Interview With Michelle Girard: No Risk Of Recession, But Fed Purchases Do Nothing But Boost Stock Prices

Includes: DIA, QQQ, SPY
by: Harlan Levy

Michelle Girard is a managing director and chief economist at Royal Bank of Scotland.

Harlan Levy: What are the implications for the economy of the new data showing disappointing housing starts, a surprising jump in initial jobless claims to a six-month high, and the inflation gauge indicating weak demand?

Michelle Girard: The economy has lost momentum this Spring following a good deal of strength around the turn of the year. It's the same pattern that has been seen over the three prior years. But I don't think that the economy is at risk of slowing too sharply.

In particular, the housing stall will prove temporary. I think there's some payback from the strength seen earlier in the years and also some adverse impact from the cool wet Spring, but activity will pick up in coming months. I believe the recovery in housing is ongoing and well-entrenched.

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

M.G.: The employment situation has not changed very much. In looking through the month-to-month noise, the trend in employment growth has been pretty steady and is consistent with a very gradual decline in the unemployment rate. I don't think the employment situation is weak enough to create risks for the broader economy.

On the other hand, it's not strong enough to set the stage for better than a 3 percent growth rate for the economy. We're not getting the kind of employment growth we need to propel the economy to a much stronger growth pace. In terms of employment, it's just more of the same, and I don't see that changing in the near term.

H.L.: What do you predict for the economy next year?

M.G.: The economy is going to continue to struggle next year and could be about the same or slightly better than this year. But I don't expect the economy to move to a significantly stronger growth trajectory. We're still going to be looking at some degree of fiscal drag.

More importantly, I don't think companies are going to be motivated to go out to hire and invest aggressively, and without the prospects for strong job growth I think the outlook for consumer spending on balance remains relatively subdued, similar to what we've seen this year. It's not awful. It's like the overall economy. It's growing at a subpar pace. It's not growing strongly enough to make people feel good, but we're not at risk for going back into recession.

H.L.: A few Federal Reserve Board members just talked about the need for the Fed to stop buying mortgage-backed securities because of the fear the Fed is distorting the market. What do you think?

M.G.: I think that there is definitely a difference of opinion among the Fed's Federal Open Market Committee members about not only the composition of the Fed purchases but also the size of the purchases every month [$85 billion of Treasury bonds and mortgage-backed securities]. You have those arguing that it's distorting the mortgage market, and others arguing that it's an important support for the housing sector.

In general there's a big disagreement on whether it's time to cut back on the overall pace of purchases. In my view I think [Fed Chairman] Ben Bernanke does not yet believe that a scaling back in size is warranted, but I would not be surprised to see the Fed taper off its purchases later this year.

I don't think that the Fed's purchase program is doing anything other than boosting asset prices, and I don't think the benefit is outweighing the cost. I think more along the lines of many of the Fed Bank presidents, but what I think and what they think doesn't matter. Fed Vice Chairman Janet Yellen, who is likely going to replace the chairman, and Bernanke, believe that it's important to continue to provide support for the economy and that the benefits outweigh the costs and not to cut back on the purchase program for now. They don't want to take away support too early.

I don't think the Fed should have started the purchase program. I don't think it's really helping the economy, other than indirectly boosting stock prices. Ultimately it poses greater risks for the financial markets and the economy. The risk is it's creating some sort of bubble in the financial markets. The Fed is very watchful of excessive risk-taking, but they themselves acknowledge that it's very difficult to identify these bubbles ahead of time.

Ultimately, the downside is that when it comes time to reverse course, it will be very problematic, and it could create a worse situation than the Fed expects. I just don't think all this excess liquidity will end well.

H.L: The Republicans in Congress are intent on austerity and cutbacks beyond the sequester as a response to the economy's problems at the same time as the federal deficit is surprisingly rapidly shrinking. What do you think of austerity and what's happening to the deficit?

M.G.: Let's face it: As you look over the longer term the situation continues to pose significant risks. After 2023, the budget outlook deteriorates dramatically as a result of healthcare spending and the demographics.

Our near-term budget picture has improved, although in my view, the improvement in this year's budget deficit reflects a series of one-off events. For example, the GSEs Fannie Mae and Freddie Mac are making large dividend payments to the Treasury as a result of accounting changes. We have also seen a surge in tax revenues this year.

However, that doesn't reflect a strong economy but rather a pulling forward of income into 2012 ahead of tax increases scheduled to take place in 2013. Thus, the strength in revenues this year may come at the expense of revenues next year.

The magnitude of the improvement in the deficit in 2013 is perhaps overstated, and I don't think it will continue to shrink at that pace in 2014 and 2015. More importantly, the longer term budget issues remain unresolved. We have not done anything with respect to entitlement spending, and, ultimately, that's going to lead to much larger deficits, so there's still work to do

In a way, the improvement in the deficit is counter-productive, because it takes pressure off politicians to really address the very difficult issues that have to be addressed when it comes to fiscal policy, that is, what to do about entitlement spending.

H.L.: The euro-zone countries other than Germany are in recession or headed there. How bad is that for the global economy?

M.G.: The euro zone recession does not pose risks to the global economy. It doesn't push much risk onto the U.S.

The bigger story globally is the aggressive action taken by the Bank of Japan to boost the Japanese economy, which could actually spur other Asian countries to follow suit. The bank began quantitative easing like the Fed but in larger sizes. That's a much bigger development, because if we get stronger growth out of the Asian region that would be a very positive development.

As for Europe, I don't see anything changing there. You'll have periodic flare-ups. Policy makers will band-aid it, but the situation won't change, and it won't pose much risk to the U.S. outlook.

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.