Fed Watch: Starting the Year on an Ugly Note

The only certainty for the New Year is that policymakers will continue to pull out all the stops to keep a floor under the US economy. And recent data highlights the difficulty they will face. Hope is high that the incoming Obama Administration can provide the stimulus necessary to generate economic growth by the second half of 2009. The numbers being floated look sufficient to do the job. But will the package provide little more than short term relief or a lasting fix?

The last two weeks were not pleasant. Working backwards, we were greeted on the first trading day of the New Year with a truly terrible report on manufacturing. Across the Curve has the details; my eyes were pulled to the decline in the export orders component. The external accounts should be cushioning the US downturn. Instead, it looks increasingly likely the opposite will happen – another sign that the global economy is hopelessly imbalanced.

Earlier in the week, the Case-Shiller index confirmed the expected ongoing decline in housing prices. Efforts to support this sector have proven insufficient to stem the pain. This should not be a surprise, as government efforts have focused on maintaining a market for mortgages made under conditional underwriting standards. Such standards limit home financing to that which is prudent for the borrower and lender, but well below that necessary to maintain housing prices. Moreover, lending for home purchases (and consumer credit in general) is now fighting against a deteriorating labor market. I don’t care how much money has been spent on TARP, you can’t reasonably expect banks to extend fresh credit to the jobless. And there is no mistake that the floor is falling out from under workers. Look at the employment component of the ISM report. Or the recent trend in initial employment claims, with a four week average of 552k; discount the seasonally affected drop last week. This Friday is likely to see another blowout employment report.

The new orders in durable goods report was better than expected, although I take little comfort in the improvement. The numbers tend to be volatile, and the ISM release noted above strongly suggests this indicator will trend lower in the months ahead. The personal income and outlays report was also better than expected as falling gas prices provided a significant boost to real incomes. But the downside in oil prices is likely limited at this juncture, and, consequently, gas is not likely to provide as much of a boost in future months. Moreover, the declining energy costs are fighting against rising joblessness and increasing saving rates. The latter two forces are likely to prove overwhelming.

Given the rising sense of despair, policymakers will continue to fall over themselves in a mad rush to pump massive amounts of stimulus into the economy. On the monetary side of the equation, traditional policy is obviously at its end. We are left with efforts to sustain lending activity that are an asset-side directed expansion of the Fed’s balance sheet while waiting for economic conditions to deteriorate enough so that Fed officials switch to quantitative easing, or policy directed toward the liability side. Yes, I know, two sides of the same coin, but the Fed appears to view those sides differently.

Until the Fed shifts gears again, fiscal policy will be the main event. And quite an event it is likely to be, with estimates that the final package will be as high as $1 trillion. That is real money that will soon start flowing into the economy, and it is difficult to see how it does not have a measurable impact. We can all respectively debate the long term effectiveness, the impact on job growth, the ultimate cost, etc., while still acknowledging it should provide significant support to the economy. The near-term risk, I think, to bonds is that it is enough support that Federal Chairman Ben Bernanke does not leap into outright purchases of Treasuries (a liability side maneuver). This does not imply that the stimulus “fixes” the US economy, just that at a minimum it should delay the most bearish day of reckoning.

The structure of the upcoming fiscal stimulus will determine whether this is money wasted trying to sustain a broken consumer/debt driven economic model or on investments that foster future economic growth. I was heartened two weeks ago by incoming head of the National Economic Council Larry Summers:

Some argue that instead of attempting to both create jobs and invest in our long-run growth, we should focus exclusively on short-term policies that generate consumer spending. But that approach led to some of the challenges we face today -- and it is that approach that we must reject if we are going to strengthen our middle class and our economy over the long run. Far from being an excuse for inaction or delay, the magnitude of the work ahead is all the more reason to begin that work.

How quickly the winds shift. From today’s Wall Street Journal:

President-elect Barack Obama and congressional Democrats are crafting a plan to offer about $300 billion of tax cuts to individuals and businesses, a move aimed at attracting Republican support for an economic-stimulus package and prodding companies to create jobs.

The size of the proposed tax cuts -- which would account for about 40% of a stimulus package that could reach $775 billion over two years -- is greater than many on both sides of the aisle in Congress had anticipated. It may make it easier to win over Republicans who have stressed that any initiative should rely more heavily on tax cuts rather than spending.

The Obama tax-cut proposals, if enacted, could pack more punch in two years than either of President George W. Bush's tax cuts did in their first two years…

True, “not exclusively” a focus on short-term consumer spending policies, but 40% of the total is massive tax relief nonetheless. To think that many of us were voting for change…looks like we are getting more of the same.

To be fair, what the Obama team is likely quickly realizing is that while talk of infrastructure spending is great, actual implementation is slow – there are not enough shovel ready projects. Some, yes, but not enough to fill the gap the Administration is trying to fill. Other initiatives, while worthy, have a similar problem. Fostering productivity enhancing innovations, such as education and green energy, are long-fuse policies – they take time to work. For instance, when I think about education, I think about what is necessary to do for the kindergartner today so they will develop the human capital for the workforce 15 years from now. That is a long time horizon. Too much time for an incoming Administration that has promised 3 million jobs. Hence, tax cuts are necessary to move money into the economy quickly, and an easy way to build favor among Republicans early on. Moreover, the Obama team appears to be hoping that, unlike last summer’s package, these are permanent tax cuts that will be largely spent rather than saved. Given the public’s current predilection toward deleveraging household balance sheets, this may be a pipe dream.

Good intentions notwithstanding, the policy is fundamentally what it is – an effort to sustain consumer spending. Rather than households taking the debt onto their balance sheets directly, they take it on indirectly as taxpayers. You cannot borrow your way to prosperity, especially if you always borrow for consumption goods.

Of course, the US is not the only economy where policymakers want to sustain the status quo…

To be sure, I am hard pressed to deny a role for tax cuts; I think that it should be part of the package to provide an immediate boost. My concern is that 40% is too much, and there is a nontrivial chance it will not give sufficient longer-term bang for the buck. This is especially the case because I don’t view the current episode as something that is easily solved with a two year stimulus package. The US economy has become dependent on asset bubbles that are now looking few and far between. Thoughtful, sustainable policy needs be in place for the long haul to help activity transition away from bubble-dependence. I worry that massive tax cutting now is neither thoughtful nor sustainable.

Bottom Line: Like most, I anticipate the incoming economic data will maintain the recent dreary tone. Policy will continue to be accommodative. Monetary policy is now a game of waiting for Bernanke’s next rabbit. While we wait, eyes are on fiscal policy, which promises to be large enough to measurably boost activity later this year, perhaps enough to keep some of Bernanke’s rabbits in the hat. The heavy focus on tax cuts in the emerging fiscal policy, however, looks like yet another short term fix that attempts to sustain a consumer heavy pattern of economic activity. The impact of that portion will likely be fleeting; hopefully some of the remaining stimulus will have more legs.

Comments

[User 268734:]

Great post - thank you.

Jan 05 11:23 AM

[Jason Rines...:]

I agree, a very well written article Mr. Duy. I view it this way about taxes of all types. Small business are your typical innovators, they are the entrepenuars behind the U.S. labor market. Taxes on everything from corporate taxes to residential real-estate are far too high.

I own a small business. There would be almost no incentive to produce, except I tend to build companies for acquisition. If it was just a paycheck, I would already be working with a beurocratic corporate animal or government. That said, most of the small business people I know are in it for a long-term paycheck and are fighting a losing battle.

In general, the average U.S. citizen works 5 months of his/her life in taxes. Compare that to 2 weeks pre-revolution and increase in taxes to 3 weeks of one's productive life turned into a physical revolt against the British. Inflation through fractional reserve lending has not kept up with wages, crushing the middle class.

Such scenerios have played out very ugly in history (middle class crushed). The U.S. to satisfy it's entitlement pledges would have to either increase taxes to 7 months a year per person or cut benefits and government supervision (bloat/pork) 60% in the process. You can imagine which one of these options I prefer. Someone loses in this process. That sucks but it cannot be the over-taxed producers/innovators. I agree with the tax cuts, 40% is NOT too much if it forces government to spend it's money wisely, not unlike the position of 300 million Americans. We need to begin attracting foreign investors outside of Treasuries and into true innovations, rather then the trade imbalance, debt model of 'financial' engineering we have seen that benefits the 1% of our population while the rest of it is in decline.

Jan 05 02:37 PM

[Jonponwon:]

Your article highlights three areas of importance. The first is the illusion of a global economy. That is one of the most potent reasons we are in the economic mess that surrounds us. The global market must be seen for what it is – a scam by the greedy and powerful to make more money. The idea was to move manufacturing away from places where legislation made it expensive to be, and into areas of cheap labour. Those who did so stood to benefit from cheap labour in the manufacturing economy and expensive sales into the American economy. The ruse worked for a time because the expensive US sales were nonetheless cheaper than the prices would have been if the goods had been manufactured in the domestic market. The real benefit was to the domestic economies of Asia. The US had to borrow ever increasing amounts of money to pay for the manufactured goods so that the benefits flowed out of the US domestic economy and into the domestic economies of Asia. I defy you to point me to a model of a global economy. There is not such thing. There is only a gigantic fraud perpetrated on the people of America, whose personal cupidity meant they greedily embraced the concept of cheaper goods without understanding what it meant for the domestic economy.
The second is that a fiscal stimulus is needed to get the economy going. Are economists and politicians totally divorced from the real world? Do they not understand what is going on here? As the saga of what happens unfolds, Americans are beginning to see that their entire economy is based on the smoke and mirrors of the Wizard of Oz. Their money is worthless because it is backed by nothing. Their wealth is fictional because it is locked up in investments that have sunk into a pit, or is in property which in many cases is worth less than they paid for it. Their economic pre-eminence in the world is a chimera, for all they have to show for their leadership is a national debt of $13tr+ which Mr Obama is proposing to grow by another trillion or more. And when they ask what the way out of the mess is, they are told “Take on more debt. Spend more.” They might have been duped in the past but they have had a shock like none ever before administered to them. They have awoken to the horror of their situation and they are not going to fall for ‘easy options’. They have gotten in touch with someone deep within them who cannot be fooled. And that is why fiscal stimulus will not work – not in the US and not in the UK. These politicians and economists fail to take into account the psyche of the people. And the people realise their life is based on a lie and they are not about to be fooled again any time soon. We need a new model of political, economic and social life. Obama saw that change was needed, and so did the people and that is why they gave him a chance. But for the time being at least it seems like he is offering nothing but more of the same.
The third area of importance is related to the two others: it is the role of government in our lives. Over the last three decades of the 20th century there were politicians who realised that government was the problem and they promised to take the axe to government. They lacked the ability. The people were ready for it, but the power-possessors were not and the power possessors won. We need an entirely new model of government, which reduced it to a wraith of what it now is.
Economics and politics do not exist in a vacuum. They grow out of the society of which they are part. We need a new model of society – the elimination of the feral, the building of worth-while values, a struggle to the death with pride and greed and vanity and self-love and all the ‘celebrity’ values. We need a moral rebirth. Will it happen? Extremely doubtful! Instead we will sink into a morass in which we will be submerged.

Jan 07 05:14 AM