Interview With Ethan Harris: Further Slowing In Summer, 20% Chance Of Recession In Next Year

Includes: DIA, QQQ, SPY
by: Harlan Levy

Economist Ethan Harris is managing director and co-head of global economics at Bank of America Merrill Lynch. Previously he worked at Lehman Brothers, where he was chief U.S. economist since 2003. Before that he worked at the Federal Reserve Bank of New York.

Harlan Levy: What do you make of the jobs numbers and other new economic data?

Ethan Harris: The U.S. economy is slowing down, but so far it's a gentle slowdown. We still are looking at an economy that can generate more than 100,000 jobs a month. Growth is running about 2 percent, and the economy is weathering the fiscal shock very well.

We do expect some further slowing going into the summer, as the full impact of the tax increases and sequester play out. The overall fiscal tightening is the equivalent of 2 percent of Gross Domestic Product, so it's too big to shrug off without some damage.

H.L.: What about inflation?

E.H.: In recent years there has been a lot of concern that central bank liquidity would create runaway inflation. However, the Federal Reserve's liquidity has been staying in the banks. It has not caused a lending or a spending boom, and hence, it has not been inflationary.

Instead, inflation is being driven by two factors: commodity markets and the labor market. In 2011, commodity markets created tremendous upward pressure on inflation. But since then commodities have cooled off, and inflation pressures have dissipated. Meanwhile, despite the recovery in the job market, unemployment remains high at 7.5 percent, and this means ongoing weakness in wages and other compensation.

Labor costs are the most important costs of business, and these weak costs have allowed businesses to maintain low pricing. This combination of weakness in commodities and labor is now pushing down inflation. The Fed's preferred measure of inflation, the Personal Consumption Deflator, is now rising just at a 1 percent year-over-year pace. This is one of the lowest inflation rates in 50 years. So, far from having an inflation problem, we have unusually low inflation.

H.L: But do we have a deflation problem?

E.H.: At this stage, we're not close to deflation. Wages are still growing at about 2 percent per year, and depending on how you measure it, prices are rising at from 1 to 1.5 percent per year.

We believe that deflation is unlikely unless the economy slips back into a recession. At this stage we see about a 20 percent chance of recession in the next year, and we think recession is only likely if there's an unexpected shock to the economy.

H.L.: What's the outlook for the Fed's policy?

E.H.: Earlier this year many economists were talking about the Fed slowing and then ending its buying program -- $85 billion a month buying Treasury bonds and mortgage securities -- this year. In our view this was never likely. With unemployment too high and inflation well below the Fed's target of 2 percent. We believe the Fed is a long way from ending its buying program. We expect the Fed to start pulling back next year, not this year.

This means continued support to both the stock and bond markets. Eventually, the Fed will need to pull back on its buying, but we expect the Fed to do so gradually and in a way that doesn't do serious damage to the equity market. As long as inflation is low, the Fed will want to engineer a soft landing.

On the other hand, if we do begin to have a serious inflation problem, then a hard landing becomes likely. So, as is always the case, ultimately whether we have a friendly or unfriendly fed hinges on whether it's fighting inflation.

H.L.: What do you see happening with stocks?

E.H.: So far this year, perhaps the best way to think about the stock market is that there's been a tug of war between concerns about fiscal austerity and the Fed's easing. So far, Fed easing is trumping austerity as the Fed continues to supply liquidity to the markets.

This is an environment that has been good for both the stock and the bond markets. As we move into year-end we think the drivers of the market will shift. We expect growth to pick up as the fiscal shock fades, and we expect the Fed to react by hinting at an end to its buying program. At that stage, the bond market could come under pressure, but stocks are likely to continue to trend upwards.

H.L.: What does the global picture look like?

E.H.: The global backdrop is similar to what we see in the U.S., that is, growth is weak. Inflation is moderate, and central banks continue to supply liquidity. We continue to be very concerned about Europe. We don't see an imminent break-up in the euro zone, but we do expect a very weak economy to continue. Unfortunately, we are probably years away from the end of this crisis.

H.L.: There's an ongoing debate between the economists who say that increasing spending in a weak economy is necessary and those who disagree. What do you think?

E.H.: Harvard economists Carmen Reinhart and Ken Rogoff argue that when a country's government debt hits 90 percent of GDP it could cause a sharp slowing in growth. This has become a hot topic of discussion among economists and policy makers. My own view is that there is no magical threshold. Accumulating large amounts of debt eventually gets a country into trouble, but the threshold is very uncertain and is probably much higher in the U.S. than in other countries.

My view is that rather than abruptly attacking the budget deficit, we should be taking a longer more gradual approach. We also should be focusing on the fast-growing parts of the budget, that is in entitlements, rather than repeatedly cutting the same programs we've already cut.

I don't think the economy needs a big stimulus plan, but what we do need is a more sensible, gradual budget process in Washington.

H.L: What's the likelihood of that?

E.H.: In recent years, the budget process in Washington has been like a game of Demolition Derby, where each side slams the other side, and in the process undercuts confidence in the economy. My hope is that, going forward, we have a much quieter version of gridlock, where the two sides agree to disagree but don't threaten the economy with sudden changes in taxes or spending.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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