Weekly Economic Commentary by Scott J. Brown, Ph.D.

Risk and Uncertainty, Confidence and Fear
October 20 – October 24

In recent weeks, the financial markets appear to have been reacting less to weaker expectations of global growth and more to the increased downside risks – that is, to the fear that things could get a lot worse. The downside risks to Europe are considerable, but America is much less dependent on exports than most other countries and the prospects for moderately strong growth into 2015 remain promising.

Students of forecasting learn that there are two parts to any projection. There’s the point estimate, the expected value at a certain point in the future, and there’s the uncertainty around that point forecast. In economics, that forecast uncertainty is often embarrassingly high and usually isn’t symmetric (meaning that downside risks could be a lot different than upside risks). That doesn’t mean that forecasting the economy is a useless effort. It’s just that one should take such forecasts with a grain of salt. It’s far more important to develop a consistent story and look for ways that the story could go wrong.

Similarly, investors typically face a given set of expectations, while the risks surrounding those expectations can be quite substantial and may increase or decrease over time. Recently, the IMF lowered its outlook for global growth in 2014 and 2015. That should have surprised no one. What has been troublesome for the financial markets is that the downside risks to that outlook have increased. Europe has faced important challenges over the last few years, but the current phase, as it battles the threat of deflation, is expected to be more difficult. Inflation is low in the euro area and the European Central Bank’s policy rates are near zero (and in the case of the rate on the deposit facility, a bit negative). The ECB has to do more, and that means quantitative easing. However, there may be legal challenges.

Europe has been an on-again off-again concern for U.S. investors in recent years, mostly reflecting concerns about the survivability of the monetary union. Those fears were put to bed when ECB President Mario Draghi promised to do “whatever it takes.” Yet, austerity efforts in Europe have been self-defeating and growth has slowed. While the U.S. economy still has a long way to go, we have remained firmly on the recovery track, with few signs of the types of excesses that would lead to an economic downturn. After a while, U.S. market participants have repeatedly put aside their worries about Europe. This recent focus on Europe may not be much different. Worries about Europe could lead U.S. firms to pull back on hiring and capital expenditure plans. However, foreign trade is much less important to the U.S. than it is to other advanced economies. Trouble in the rest of the world may have a significant impact on some U.S. firms, but it’s not expected to have a large effect on the domestic economy as a whole.

One side effect of a soft global economy is a strong U.S. dollar and downward pressure on commodity prices. That should be helpful for consumers. Along the usual seasonal pattern, retail gasoline prices can be expected to fall about 12% from May to December. This year, they’ve fallen about 13% so far, with further declines expected in the weeks ahead. That’s somewhat supportive for the consumer spending outlook, but not enough to boost sales activity sharply for the holiday shopping season. The impact of lower gasoline prices depends on the magnitude of the decline and how long prices remain low.

As Fed Governor Stanley Fischer recently noted, monetary policy, while focused on the outlook for the job market and inflation, must consider what’s happening in the rest of the world and take into account the feedback from abroad in reaction to any policy changes. The downward pressure on inflation is likely to contribute to a delay in the Fed’s initial increase in short-term interest rates. Indeed, most private-sector economists are likely to push out their forecasts of the timing of the first rate hike. Some are suggesting that the Fed may even want to delay the end of QE3 or introduce QE4. That is unlikely. Remember, QE3 was meant to impart positive momentum in the economy, especially in the job market (mission accomplished). Officials believe that asset purchases are less effective over time and potentially more risky. So QE4 isn’t going to happen unless the economy takes a serious turn for the worse, and there’s not much chance of that.

The exaggerated fears of Ebola are a good example of the difficulties in defining downside risks. Your chances of contracting the Ebola virus are extremely low. You are much more likely to die of the flu than Ebola (and, as an aside, you can reduce that risk by getting a flu shot). Yet, Ebola fears played a role in last week’s market volatility. One recent survey showed that 25% of Americans are worried about catching Ebola. If 10% of those people decide not to travel, then you’re talking about a 2.5% reduction in air travel (that’s assuming that the 25% are a representative sample of potential travelers, which is a leap). Granted, this is a crude (and almost certainly wrong) estimate of the impact, but it gives you an idea of how a panic can begin to affect the economy. Most likely, the cable news stations will eventually find something else to worry about.

Friday’s rebound in the stock market was encouraging, but we may still see an elevated level of market volatility in near term. This week’s economic calendar is not going to have much of an impact on the overall picture, but the following two weeks will be a lot more eventful, as we get some indication as to where the U.S. economy is heading in the near term. Mostly, the outlook will remain moderately positive, especially in comparison to the rest of the world. Investor confidence should improve.


Global Worries (And Some Benefits)
October 13 – October 17

In the latest update of its World Economic Outlook, the IMF revised lower its expectations of global growth in 2014 and 2015. None of that should have surprised anyone. At this point, the IMF expects that European GDP will be relatively weak in 2014 (+0.8% 4Q14/4Q13) and should improve in 2015 (+1.6% 4Q15/4Q14). However, risks are weighted predominately to the downside. Weaker European growth and a stronger dollar will have a significant impact on many U.S. firms, but may have some benefits for the economy as a whole.

Global investors have worried a lot about Europe in the last few years. However, the key fear, that we’d see a breakup of the monetary union, was largely put aside when ECB President Mario Draghi promised to “do whatever it takes.” Issues present at the creation of the monetary union had finally come to a point where they had to be addressed. Critics cautioned early on that Europe needed a banking union and a fiscal union to make the monetary union work. European authorities have made progress in recent years, but still have a long way to go.

While Europe’s crisis of the last few years has been called a “sovereign debt crisis,” government debt was not the catalyst for weakness. It’s been a crisis of capital flows. With lower borrowing costs, money poured into the peripheral countries when the euro was introduced (contributing to housing bubbles in Ireland and Spain), then capital started to flow out during the global financial crisis. Many had expected Europe’s difficulties to lead to a flight-to-safety in the U.S. dollar. However, the safety flow went largely to Germany, leaving little impact on the exchange rate. More troublesome, the misdiagnosis of the cause of the crisis led to the bad prescription: austerity.

Government budget deficits and debt levels are important long-term issues. There are well-known concerns about using fiscal stimulus (lower taxes, increased government spending) to boost growth (how big, how to unwind), but what’s clear is that fiscal tightening (higher taxes, reduced government spending) in an economic recovery is a bad idea. It contracts the economy. Growth will be slower than would have occurred otherwise. Moreover, slower economic growth means a slower recovery in tax revenues, and less budget improvement than was anticipated. It’s a self-defeating policy.

Europe is now in a much more precarious phase. Inflation is trending very low. Economists note that it’s real (that is, inflation-adjusted) interest rates that matter. For any given level of interest rates, lower inflation implies a higher real rate of interest – and slower economic growth than you’d see otherwise. The European Central Bank has lowered benchmark interest rates to near zero (and in case of the interest rate on the deposit facility, negative). It can’t go lower.

Saddled with the zero lower bound on interest rates textbook economics (granted, graduate-level textbooks) suggest that the central bank can expand its balance sheet to support economic growth. The ECB is embarking on an asset purchase program, but this is more akin to the Fed’s TALF, the Term Asset-Backed Securities Loan Facility (from March 2009 to June 2010). The central bank receives asset-backed securities and gives the banks cash, which they will use to make more loans (or at least, that’s the theory). This is different from outright quantitative easing, but has similar economic effects in the short-run. The ECB is widely expected to undertake real quantitative easing (the outright purchases of sovereign debt) in the months ahead (at the clear objections of the Germans).

Whether the ECB’s efforts to spur growth will work soon enough is an open question. The key point for financial market participants is not that Europe’s economy will necessarily fall apart, but that the downside risks are considerable. Weak European growth will have a negative impact on countries like China, which remain dependent on exports (China may also have to contend with the collapse of a housing bubble).

European weakness will have a significant impact on many U.S. firms, which are expected to see weaker earnings growth from Europe and a loss in the currency translation (due to the stronger dollar). However, while we should see a decline (or at least softer growth) in exports to Europe, that weakness is unlikely to drag the broader economy down.

There may be some parallels with the Asian financial crisis of 2007 (of course, there are many more differences than similarities to the current situation in Europe – just hear me out). In the Asian financial crisis, the hit to U.S. exports subtracted a full percentage point from GDP growth. However, the crisis put downward pressure on inflation and boosted capital inflows, which was far more significant. Similarly, we are now seeing a stronger dollar put downward pressure on commodity prices. Increased capital inflows should help keep long-term interest rates relatively low and the stronger dollar will likely delay the Fed’s first increase in short-term rates.

Gasoline prices have drifted lower in recent months, but not enough for a sharp boost in consumer spending (note that gasoline prices normally fall about 12% from May to December, and have fallen about 10% so far this year). However, gasoline prices are likely to fall faster in the near term and a further decline (to below $3 per gallon) would add more significantly to consumer purchasing power into early 2015.

The Asian financial crisis had a negative impact on the U.S. stock market, but that turned out to be a great buying opportunity. We may see some imbalances develop (a wider trade deficit), but the U.S. may benefit from Europe’s weakness.


The September Employment Report
October 6 – October 10

The headline figures from the September jobs report were better than expected. However, the details were more consistent with moderate growth and a continued high degree of slack. Fed officials aren’t going to jump to any conclusions.

Payrolls rose by 248,000 in the initial estimate for September, while figures for July and August were revised a net 69,000 higher. Part of September’s strength reflects a rebound from two special factors that reduced the August total (a seasonal adjustment quirk in autos and labor difficulties at a New England grocery chain). One can ex-out this impact, by averaging the last two months (a +215,000 average, vs. a +261,000 pace over the four previous months). Private-sector payrolls averaged a 217,000 monthly gain in 3Q14 (+216,000 over the 12 months).


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Seasonal adjustment adds some uncertainty to the headline payroll figures for September. Prior to adjustment, we added 1.487 million education jobs (vs. +1.416 million in September 2013), and shed 786,000 non-education jobs (vs. -823.000).

The unemployment rate fell to 5.9% in September (from 6.1% in August), the lowest since July 2008. However, most of the drop was due to a decrease in labor force participation (which may have reflected seasonal adjustment issues at the start of the school year). The employment/population ratio was flat at 59.0%, up just 0.4 percentage points from a year ago. The participation rate is now at its lowest point since October 1977.


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Some short-term job market measures, such as weekly claims for unemployment benefits and the percentage of people out of work for less than half a year, are at levels we normally associate with an economy that has fully hit its stride. However, other gauges, such as the employment/population ratio, long-term unemployment, and involuntary part-time employment, continue to suggest that a lot of slack remains.

For Fed policymakers, the September employment figures tell us nothing new. The job market is improving, but we’ve a long way to go. The Fed has plenty of time to decide when to begin raising short-term interest rates. The economic figures over the next several months should dictate that decision, but we didn’t really learn much that was new last week.


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