Weekly Economic Commentary by Scott J. Brown, Ph.D.
Budget deficit fears
April 25 – April 29, 2016
Just when you thought all the fear-mongering had subsided, the national debt has resurfaced as a topic in this year’s presidential race. Yes, the deficit is large. No, it is not a problem. However, there some concerns about the longer run.
The federal budget deficit hit $1.4 trillion in FY09, or about 10% of nominal GDP. That is enormous, but it simply reflected the magnitude of the Great Recession. Revenues fell. Recession-related spending (unemployment insurance, fiscal stimulus) rose. As the economy recovered, recession-related spending went away and tax receipts improved. The deficit is now down to 2.5% of GDP, which is sustainable.
Some politicians talk as if cutting the deficit were simply a matter of “trimming the fat.” However, if one excludes social Security, Medicare, interest payments, and defense outlays, there’s not a whole lot left to cut. If you cut nondefense discretionary spending to zero over the next 10 years, you would still be running a budget deficit.
While the deficit (as a percentage of GDP) is currently manageable, it is expected to rise in the years ahead as the baby-boom generation continues to move into retirement. The Congressional Budget Office projects that the deficit will approach 5% of GDP by FY26. So, something’s going to have to give at some point. We can reduce the deficit (or limit its growth) by scaling back entitlements or by raising revenues. Some now argue (I kid you not) that we have to cut entitlements now so that we don’t have to cut them later (which makes no sense if you think about it for more than a second). Raising revenues is tricky. Republicans aren’t going to go along with increases in tax rates (even if called “revenue enhancements,” as they were during the Reagan years). Broadening the tax base, as part of overall tax reform, could get bipartisan support, but that means giving up certain tax breaks that some will object to (that is, those benefiting from those tax breaks). It’s true that the U.S. has one of the highest corporate tax rates in the world, but the effective rate (what corporations actually pay) is among the lowest. If you started from scratch, you could certainly come up with a better, more efficient tax system, but the problem is you can’t start from scratch.
The national debt, the sum of past budget deficits, is now over 100% of GDP. However, marketable debt is about 76% of GDP (the difference is the money that the government owes itself, mostly the Social Security and Medicare trust funds). There is no magic level of debt that gets an economy in trouble. Research arguing that view has been discredited. The federal government currently has no problem borrowing, nor is there any evidence that it is crowding out private investment.
Here is something to worry about. The Great Recession has put potential GDP on a lower, slower track. This makes future budget strains more of a problem than if we had remained on the pre-recession trajectory. More unsettling, that assumes that the economy does not stumble into a recession along the way.
The Fed, the dollar, and trade activity
April 18 – April 22, 2016
Financial markets have some tendency to over-react to news and the increased globalization of financial markets means that things can now get out of hand a lot more quickly on a global scale. Minor shifts in the Fed policy outlook have had a large impact on exchange rates. The strengthening of the dollar has had an outsized impact on commodity prices. However, shifts in the financial markets can themselves have important effects on economic conditions. It’s enough to make your head spin.
As with most countries, the responsibility for the dollar falls to the Treasury, not the central bank. The Fed can influence exchange rates, to be sure, and react to the impact of exchange rate movements on the economy, but the exchange rate of the dollar is not its job. Talk of “currency wars” is way overdone. Central bank policy is driven by the outlook for the domestic economy. The strength in the dollar over the last two years has been due to a number of factors, but many would put tighter Fed policy at the top of the list (along with easier monetary policy abroad). Yet, the Fed has raised rates by only 25 basis points – and the expected path of rate increases is very gradual.
The dollar’s strengthening against the currencies of our major trading partners was especially pronounced. From the end of 2013, the U.S. dollar had appreciated 35% against the Canadian dollar and 45% against the Mexican peso. These are large moves and cannot be justified by monetary policy differentials.
In general, policymakers do not worry too much about the level of exchange rates. It’s the speed of adjustment that is worrisome. Rapid moves are destabilizing. The Treasury can intervene by buying or selling currency reserves, or use open-mouth operations to try to talk the exchange rate in one direction or the other – but when push comes to shove, intervention can be only a temporary fix. Currency flows are simply too large for the authority to do much about it.
Canada and Mexico account for more than a third of U.S. exports. Anecdotal reports from businesses exporting to these two countries were increasingly sour in the first couple of months of the year (and exporters to the rest of the world weren’t exactly cheery either). It’s well known that currency movements tend to overshoot. The currency market did begin to turn in early February, coinciding with economic data and market conditions that suggested a softer Fed rate outlook. Still, while the dollar’s softening has provided some relief, there’s a question of how much damage has been done.
Not surprisingly, the U.S. has imported more stuff from abroad. However, nominal imports (the amount we pay for imported goods and materials) have fallen year-over-year due to the drop in import prices (mostly petroleum). The U.S. ran a trade surplus with OPEC last year (and in the first two months of 2016). This is a huge problem for many of the countries in OPEC, which have tied government spending programs to oil revenues. Moreover, while the contraction in U.S. energy exploration has been sharp, energy extraction is still going strong (down, but still high by historical standards).
U.S. merchandise exports have fallen, but mostly due to lower prices, especially for agricultural products and raw materials. The exception is exports of capital equipment, which have declined in inflation adjusted terms, reflecting the slowdown in capital spending worldwide. That slowdown in business investment is troubling, but it’s unclear how long it will last.
We have an inherently unstable global financial system. That doesn’t mean that downside risks will materialize, but they may. Trade is important to the U.S. economy, but we’ve always been relatively self-contained and strength in the domestic economy should remain the driving force in the quarters and years ahead. For the financial markets, we’re likely to see forces of optimism and pessimism duking it out for some time.
Expecting mixed economic data
April 11 – April 15, 2016
"Statistics are used much like a drunk uses a lamppost: for support, not illumination." – Vin Scully (among others)
The broad range of data suggests that the U.S. economy slowed in the first quarter. It’s more likely that this is merely “a slow patch” than the start of a more substantial downturn (not gonna use the r-word). The mixed nature of the economic data allows one to make any particular argument one wants and the noise is likely to add to market volatility in the near term.
The Atlanta Fed’s GDP-Now model has received increased attention from the markets. Most economists use a similar methodology in estimating GDP growth. One simply forecasts the components and adds them up (it’s actually a little trickier than it sounds since you can’t add inflation-adjusted figures). Economists will differ in how they forecast the components. The problem with this framework is that your GDP forecast will shift around as each economic release arrives. In late March and into early April, the components have come in generally weaker than expected. The Atlanta Fed’s model is now estimating a 0.1% annual rate. I’m currently at +0.5% (±1.0%), but that will change as more information becomes available.
Note that in the last six years, first quarter GDP growth has generally been a lot lower than in the rest of the year. This raises the issue of whether something may be wrong with the seasonal adjustment. Indeed, the Great Recession may have permanently altered seasonal patterns in economic activity. We can’t say for sure. The sample size here is too small. If the seasonal patterns have changed, the government’s seasonal adjustment will pick that up over time (and eventually, we may see first quarter GDP figures revised higher).
First quarter weakness is much less apparent in the government’s measure of underlying domestic demand. Real Private Domestic Final Purchases can be thought of as the “meat and potatoes” of the U.S. economy. It is made up of consumer spending, business fixed investment, and residential homebuilding (alternatively, it’s GDP less the change in inventories, net exports, and government). PDFP is less volatile than GDP (as it excludes the more choppy GDP components).
Federal Reserve policymakers are well aware of the GDP arithmetic. However, most officials favored a more cautious approach in deciding when to raise rates in mid-March, before the recent string of softer GDP components. Ahead of the March policy meeting, the Fed conducted its regular surveys of primary dealers and bond market participants. Both of those surveys showed a median expectation that the Fed would move in June and follow up with two additional 25-bp moves by the end of the year. Meanwhile, the federal funds futures market is now suggesting about a 64% chance of just one rate hike by the end of this year. The yield on the 2-year Treasury note has fallen by nearly 30 basis points since mid-March, also consistent with a more cautious glide path for the overnight lending rate.
Over the next several weeks, the economic data are likely to remain mixed, but with a more positive tilt overall. Stock market participants may react to the twists and turns in the data reports, but are more likely to use selective figures as support. Earnings reports ought to be important in the near term, but much of the bad news may be already factored in.
Over the last several months, the bond and currency markets have over-reacted to shifts in the Fed policy outlook. All else equal, tighter monetary policy should be positive for the dollar, but by how much? The dollar moves over the last year, especially relative to our largest trading partners, Canada and Mexico, appeared way overdone, and we have seen a reversal. A more gradual tightening path may hasten that correction. A softer dollar would also help the rest of the world to recover.
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