I say this with no exaggeration: The picture painted by the data flow of the past two weeks is deep into the left tail of any of my reasonable distribution of probable economic outcomes. The die is now cast – fiscal stimulus will be too late to prevent the snowballing that will occur throughout the first half of next year. In this environment, policymaking will become increasingly desperate.
The free fall in economic activity reported by the ISM in both the manufacturing and nonmanufacturing sectors yielded the worst for the labor market. There is no way to candy coat the November employment report. It was simply dismal; downward revisions to the previous month boosted the sense of dread that emanated from the BLS release. And the damage to labor markets appears to be accelerating, with the rise in initial jobless claims last week pointing toward a December job loss of 600k or more. Expectations of rising headline unemployment rates can be tempered only by defections from the labor force; I would not be surprised to see the broad U-6 measure of unemployment coast through 15% before the first quarter is over.
With the labor market in disarray, the Fed will feel compelled to do more, as only they can deliver stimulus in the near term. The FOMC begins a two day meeting tomorrow, with a further 50bp of rate cutting almost certain. Also almost certain is that no one believes that the last 100bp has much stimulative power to offer. The rate cut itself, thus, is largely irrelevant. What is relevant is the statement – will the Fed more explicitly define their apparent policy of quantitative easing? Federal Reserve Chairman Ben Bernanke’s recent speech set up expectations that such a shift was coming. Failure to follow through would be yet another communication failure.
I am torn on the wisdom of this move. On one hand, using the Great Depression as a guide, the appropriate policy direction appears clear – flood the markets with liquidity, coupled with massive fiscal stimulus. This is the track the policy train is on. I completely understand this policy in a closed economy suffering from insufficient demand relative to supply. But when faced with a large open economy with a substantial current account deficit, the back of my mind screams “caution.” It is an itch I can’t scratch.
In my view, policymakers tend to see the current account deficit as almost an unimportant residual, something that just falls out of the global economy, but tells you little about the economy itself. I tend to view it as representing a fundamental imbalance. I believed that as part of the adjustment of the past year, a combination of import compression and export expansion would eliminate the imbalance, and that the appropriate role of policy was to facilitate and cushion that imbalance.
In nominal terms, high oil prices in the first half of the year stalled that adjustment and forced an intensification of import compression by undermining consumer spending. This triggered a more intense adjustment than I would prefer (obviously), but I could see that the expected improvement of the current account deficit would provide room for aggressive policy response. This was especially the case given collapsing oil prices. And if domestic saving rose enough as households and firms restrained spending, the federal government could have a very significant gap to fill.
But then a funny thing happened…global trade appears to be collapsing, undermining US exports and leaving the nominal current account deficit stable, meaning that the US still remains very dependent on capital inflows. Brad Setser scared me straight last week on this topic:
The US trade data surprised on the downside — and while it is far too soon for the dollar’s recent rise to really have an impact on the trade data, the rise in the deficit perhaps did remind the market that over time a rising dollar would tend to maintain the still large trade deficit not bring it down. Macro Man was far more surprised by the rise in the non-oil deficit than I was; it was always going to be race down between imports and exports.
Simply a race down, or a race to the bottom? My challenge is that lacking an adjustment of the external imbalance, I can easily see that the current policy path becomes a dead end. Emphasis on “dead.” Yves Smith lays out an alternative scenario that reminded me of old concerns:
Now to my doubts about the proposed remedies, namely monster stimulus and monetary easing. First, as mentioned before, the analogy is to the US in the Depression, which we have said repeatedly before is questionable. The US in the 1920s was the world's biggest creditor, exporter, and manufacturer. Our position then is analogous to China's now. Indeed, Keynes in the 1930s urged America to take even more aggressive measures, and argued that it was not reasonable for the US to expect over-consuming, debt-burdened countries like the UK and France to take up the demand slack. So even though most economists are invoking Keynes, it isn't clear he'd prescribe such aggressive stimulus for the US and UK now.
If Yves is correct, the coming massive US policy response is a desperate attempt to maintain a global economic structure that is fundamentally broken. This is a story I have long championed, but, in recent months, one I was willing to discount given my expectations of an improvement in the current account. Indeed, this seemed consistent with the strengthening of the dollar. But recent trade data suggests I may have become too complacent with regards to the external dynamic.
The threat, of course, is that the Fed and Treasury are setting the stage for a disorderly adjustment of the dollar by ignoring the imbalance. Without the external adjustment in place, pushing rates to zero, flooding the economy with money, and pumping out hundreds of billions of new debt threatens to pull the rug out from under the dollar. Even more worrisome, however, is that surplus nations respond with competitive depreciations as they also seek to maintain the fundamental imbalance. We all race to the bottom together.
The recent stability of the US dollar has almost certainly put to rest any worries on the part of policymakers. But it is looking like the dollar has peaked. From Bloomberg:
Speculation that the dollar has peaked gained steam last week as the currency plunged 4.9 percent against the euro to $1.3369, its biggest drop since Europe’s common currency was created in 1999. It weakened 1.75 percent versus the yen.
“We’re at a turning point in terms of dollar dynamics,” said Jens Nordvig, a New York-based strategist at Goldman Sachs (NYSE:GS), the biggest U.S. securities firm to convert to a bank. “The dollar shortage has been addressed and we’ll see people start to focus on other things and those are all dollar negative.”
With delivering induced flight to quality largely complete, the stage is set for underlying factors to come into play. And those factors do not appear to be supportive of dollar denominated assets. One would think that near zero rates would stem the allure of the dollar (one would also think that domestic savers rethink keeping their money anywhere but a safe deposit box). Indeed, that appears to be the case versus the yen.
But to be a real dollar rout, we would expect to see Treasuries come under severe pressure, which has not exactly been a recent trend. So perhaps there really is nothing to fear. Indeed, I have argued that if the stimulus is too excessive, that excess should reveal itself in the Treasury market, and policymakers can simply back off. No problem – ease away. Build those bridges.
This assumes that policymakers back off. What if rising Treasury rates encourage the Fed to double down, expanding quantitative easing to hold rates low and stimulative. What if years of research on the Great Depression have left even the best and the brightest with tunnel vision such that they could not accept that they were wrong?
Bottom Line: The Fed is headed to the zero mark, with another 50bp almost certain this week. It is widely expected that they will give some guidance as to their next steps, pointing us in the direction of an explicit policy of quantitative easing. Fed policy, as well as fiscal policy, assumes that the Great Depression is the most accurate analogy. This assumption ignores the external position of the US, which stubbornly refuses to adjust. If that failure to adjust is relevant, then recent dollar stability was simply a head-fake.
We should see pressure on the dollar and, ultimately, Treasuries. Policymakers could adjust, but would they? With pursuit of the Great Depression case as the baseline scenario, it seems prudent to keep in mind the risk that this is not the relevant analogy for the US, and that policymakers are not prepared to accept such a possibility.