Interview With Andres Carbacho-Burgos: Fed May Stop QE Mid-2014, But Significant Risk It Will Stop Later Due To Slow Recovery

by: Harlan Levy

Andres Carbacho-Burgos is a senior economist at Moody's Analytics. He currently analyzes the U.S. housing markets and the state of Connecticut. Previously he was an economics professor at Texas State University.

Harlan Levy [H.L.]: Do the disappointing July job numbers - only 162,000 new jobs and the growing crowd of part-time workers - and July's unimpressive Gross Domestic Product growth tell you that the sequester is finally affecting the economy among other realities?

Andres Carbacho-Burgos [A.C.B.]: Yes, and not just cuts to military spending. We also mean furloughs of federal employees and slightly reduced funding for Medicare, and of course, the lingering effect of the end of the payroll tax holiday. All those factors are combining to slow down the U.S. economy, not to mention the slowing global economy, which slows down U.S. exports and the U.S. recovery.

The Federal Reserve also didn't help by commenting that it would soon taper off quantitative easing, which resulted in rising bond and mortgage rates.

H.L.: In light of the jobless report, when do you think the Fed will start tapering off quantitative easing? Also, when do you see it stopping, and would that be as bad a development as many market watchers seem to think?

A.C.B.: The Fed stated a timeline for starting to taper in December. We still have that as our baseline forecast. I think there's a significant risk that they may be forced to start tapering later, because of the slowing U.S. recovery. That's still a downside risk. We still think that the U.S. will go to a moderate recovery through the end of this year and that the Fed will start tapering off quantitative easing on schedule.

My guess is that after tapering starts at the end of the year, it may stop somewhere around mid-2014. My opinion is that the Fed should be doing more to push the U.S. recovery. They should be leaving quantitative easing in place longer. The pace of recovery is very slow. The jobless rate edged down to 7.4 percent this month. A lot of this is because the growth rate of the U.S. labor force is still significantly below its level before the recession, with a lot of workers not looking for work. As a result the labor market's recovery is overstated.

A lot of economists think that a better indicator of labor market performance is the ratio of employed workers to the population of working age adults. That ratio has barely moved since the start of the recovery.

H.L.: Where do you see the U.S. jobless rate going from its 7.4 percent perch?

A.C.B.: We see it declining at its current rate for the next two to three years. The unemployment rate peaked at 10 percent in late 2009, and it's taken 3 ½ years to bring it down to 7.4 percent. At that rate of decrease, which we expect that somewhere around the end of 2016 it will be about 5.5 percent, will be a much tighter labor market but won't be as tight as before the recession beginning in 2006 to 2007.

To summarize, we expect the recovery to continue but are not optimistic about any sudden improvement in the labor market. It will improve painfully slowly.

H.L.: How seriously will the looming threat of a government shutdown by the Republican-controlled House of Representatives affect the U.S. recovery?

A.C.B.: It's definitely a downside risk. Our baseline is that it won't happen. At the last minute they'll come to some kind of deal. The impact is before and after such a budget deal. The closer they come to the deadline, the more households and businesses will become jittery and hold back on spending to a slight degree.

The bigger unanswered question is what will happen with the sequester in a new budget deal. My guess is that it will continue at the same level and that the government will have to continue tightening its belt through the coming fiscal year.

H.L.: How destructive to the economy and to the country is the rapidly growing gap between rich and poor?

A.C.B.: It's not a question I can answer in a short interview. But here's a brief rundown: Before the recession the growing inequality was a contributing factor to the financial crisis, because it made households close to the median income and below take out bad loans, one of the reasons for the subprime lending crisis. That was several years ago.

Now the growing gap in inequality is slowing down the rate of recovery. It's keeping most consumer spending down and also exerting downward pressure on consumer lending, especially mortgages. Mortgage lending has increased over the past year and a half, but that's mainly because a larger proportion of mortgage applications have been approved, but the overall volume of applications has barely shifted over the past year and a half. That's a significant factor that may put the brakes on the U.S. recovery.

The rise in house prices in 2012 was fueled significantly by investor purchases, and these purchases are mostly financed with cash. By the end of this year, housing will not be as undervalued as it was at the start of 2012, and that will reduce a large part of the incentive for investor purchases. After that, the housing recovery will depend much more on mortgage lending, and so my guess is that after the end of this year you'll get slower house price growth and the growth rate of home purchases will slow.

The other major effect is that non-housing purchases by households have grown at a slow pace since the start of the recovery, and that can be laid at the feet of increased inequality.

The overall effect of inequality is that the overall pace of recovery isn't as fast as it could be.

H.L.: I've heard at least one eurozone analyst say that the eurozone may be starting to get out of recession and that China is in worsening shape. What do you think?

A.C.B.: Regarding the eur zone, I think Germany and France are more stable in part because of a more stable financial situation which has helped stabilize output. Having said that, Europe is not out of the woods by any means. Italy, the eurozone's third-largest economy is still slowing, and things are starting to get worse politically with the main focuses of the debt crisis on Spain and Greece.

As for China, it's slowing down, mainly for two reasons: slowing export growth and because there's only so much infrastructure and construction that you can do in the main cities near the coast. As a result, the coastal economies have started to slow down, which has put growing pressure on China's labor market and also reduces the growth rate of its Gross Domestic Product. Most economists (and I agree with them) say that to continue the growth rate over the last decade, China has to, first, encourage more consumer spending, and, second, it has to move the remaining portion of investments further inland to develop the inland market. They have been doing this, possibly not at a fast enough rate to prevent an economic slowdown.

That's bad for the world economy, because the Chinese economy had been contributing a substantial share of the world's economy. That means the rest of the world's exports to China will slow as Chinese growth slows. It won't be so bad, but it makes a recovery by the non-Asian countries more important, since China will be less able to sustain a huge volume of trade. The main problems in the world are in Europe and to a lesser extend in China and the U.S.

H.L.: What's happening in Connecticut?

A.C.B.: At the end of 2012, Connecticut was looking critical, and in fact was the only state in which Gross Domestic Product did not increase in 2012. Over the past six months, Connecticut has started looking better, as job growth has reappeared. But the state is still growing at a very slow pace nonetheless.

There are a couple of drags on the state economy: First, and most important, is state government's fiscal situation, which is still very tight. The state has a lot of spending burdens, including trying to improve the state pension system. You shouldn't expect any tax cuts or major spending increases in the near future. The second drag is the financial industry. For both the insurance companies in Hartford and the hedge funds in Fairfield County, their financial numbers are looking pretty good. But that hasn't stopped most financial companies from relocating jobs out of state. So three years in a U.S. recovery, the state's financial industry is still losing jobs.

A third side is manufacturing. Combining the effects of the sequester and slow exports to Europe, the sequester has already cost Sikorsky a first round of layoffs and may do so again. As a result of the sequester, there will be slower growth in the aerospace industry.

What will also slow growth in Connecticut is the slowing world economy, recession in Europe and the slower growth in China. Connecticut is not going to another recession, but it will continue to lag behind GDP and job growth nationally.

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.