It is difficult if not impossible to deny the firming of economic data in recent months. But that firming has been inexorably tied to a host of fiscal and monetary stimulus measures. Fiscal stimulus is dependent upon political will and Treasury’s ability to sell debt cheap. And anything less than 4% on the 10-year bond looks pretty cheap historically, especially given the mountain of paper issue by the US Treasury. On the monetary side, the Fed looks poised to sustain that stimulus until a potentially inflationary situation emerges. From policymaker’s perspective, that remains a distant threat. What – and how many – global distortions will emerge as a result of the Fed’s extended zero-interest rate policy? And what will bring the new house of cards crashing down?
The flow of data continues to point to a turning point in economic activity. The ISM manufacturing report pushed above the 50 mark, rising to its highest level since the summer of 2007 on the back of a surge in new orders. Likewise, the nonmaufacturing counterpart moved higher as well, although the gain was not as dramatic, and overall activity failed to cross the boundary into expansion. Firmer activity in manufacturing suggests that the July gain in industrial production will be repeated this month. Adding to the manufacturing upswing are leaner inventories, with the inventory to sales ratio falling to 1.38 from its cycle high of 1.46 in January of this year. Even that much beleaguered housing sector is showing signs of life, with housing starts apparently bottoming in the spring; the cessation of freefall is certain to support third quarter GDP. Finally, households are feeling a bit more confident, and that translated in consumption growth in July. Anecdotally, the word on the street is more positive, as summarized in the opening paragraph of the most recent Beige Book:
Reports from the 12 Federal Reserve Districts indicate that economic activity continued to stabilize in July and August. Relative to the last report, Dallas indicated that economic activity had firmed, while Boston, Cleveland, Philadelphia, Richmond, and San Francisco mentioned signs of improvement. Atlanta, Chicago, Kansas City, Minneapolis, and New York generally described economic activity as stable or showing signs of stabilization; St. Louis remarked that the pace of decline appeared to be moderating. Most Districts noted that the outlook for economic activity among their business contacts remained cautiously positive.
All in all, it seems a fair bet that the NBER recession cycle dating team will pin the end of the recession sometime during the summer of 2009.
That said, even the most optimistic bull will note that I just cherry-picked the data. While time and inventory control have come into play, firming activity has been inexorably linked to a host of fiscal and monetary stimulus measures. Consumption and manufacturing have both been boosted by the now concluded “Cash for Clunkers” program; we are now anxiously waiting for the likely painful hangover from that spectacular demolition derby where all contestants won a prize. And, interestingly, despite the car buying binge, consumer credit contracted by a whopping 10% annualized in July, a testament to the mix of restriction to and aversion of credit that continues to weigh on household spending plans. Likewise, housing sales have been supported by the $8,000 tax credit for “first-time” buyers, which has been estimated to fatten real estate agent wallets with the addition of almost 400,000 home sales. Like the Clunkers program, the homebuyer’s tax credit is set to expire, threatening to pull the rug out of the housing market just as foreclosure activity looks to be heading higher. Should it be extended? Not just real estate agents and home builders think extension – and enhancement – is a no brainer:
“There will be some payback, particularly late this year and early next and that’s one of the reason house prices are going to begin weakening,” Mr. Zandi says.
Mr. Zandi’s reasoning could provide fuel to those in Congress and the administration who want to extend the tax credit. While some in the administration think it should be extended, concerns about the mounting deficit may make such an argument politically tricky.
For his part, Mr. Zandi says the tax credit should be extended and possibly expanded to all home buyers — not just those purchasing for the first time. He says the credit could have a bigger impact once the job market recovers and fewer people are out of work and able to buy homes.
Leaving aside the issue of whether or not it is wise to create a fresh entitlement for housing purchases (not), the likely all-out push for an extension points to the current vulnerability of the recovery. It looks neither durable nor sustainable at this juncture; moreover, once again the recovery falls short of providing a significant boost to the labor market. Yes, the pace of deterioration in nonfarm payrolls is clearly improving, and a turning point has been reached. But payrolls data continues to deteriorate nonetheless, with only the health care and social assistance sector proving a significant supporting role during the month of August. Moreover, unemployment is staring at the 10% mark while underemployment is just shy of 16%. The pace of improvement in initial claims has become anemic, and soon claimants will begin dropping off the roles, another headwind for consumption spending (let alone the human cost) if hiring intentions don’t soon head significantly higher.
The weak labor market is clearly weighing on inflationary pressures. From the Beige Book:
Wage pressures remained low across all Districts. Several Districts noted businesses and local governments imposing wage freezes or even reducing employee compensation in some instances. Boston noted that several manufacturers who have cut wage rates do not expect to restore pay levels until next year. Kansas City, Philadelphia, Chicago, Minneapolis, San Francisco, Dallas, and Richmond noted an increase in the cost of some raw materials, including fuel, metals, and steel. Chicago and Dallas mentioned that excess supply was putting substantial downward pressure on natural gas prices. Retail prices were described as generally steady in most Districts, although Kansas City and San Francisco noted continued discounting and downward pressure on consumer prices.
From the Fed’s perspective, the flow of data and anecdotal evidence points to an economy that is definitely improving but not so much as to generate inflationary pressures. Moreover, the profound and persistent weakness in the job market leaves open the question the sustainability of an external inflation pressures (from commodity prices, for example). If high prices do not trigger higher wages, the much feared inflationary spiral cannot take hold. And thus is why Fed officials keep warning that a rate rise is not in the cards in the near term; Chicago Federal Reserve President Charles Evans reiterated this position Wednesday:
Evans also said that when it comes to rate hikes and major unwinding of other emergency support programs now, a shift lies “some time down the road.” In reaching a determination of whether rate hikes are needed, Evans said that “we are going to be looking very carefully at how the economic recovery is preceding,” and will be watching inflation and unemployment measures.
“As the economy continues to improve, and when we see rising inflation pressures, Fed policy will respond aggressively,” Evans said. When the time does come to raise rates, “we could have a pretty reasonable withdrawal of accommodation.”
Remember, in the last jobless recovery the Fed was still cutting rates well after the official end of the recession. Of course, the Fed could very well move faster when the signs of sustainable recovery emerge – but if sustainability and inflation potential are based on the labor market, that recovery is easily a long way off. Moreover, the Fed will not be keen on risking a premature reversal of policy; such reversals never did the Japanese economy any favors. Speaking of Japan, another prime example of start-stop “recovery”:
Japanese machinery orders fell more than economists forecast in July, signaling companies are wary that a rebound in sales abroad will last.
Orders, an indicator of capital spending in the next three to six months, declined 9.3 percent from June, when they jumped 9.7 percent, the Cabinet Office said today in Tokyo. Economists surveyed by Bloomberg News predicted a 3.5 percent decline…
…“There’s been an enormous wave of confidence in the stock markets but that hasn’t been shared by business leaders,” said Martin Schulz, senior economist at Fujitsu Research Institute in Tokyo. “Producers know that lots of the improvement in exports and in the overall outlook has been on the back of government programs and they’re still troubled by the outlook.”
It is not easier to pull one over on Japanese business leaders; they have been living this dynamic for nearly two decades.
To be sure, there will be consequences of the Fed’s extended ZIRP policy; pump enough money in the economy, and it has to show up somewhere. Pump enough of a reserve currency into the global economy, and things can get interesting fast. From Bloomberg yesterday:
“Over the next few months, we see the yen strengthening against the dollar and European currencies,” Greg Gibbs, a foreign-exchange strategist at RBS in Sydney, wrote today in a report. “We expect the yen to continue to be replaced by the dollar, and even possibly European currencies, as the preferred funding vehicle for higher-risk, higher-yielding assets and currencies.”
Consider what has occurred – the principle reserve currency, that which is supposed to be an effective facilitator of exchange and a store of wealth, is threatening to overtake the yen and become the primary financing vehicle of hot money gambling. Under such circumstances, the current market dynamic should come as little surprise – commodities stronger (Gold again breached the $1,000 mark before retreating) while the Dollar is substantially weaker and US equities get a lift. Seriously, can this really end well?
“It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose,” he said.
When will it come crashing down, as all free money pyramids eventually do? As always, when some aspect of policy or economic activity makes a fundamental shift. We need to be on the watch those changes. Renewed financial crisis that sparks a flight to safety, assuming the Dollar is still considered safe? But what is the likelihood of true counterparty risk when US policymakers have effectively implemented a too-big-to-fail policy that will soon evolve into a too-big-to-regulate policy – even as, according to the Wall Street Journal, the appetite for risk of the top five banks has risen to record levels. Sure, if your counterparty is Podunk Bank in Nowhere, North Dakota, you have risk. But Bank of America (BAC) or Morgan Stanley (MS)? Get real – they have tighter security than President Obama. Domestic policy change? The Fed is trying to get credit flowing to consumers, but the data is saying that just is not happening. Would the situation improve by raising rates? No, and assuming the jobless recovery scenario emerges, there will be no pressing domestic reason to rush to tighten. And if markets stumble as the Fed winds down its purchases of Treasuries and mortgage securities, the best bet is that the Fed would reverse course and expand the balance sheet further. Lack of political will to maintain US stimulus? Goodness knows that when push comes to shove, the US Congress loves to spend as much as any drunken sailor. External changes? China becomes unwilling to hold its Dollar portfolio in response to rising protectionism and makes a bid for the Renminbi to supplant the Dollar as the global reserve currency? Or rising commodity prices foster foreign inflation, which in turn prompt foreign central banks to raise rates and choke off growth?
The Fed is fueling a nice little train of trading, if not economic, activity. The Fed will fuel the ride until inflation pressures truly emerge, a ride that can last for a long time given the current state of the labor market. Everyone should join in for that ride. But train rides fueled by cheap money always end the same – we pretend the ride can continue indefinitely, but eventually the train moves on to a track that policymakers can not tolerate. We need to be watching for that track. The risk: That track could be a ways off, and we will become complacent before we get to it.