflation expectations.
Having worked out the technical details, Federal Reserve officials are confident that monetary policy accommodation can be scaled back in time to prevent inflation from rising too sharply. However, officials are also aware that many financial market participants aren’t as confident in the Fed’s ability to contain inflation.
There is some debate about the size of the output gap (the difference between actual and potential GDP) as well as the degree of disinflation pressure resulting from that gap. Some frictions could develop as the economy begins to recover (for example, as firms struggle to hire qualified workers). However, the pace of economic recovery is likely to be gradual, with excess capacity being mopped up over a period of years.
Complaints about the $787 billion fiscal stimulus package passed in February fall into two camps. One group says that the package is a failure because it’s been four months and the economy hasn’t improved. However, currently, only $50 billion of the package has gone out the door. About $135 billion in stimulus will arrive in the remainder of the current fiscal year (ending in September) and 400 billion will arrive in FY10. It’s too soon to see much of an impact.
Another group says that with the economy nearing recovery, we don’t need the fiscal stimulus. However, part of the recovery is predicated on that stimulus showing up – the expectation of that stimulus has generated some degree of optimism. The bigger question is what happens in FY11, as the stimulus begins to wind down. The shift in stimulus for FY11 is -$265 billion. Hopefully, the private-sector economy will improve enough to offset that drag. If it doesn’t, more fiscal stimulus may be needed – although it might prove to be difficult getting anything through Congress.
A common mistake in recoveries from severe recessions is to unwind policy too soon. The Fed and the Obama Administration are both aware of this. Tax increases meant to move the budget back toward balance would dampen the recovery. Reining in healthcare cuts is seen by the Obama Administration as a key factor in reducing the budget deficit and strengthening the economic recovery.
Ben Bernanke’s term as Fed Chairman ends in January. Rumor has it that Larry Summers, the head of the National Economic Council and former Treasury Secretary, will get the nod if Bernanke is ousted. Summers would maintain Fed independence, but financial market participants might fear otherwise. Bernanke is collegial, willing to listen to other points of view. To put it politely, Summers has some rough edges.
Fed Policy Outlook: Steady As She Goes
June 15 – June 19, 2009
The Federal Open Market Committee will meet next week to set monetary policy. It’s widely expected that Fed officials will leave the target range for Fed funds at 0% to 0.25%. Long-term interest rates have risen recently. Higher mortgage rates threaten to postpone a recovery in housing. However, policymakers have given no hint that they will increase purchases of mortgage-backed securities and long-term Treasuries to push these rates back down.
There are a number of possible explanations of the recent rise in long-term interest rates. Many financial market participants are fearful of future inflation and large federal budget deficit. That’s understandable. However, the Obama Administration seems committed to a return to fiscal balance after the economic recovery. Fed officials are confident that monetary policy accommodation can be removed without generating inflation. The Fed will begin raising short-term interest rates at some point and most of the special liquidity and lending facilities will disappear over time. In fact, the Fed is already seeing reduced demand in some of its liquidity programs. So fears of inflation and runaway budget deficits are overdone.
The rise in long-term interest rates is also a natural consequence of the unwinding of the flight-to-quality. There was real fear a few months ago (note that magazine articles about “the end of capitalism” are a good sign of a market bottom). Recent data have been consistent with the view that the worst part of the economic decline is behind us. Jobless claims appear to have peaked in March. The economy is still contracting, but is likely to bottom out in the second half of the year. Granted, the recovery is widely expected to be gradual. It will be years before the economy gets back to its potential (the unemployment rate back to 5%), but the “improved” outlook naturally leads long-term rate higher.
The rise in long-term interest rates may, in turn, have a mixed, but generally negative impact on the economy. A steeper yield curve should encourage bank lending and risk taking. However, it will also dampen the prospects for a recovery in the housing sector. Long-term interest rates should rise as we approach a bottom in the economy, but not so much that they threaten the recovery. Expect some choppiness in the bond market.
The Fed is confident that inflation will not be a significant problem in the recovery, but that’s partly because officials will remain vigilant. Large amounts of slack indicate that inflation pressures will not come through the labor and product markets anytime soon. However, there’s a little more concern regarding commodity prices, oil in particular. The Import Price Index has risen as the price of oil has rebounded. However, ex-fuels, import price inflation has been minimal (down 4.1% over the last 12 months, but starting to flatten). The import price figures suggest no significant inflation pressure from a softer dollar, but they also show a reduction in the deflationary pressure that was apparent over the last several months.
The Fed stepped up its credit easing efforts considerably at the policy meeting in mid-March, but left those plans unchanged in late April. There was some speculation that the Fed would respond to higher long-term interest rates by increasing the amounts of mortgage-backed securities and long-term Treasuries it plans to purchase. However, in testimony two weeks ago, Fed Chairman Bernanke gave no hint that the Fed was particularly worried about the rise in long-term rates.
After the May Employment Report, which showed a smaller-than-expected decline in nonfarm payrolls, the market shifted forward its expectation of when the Fed will start raising short-term interest rates, pricing in a 25-basis-point hike by the end of the year. That seems too soon. The Fed will want to give the recovery a chance.
Mixed Signals From the Job Market
June 8 – June 12, 2009
The May Employment Report was a mixed bag, with a smaller-than-expected drop in nonfarm payrolls (with an upward revision to previous payroll levels) and a larger-than-expected increase in the unemployment rate. So is the labor market improving or getting worse? In a way, both – that is, if you consider getting less worse to be “improvement.” Still, the data are consistent with the overall economy reaching a bottom within a few months.
The employment report consists of two separate surveys. The establishment survey, which covers about 160,000 firms and 400,000 worksites, gives us estimates of nonfarm payrolls, hours, and earnings. Payroll figures are benchmarked once a year to tax records. From the household survey, we get estimates of the unemployment rate and labor force participation. The household survey is a sample of 60,000 households. That doesn’t sound like a lot, but it’s enough to get a relatively accurate measure of the unemployment rate. The household survey does not generate accurate measures of the level of employment or the size of the labor force – month-to-month changes in these series tend to be large and erratic. However, that doesn’t stop some analysts from making proclamations about whatever the latest swings in the data seem to suggest.
Note that the unemployment rate sometimes signals changes in the availability of unemployment insurance benefits. When benefits run out, many unemployed individuals give up looking for a job – and hence, are no longer officially counted as “unemployed” (to be counted one has to be actively looking for a job). Conversely, an extension of unemployment insurance benefits leads some individuals back into the labor force (a requirement to receive unemployment insurance benefits is to be actively looking for a job). When the unemployment rate begins to decline it’s often unclear whether people are getting new jobs or their benefits have run out.
In May, the unemployment rate rose sharply (to 9.4%), while the establishment survey showed a more moderate decline in nonfarm payrolls. Both figures seem at odds with weekly claims for unemployment insurance benefits. The level of claims is below the March peak, but still very high by historical standards. Layoffs in the auto industry appeared to push claims higher in May and auto industry payrolls continued to fall sharply. However, the broad improvement in payrolls (falling at a more moderate pace across most industries) seemed a bit overstated. Seasonal adjustment may have been a factor. Unadjusted payrolls rose by 319,000 in May, well below the normal gain (hence, a seasonally adjusted decline).
In short, take the headline figures with a grain of salt. There’s a fair amount of uncertainty in these numbers, but they are consistent with the idea that the worst part of the decline is well behind us.
Nobel Laureate Clive W.J. Granger passed away on May 27. I was a student of Granger’s at UC San Diego. His contributions to the fields of time series analysis and forecasting were considerable. Granger was also a class act, a true gentleman, who treated people with respect and was generous with his time.
On one occasion, I gave Granger a ride to pick up his car at the mechanic. I drove an old VW bug at the time and he noticed that the fuel gauge was on empty. I told him that the gauge was busted and that I had to keep track of the mileage to figure out when to refill.
“It’s not a hard forecasting problem,” I said, thinking he would appreciate my forecasting skill.
“I realize that,” he replied, still looking concerned, “it’s just that it makes me wonder what other parts of your car might fail.”
He smiled. That’s what separates the great from the good. You have to look beyond the obvious.
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.
All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.
