Interview With Nicholas Perna: It's A Slow-Growth Economy

Includes: DIA, QQQ, SPY
by: Harlan Levy

Economist Nicholas Perna is the economic adviser to Webster Financial Corp., managing director of consulting firm Perna Associates, and a visiting lecturer at Yale University.

Harlan Levy: Do the latest economic data - including rising jobless claims and less borrowing but stronger retail sales - indicate a slowing economy, in spite of the stock market's march upward?

Nicholas Perna: It's poking along, basically a little better than treading water. It's a slow-growth economy.

Second-quarter Gross Domestic Product growth could be as low as 1 percent on an annual rate. The first quarter was 1.8 percent, which is really pretty sluggish. But it should come as little surprise.

Much of it is the fault of our elected officials in Washington. The sequester - the $1.2 trillion cuts to domestic and defense spending over 10 years - and the end of the payroll tax holiday matter. Congress may not believe that budget policy matters, but the economy certainly does.

President Harry Truman referred to the "do nothing" congress. This is the "do the wrong thing" Congress.

H.L.: So where do we go from here?

N.P.: I feel like Bill Murray in the movie "Groundhog Day."

Everyone I talked to over the last few years referred to the following risks: budget policy, usually the debt ceiling, Europe, the Middle East, and China. With the House and the Senate so far apart, and with the Senate having a considerably higher spending plan than the House, that may make for a debt ceiling stand-off. Europe is still in recession. In The Economist magazine, they referred to the European "zombie banks," a bank with an office and nobody home. They don't have the wherewithal to do any lending.

We're also worried about the Middle East. If it isn't Iraq, it's Syria, or Israel, and Iran. Now we're worried about Egypt again. I don't know what a civil war in Egypt means, but with the military involved, most experts worry that it could flare up into something bigger -- Arab world turmoil. The concrete consequence of that will be the effect on oil.

And we have China to worry about. China is trying to moderate growth, and maybe it has the wherewithal to pull off a soft landing, because the central government controls everything. The Chinese do not import capital and have more control over their banks than any other country. But if they slow enough, it makes life harder in Europe because of fewer exports to China,

So there's a lot on the radar screen we need to get through before we break out over the less than 2 percent growth we'll have for this year's four quarters.

H.L.: What's not a problem?

N.P.: Inflation. The Producer Price Index came out with a big increase for June, but that was largely gasoline prices. If you look at the core, the PPI excluding food and energy, it was well-behaved. If you look at what the Federal Reserve looks at, it's well below 2 percent over the last 12 months, which is well below the Fed's target before it would raise interest rates.

What's happened is that the proceeds of the Fed's quantitative easing ended up largely in the banking system. When the banks sold their holdings to the Fed, they kept the cash. The problem is most of it is now idle excess reserves.

Also, there's a misconception that Fed Chairman Ben Bernanke printed money to buy the securities, and therefore we face an inflation conflagration. But he didn't print money. He printed reserves. It's really magic. When Bernanke wants to buy another $85 billion in those securities, the guys at the Fed call up investment banks and say we want to buy $85 billion worth and credits the banks with the money. He didn't print money. It's a really important distinction that most people refuse to understand. What the banks do is get 0.25 percent interest on the reserves, which the Fed pays in real money.

Suppose the banks are confronted with a lot of loan demand as the economy takes off. The Fed then can raise the rate it pays for the idle reserves. Thus, it can keep the reserves idle with no risk to the banks instead of fueling inflation by being lent out. The Fed got this power in 1998, so I don't stay up at night worrying about inflation.

Reserves that sit there doing nothing actually do nothing. In order to get inflation, what has to happen is that the banks have to start lending the excess reserves.

Now take gold. I believe that's the refuge of the neurotics. It's under $1,300 an ounce and was up to $1,900 an ounce. You hear that gold is the refuge from inflation. But if you want a really decent inflation hedge you can buy TIPS, Treasury-Inflation-Protected Securities. But you can say the U.S. government is going to collapse, if you're neurotic.

H.L.: Is there too much capital around and not enough lending?

N.P.: You can lead a horse to water, but you can't force it to borrow. There's been some pickup in lending, but it's not big enough yet to trigger companies to expand.

There's still a lot of lethargy in the corporate offices these days. By this time, if this were a normal recovery, loan demand would be very strong, because companies would have used up all their internally generated cash and would have turned to the banks to finance inventories, working capital and equipment purchases. But companies are cash-rich. And on top of that, they're hyper-cautious when it comes to doing anything that exposes them to risk. They have been spending some money on equipment, but they haven't been going out and building new plants for anticipated needs. They're really reluctant to do that because the future is so uncertain.

H.L.: How seriously should stock investors and traders take Bernanke's comments about slowing down quantitative easing?

N.P.: Ever since I was a little kid I've been a fan of Yogi Berra. The subtitle of his book is "I didn't say all the things I said." When I hear about the turmoil in financial markets because of Bernanke's statements, Yogi's comment is what I thought about.

I find markets laughable at times. Financial traders are bipolar Nintendo players who drink too much coffee. They're all over the place. Bernanke hasn't said anything different from what the Fed has been saying for the last two years, trying to articulate an exit strategy from zero overnight interest rates and quantitative easing. It's trying to do it in a way that doesn't tie their hands but at least gives markets something to watch.

The only reason the markets overreacted is because traders thought Bernanke was about to pull the punchbowl. And that's not what he meant at all. But traders love to trade, and you can't trade on flat numbers. Traders are not fundamentalists. They're good at figuring out what another trader is going to do. The comments came from the only game in the world. The most important institution in the world is the Federal Reserve, the only one with chutzpah, and everybody worries if the Fed is showing signs of backing off stimulus. The Asians worried about it. The Europeans worried about it. Congress didn't worry about it, because those guys don't understand what the Fed does, anyway.

What Bernanke said previously is that when unemployment gets down to 6.5 percent, the Fed will examine the policy of zero percent short-term interest rates. Before that he said they would be kept low until 2014 or 2015. But now Bernanke decided to make markets aware of the fact that policy was more dependent on the performance of the economy instead of counting the months until 2014 or 15.

Maybe he shouldn't have said anything. But what his statements recounting that interest rates would go up at some point did was to remind people that they had been taking on considerable interest rate risk by buying longer and longer term bonds that are more susceptible to changes in interest rates, and also in the search for yield they've been taking on more credit risk by buying more and more junk bonds. To sum up what's happened, in the bond market in particular, short-term rates were not going to rise, because the jobless rate isn't likely to get to 6.5 percent any time soon without further declines in labor market participation. If you look at surveys of interest rates, they had bond yields rising a little bit this year and some more next year and some more the year after ahead of short-term rates. This is not unusual. They were basing this on a strengthening economy and the Fed winding down quantitative easing. All that's happened is that some of those forecasts were brought forward in time by the financial markets. They figured it was going to happen so we might as well deal it today rather than taking the loss later on. If you get enough people to believe something is going to happen, it will happen for a while.

And even if the unemployment rate fell to 6.5 percent in December, if it fell because of much lower labor participation, it would not justify tightening. There has to be a real improvement in the labor market that would provide the justification for tightening, not just a statistical improvement, and so far what we've had is a statistical improvement.

H.L.: Will the jobless rate get better?

N.P.: Getting, say, 200,000 new jobs a month would be fine when you have 5 percent unemployment, but it's not enough to make a dramatic decline in unemployment. There are so many people looking for work and so many who have dropped out.

What's happened is that much of the decline in the jobless rate since the end of the recession -- from 10 percent to 7.5 percent -- is the result of declining labor force participation. There's job growth, but there's also a lack of work as well as population growth. Any policy has to aim at not only reemploying the people thrown out of work because of the recession but also employing the newcomers to the workforce.

H.L.: There's a lot of debate about anew effort to increase capital requirements for banks. Where do you stand?

N.P.: People are all over the place on bank regulation. Mark Twain said that it was the lack of money that is the root of all evil. To me the lack of capital was the root of all evil back in 2008 and 2009. If we had adequately capitalized low-leverage financial institutions, then the collapse of the sub-prime market would not have had anywhere near the adverse effects it had. Because what leverage does is exacerbate financial crises. If you decrease leverage by increasing the capital banks have to set aside, of course you decrease their earnings. You also reduce the instability of bank earnings, which make lower earnings palatable to investors.

H.L.: What will happen to stocks?

N.P.: The stock market is a puzzlement. It's trading on the idea that there's nothing left to trade on than Bernanke. But I think we have to be cautious. We already see that long-term interest rates will be rising. I think a year from now the 10-year Treasury, which is paying 2.55 percent in interest, will be paying in the vicinity of 3.5 percent. That's a sizable increase. That's almost 200 basis points from the low of this year, 1.7 percent. If they go up faster than earnings rise, stocks could have a problem.

I am also concerned about the kind of uncertainty that may unfold when it comes time to replace Bernanke, which is only a few months away. The president will come up with a qualified candidate, but then there will be a showdown in the Senate with its confirmation hearings. That could really roil the financial markets, especially if the successor looks like he or she is cut from a far different cloth. Stocks are based primarily on the difference from the measly returns from fixed assets with insufficient attention given to the risks that are out there.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.