If you were looking for a final, cataclysmic collapse of the US economy, you remain disappointed. To be sure, the fallout from the financial crisis is severe, with the palpable wreckage evident in the bottom line, a rate of underemployment at 17.2%. Yet even the most diehard pessimist could not fail to recognize the numerous signs of a cyclical turning point in the second half of 2009. And those signs continued into the new year with today’s ISM release. The bulls had reason to run with these numbers; the near term outlook appears baked in the cake . Yet the near term is not an interesting question, in my opinion. The interesting question is what will emerge in the second half of the year. Is the first half a head fake? And, more importantly, where will incoming data lead policymakers, particularly at the Fed? My expectation remains that the Fed will wait until the medium term uncertainty is lifted before raising interest rates, which would be well into the back half of this year if not into 2011. But that might not be the ball to watch; policymakers probably worry about the size of the balance sheet more than the level of interest rates. The near term risk is that stronger than expected growth in the first half would tempt the Fed to withdraw that liquidity before the recovery became fully entrenched.
The ISM manufacturing numbers for December stoked a fire on Wall Street Monday morning, with the better than expected headline number bolstered by strong gains in new orders, the lifeblood of future factory production. Moreover, the employment numbers moved higher, which, coupled with steady declines in initial unemployment claims, points toward actual – gasp – job growth as early as the first quarter. Industrial production gained a solid 0.8% in November, returning to something resembling a “V” shaped recovery in the making after a flat reading in October. Similarly, core manufacturing orders continued their upward trend that same month. Inventory to sales ratios continue to fall, arguing for continued restocking support. And consumer spending continues to edge forward despite declining consumer credit and rising saving rates, a dynamic that will be increasingly supported by firming job markets. What’s not to like? No wonder then that Treasury markets have sold off modestly, the 10 year bond heading toward the 4% mark.
Indeed, using the typical post war recession as a guide, one would think the pessimists would by now have folded their cards, leaving that smoky back room of despair for the clear air and bright sunshine that mark the beginning of a new day. But alas, the fear remains that there is no longer such a thing as a “typical” post war recession. The recovery appears inexorably linked to a host of stimulus measures that reach into virtually every strand of the fabric that is the US economy. And therein lies the uncertainty – few are confident that the economy can stand on its own. And the hypothesis that it can has not been tested. The Fed continues to expand its holding of mortgage securities, still looking toward March as the end date for that program. The positive growth impulse from fiscal stimulus will continue through the first half of this year. Support for housing comes via many channels – and despite rising existing home sales and price stabilization, no one believes the housing market remains anything but broken. Moreover, it is difficult to forget that solid US growth of the past decade and earlier was dependent on asset bubbles to fuel consumer spending. No such convenient asset bubble is on the horizon at the moment.
Where does the economy stand when the support for housing is withdrawn, when fiscal stimulus runs its course, when the inventory correction process is complete? The most dire predictions point to the possibility of a double dip recession:
Nobel Prize-winning economist Paul Krugman said he sees about a one-third chance the U.S. economy will slide into a recession during the second half of the year as fiscal and monetary stimulus fade.
“It is not a low probability event, 30 to 40 percent chance,” Krugman said today in an interview in Atlanta, where he was attending an economics conference. “The chance that we will have growth slowing enough that unemployment ticks up again I would say is better than even.”
But as Krugman notes, even a slowing in the rate of growth would be sufficient to derail any nascent recovery in the job market pushing the unemployment rate higher. And the outlook for unemployment was not particularly optimistic to begin with, especially if a job market revival draws discouraged workers back to the job lines.
Simply put, despite an improving economy, the enormous uncertainty surrounding the path of growth in the second half of this year coupled with still high unemployment forecasts, look likely to keep policymakers on hold through at least the first half of this year. Recent Fedspeak has not been particularly optimistic at all, tending to favor stories of drags on the economy. See Federal Reserve Governor Elizabeth Duke via Calculated Risk. See also Federal Reserve Vice Chairman Donald Kohn:
Lingering credit constraints are a key reason why I expect the strengthening in economic activity to be gradual and the drop in the unemployment rate to be slow. Even as the impetus from fiscal policy and the inventory cycle wanes later in 2010, however, private final demand should be bolstered by further improvements in securities markets and the gradual pickup in credit availability from banks. In addition, spending on houses, consumer durables, and business capital equipment should rebound from what appear to be exceptionally low levels. We have already seen some hints of this increase in private demand in recent months. But, understandably, households and businesses and bank lenders remain very cautious, and the odds are that the pickup in spending will not be very sharp.
And finally, note that in Federal Reserve Chairman Ben Bernanke’s most recent speech, he explicitly relies on the Taylor rule as evidence that the Fed Funds rate was not too low during the run-up to the housing boom. That same rule posits that the Fed Funds rate should hold at zero. Indeed, Paul Krugman notes that Taylor rules coupled with the Fed’s forecast point to negative interest rates through 2012 , a point that Bernanke ignores, clearing not wanting any criticism that he needs to more rather than less, by imposing the zero bound on his charts. Still, the point is clear; to the extent that the Fed’s forecast is not changing, there seems to be no need to back off the zero interest rate policy any time soon.
But what about the balance sheet expansion? Recall St. Louis Federal Reserve President James Bullard from November:
In an interview posted on the newspaper’s website on Sunday, St. Louis Federal Reserve Bank President James Bullard said he would not favor tightening monetary policy before recovery was well-established.
“You are going to need to have jobs growth and you are going to need to have unemployment declining,” said Bullard, who moves into a voting seat on the Fed’s rate-setting panel next year.
…Bullard said that tightening monetary policy “does not have to involve as its first step moving the federal funds rate off zero”. Instead, he favored at that point selling back assets the Fed had acquired, the Financial Times said.
Many Fed officials have said asset sales could disrupt financial markets and push up long-term interest rates. But Bullard said that with proper planning, asset sales did not need to be disruptive.
Suppose that the combined effects of inventory correction and federal stimulus are sufficient to pop the nonfarm payrolls numbers, a possibility enhanced if firms cut employees a little too aggressively in 2009. This is likely not enough to spook the FOMC into hiking rates, but could be sufficient to test the waters on liquidity withdrawal. Would they spoke that easily? Note Kohn’s words of caution:
Third, because monetary policy typically acts with long lags on the economy and price level, the choice of when and how to exit will depend on forecasts. We will need to begin withdrawing extraordinary monetary stimulus well before the economy returns to high levels of resource utilization. The FOMC has been clear that its expectations for the stance of monetary policy depend on economic conditions, including resource utilization, inflation, and inflation expectations. Accordingly, the judgment as to when to begin initiating steps to withdraw stimulus will depend on the outlook for these variables.
Finally, it is well to remember that we are still in uncharted waters. We do not have any recent experience with financial disruptions of the breadth, persistence, and consequences of those that we have experienced over the past several years. And we have no experience with most of the sorts of actions the Federal Reserve has taken to counter the shock. The calibration of our exit from these policies is complicated by a paucity of evidence on how unconventional policies work. We will need to be flexible and adjust as we gain experience.
While Kohn is warning that the Fed would need to move quickly to get ahead of a turning economy, a pop in payrolls might not be sufficient to force near term action. The addition of rising inflation expectations, however, could be the final straw. Although actual core inflation was flat in November while the unemployment rate suggests resource slack for years to come, the 10 year Treasury TIPS breakeven has widened to a pre-crisis level of 239bp. But the general public appears to hold low inflation expectations. Will those shift dramatically? Again, given high unemployment, this looks unlikely. But what would surely cause expectations to shift is a steady rise in energy costs. Oil has moved back through the $81 dollar mark (on the back of ease Fed policy again?), and Calculated Risk notes that this may already be impact driving habits. Last time inflation expectations spiked on oil, the Fed looked through the gains, eyes firmly focused on the evolving financial crisis. But this time the balance sheet would be much bigger, a fact that would stick out like a sore thumb a an FOMC meeting.
The risk of course is that if the Fed is pushed into a premature withdrawal, financial anarchy would ensure. Indeed, via naked capitalism, some are already looking for that outcome on the back of the stabilization of the Fed’s balance sheet in the latter half of 2009. Of course, risks are not all US centered. China plays a role as well. From Bloomberg:
Chinese central bank Governor Zhou Xiaochuan reiterated government warnings that investment in industries with excess capacity and in redundant infrastructure projects could threaten banks’ loan quality.
The People’s Bank of China will guide credit, seeking to avoid volatility in lending, Zhou said in an interview dated yesterday on the Web site of China Finance, a central bank publication. Investment in duplicated projects or industries with overcapacity could “pose a risk to the quality of banks’ loans,” Zhou said.
China’s policy makers are seeking to contain risks from an unprecedented credit boom, in which banks extended 9.21 trillion yuan ($1.3 trillion) of new loans in the first 11 months of 2009. Liu Mingkang, chairman of the China Banking Regulatory Commission, said yesterday that lenders have “more than” enough capital, while also cautioning that asset bubbles may emerge in the world’s third-biggest economy.
“The credit boom last year to cope with the financial crisis has brought side effects, including housing bubbles in some cities and overcapacity in manufacturing,” said Isaac Meng, a senior economist at BNP Paribas SA in Beijing. “These are risks that China will need to guard against this year.”
Specifically, I’m wondering if the pent-up inflationary pressure takes the form of inducing consumers and businesses in China to try to acquire any hard assets they can, with the result that rather than overall inflation we see remarkable increases in the relative prices of such items.
The concern, of course, is that the next negative demand shock does not have to originate in the US, fears of a Fed overreaction aside. Tighter credit in China to stem inflation could be sufficient to once again push the global economy to the brink.
Bottom Line: The economy is gathering steam. Can’t deny it. But the clear path to sustained recovery remains clouded by government stimulus, both in the US and abroad. Few policymakers are confident that economic activity can stand on its own as stimulus fades, leaving the Fed disinclined to rush for the exits given existing forecasts. Indeed, there is reason to believe based on Taylor Rules that interest rates should be held at the zero bound through 2010 and beyond. But policy mistakes happen. And FOMC worries about the timing of withdrawal could be the basis for such a mistake if near term activity accelerates rapidly and inflation expectations gain. The focus on the Fed may be misplaced; he FOMC is not the only policymaker that might upset the apple cart. The next negative shock might come from abroad.