Ben on the Hill: Economic Outlook

The following are excerpts from Fed Chair Ben Bernanke’s testimony today before the House Budget Committee, along with my notes interspersed:

“The economic recovery that began in the middle of 2009 appears to have strengthened in the past few months, although the unemployment rate remains high. The initial phase of the recovery, which occurred in the second half of 2009 and in early 2010, was in large part attributable to the stabilization of the financial system, the effects of expansionary monetary and fiscal policies, and the strong boost to production from businesses rebuilding their depleted inventories.

“But economic growth slowed significantly last spring and concerns about the durability of the recovery intensified as the impetus from inventory building and fiscal stimulus diminished, and as Europe’s fiscal and banking problems roiled global financial markets.”

In other words, he is saying that the ARRA (stimulus act) was effective in helping to stabilize the economy. That is what he is mostly talking about when he says “expansionary fiscal policies.” The Fed also helped by cutting the Fed Funds rate to near zero.

However, much of the growth simply came from restocking store shelves that had become empty. The inventory restocking process was still very much at work even in the second and third quarters of 2010. The change in inventories was responsible for 62% of the growth in the fourth quarter and 48% of the growth in the second quarter.

That changed big time in the fourth quarter, as inventory growth slowed dramatically and thus became a huge drag on growth. Absent the inventory effect, growth would have been 6.9% in the fourth quarter, not just 3.2%.

“More recently, however, we have seen increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold. Notably, real consumer spending rose at an annual rate of more than 4 percent in the fourth quarter. Although strong sales of motor vehicles accounted for a significant portion of this pickup, the recent gains in consumer spending appear reasonably broad based.

“Business investment in new equipment and software increased robustly throughout much of last year, as firms replaced aging equipment and as the demand for their products and services expanded. Construction remains weak, though, reflecting an overhang of vacant and foreclosed homes and continued poor fundamentals for most types of commercial real estate.

“Overall, improving household and business confidence, accommodative monetary policy and more-supportive financial conditions, including an apparently increasing willingness of banks to lend, seem likely to result in a more rapid pace of economic recovery in 2011 than we saw last year.”

We are back on track. The quality of the growth in the fourth quarter was much higher than the growth earlier in the year. It now appears to be self-sustaining. The comeback of the Auto industry is playing a major role, but it is not the only factor.

Construction, both residential and non-residential, is likely to remain weak and not have the sort of robust rebound that is usually associated with an economic recovery. On the other hand, it is the change in Construction spending, not the level that will influence GDP growth. We probably will not see much more deterioration, simply because there is not that much of it left.

“While indicators of spending and production have been encouraging, on balance, the job market has improved only slowly. Following the loss of about 8-3/4 million jobs from 2008 through 2009, private-sector employment expanded by a little more than 1 million in 2010. However, this gain was barely sufficient to accommodate the inflow of recent graduates and other new entrants to the labor force and, therefore, not enough to significantly erode the wide margin of slack that remains in our labor market.

“Notable declines in the unemployment rate in December and January, together with improvement in indicators of job openings and firms’ hiring plans, do provide some grounds for optimism on the employment front. Even so, with output growth likely to be moderate for a while and with employers reportedly still reluctant to add to their payrolls, it will be several years before the unemployment rate has returned to a more normal level. Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established.”

We are on the road back with regards to jobs, but the road is going to be a long, hard one — a journey of 1000 miles, and all that. While it is likely that the pace of job creation will pick up in 2011, perhaps to double the average rate in 2010, that would still mean creating only about 2 million jobs. Since we are 7.75 million jobs short of where we were at the employment peak, that would still leave us down by 5.75 million jobs relative to December 2007, and the population continues to grow.

We would need almost three more years at that pace after 2011 to erase that jobs deficit. In other words, we would get back to end of 2007 job levels by the end of 2014 or so.

“On the inflation front, we have recently seen increases in some highly visible prices, notably for gasoline. Indeed, prices of many industrial and agricultural commodities have risen lately, largely as a result of the very strong demand from fast-growing emerging market economies, coupled in some cases with constraints on supply.

“Nonetheless, overall inflation is still quite low and longer-term inflation expectations have remained stable. Over the 12 months ending in December, prices for all the goods and services consumed by households (as measured by the price index for personal consumption expenditures) increased by only 1.2 percent, down from 2.4 percent over the prior 12 months.

“To assess underlying trends in inflation, economists also follow several alternative measures of inflation; one such measure is so-called core inflation, which excludes the more volatile food and energy components and therefore can be a better predictor of where overall inflation is headed. Core inflation was only 0.7 percent in 2010, compared with around 2-1/2 percent in 2007, the year before the recession began.

“Wage growth has slowed as well, with average hourly earnings increasing only 1.7 percent last year. These downward trends in wage and price inflation are not surprising, given the substantial slack in the economy.”

Inflation, particularly core inflation, is very well behaved, and is likely to remain so as long as we have high rates of unemployment and, I would add, low rates of capacity utilization. It is China and India, etc. that are driving the rise in oil (and hence gasoline) prices. A rebound in growth in the U.S. is also playing a bit of a role.

Poor harvests due to bad weather (the heat wave last summer in the former USSR, floods and cyclones in Australia, floods in Brazil) along with rising demand for meat in China and the rest of the developing world (and hence the need to feed the animals, which uses up more much grain than eating the grain directly) are behind the rise in food prices.

Those who have been predicting runaway Weimar/Zimbabwe-type inflation since the start of the financial crisis have been dead wrong and are likely to remain so. Even those predicting milder inflation (say, the U.S. in the 1970’s) have been — and are likely to remain — wrong.

In short, the story is one of accelerating growth with low inflation. We are in such a deep hole from the Great Recession, however, that even with a fairly long period of robust economic growth there are still going to be millions and millions of people who are unemployed and hurting. While that is bad news for them, it is also the sort of environment in which the stock market can do very well.

We are in a cyclical upswing and that should be very good for cyclical stocks in particular. Commodity producers of all types should do very well. High oil prices will benefit producers like Clayton Williams (CWEI) and Range Resources (RRC). So should mining companies like Southern Copper (SCCO) and Teck Resources (TCK). That means strong farm income, which will benefit farm machinery firms like Deere & Co. (DE).

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