Even with Growth, Markets Have a Long, Hard Road Ahead

The economic backdrop behind this week's FOMC meeting is almost startlingly refreshing. The recession likely ended at some point during the summer, an occasion effectively confirmed this week by the highest authority in the land, Federal Reserve Chairman Ben Bernanke. For those still in denial, industrial production posted its second consecutive gain, and there is little doubt that GDP will post a significant positive reading for the third quarter. Finally, in a seemingly impossible development, the retail sales report suggested that consumers eagerly converged onto the nation's shopping establishments in August. The economic summary paragraph in the upcoming FOMC statement will certainly identify the positive economic developments since their last gathering. But will improving conditions be sufficient to prod the FOMC to adopt language that points in the direction of tighter policy? Almost certainly not. The exit from the recession is clearly much too tenuous - and much too dependent on fiscal and monetary life support - to allow the risk of premature policy withdrawal. Moreover, even if economy activity were on a self-sustaining upward trend, the hole we are climbing out of is so deep that it could literally be years before resources are sufficiently utilized as to allow for significant policy reversal.

Let's start off with the good news. The stabilization of consumer spending that we saw begin earlier this year is supporting an inventory correction story. Firms are no longer chasing spending plans down, which alone gives some boost to final output. Moreover, some restocking is likely occurring; anecdotally, I hear from firms that are surprised to learn that their suppliers are running low on inventories despite weak final sales. Restocking is also a consequence of the "Cash for Clunkers" program, as auto firms look to rebuild depleted inventories. And, the August retail sales report points to sales gains across a wide range of retail stores. All in all, the inventory cycle looks to be making a pretty clear turn, offering support to activity:

In addition, the strength of fiscal stimulus is coming to bear on the economy. And one cannot discount the additional boost delivered by the first time homebuyers credit, which helped support a bottom into the new housing market this summer. Adding everything together, it is not difficult to see why forecasters are looking for growth in the range of 3 to 4% this quarter. Not surprisingly, industrial production numbers are turning:

All of that is well and good. The FOMC, however, will look at this data flow and ask "what's next?" An inventory correction in the wake of the 2001 recession provided little lasting support, leaving the economy struggling until the housing bubble gained force in 2003-04. The clunkers program and the homebuyers credit likely borrowed some spending from the future. And even if the homebuyers credit is extended, the marginal impact is likely to decline as it increasingly benefits those looking to buy anyway.

Moreover, there is growing concern that this summer's buying binge - such that it was - can be partly attributed to a slowing in foreclosure activity earlier this week. Now that the pace of foreclosures looks to be picking up, and the threat of the option-ARM lending comes more clearly into the view, the sustainability of this summer's housing gains comes into question. On top of all that housing concern, the possibility that the FHA might need a bailout indicates that the risk of loaning into an overpriced housing market has simply been shifted from the private sector to the taxpayer. Consequently, the FHA - the current housing lender of last resort - is poised to tighten credit standards. And even the surprisingly strong retail sales numbers are somewhat suspect, as they don't appear to comport with the anecdotal reports of retailers. A reasonable midpoint analysis, via the Wall Street Journal:

The July/August average for “core” retail sales is still not much stronger than the [second-quarter] average, but after a string of contractions, these data suggest that consumer demand is, at a minimum, stabilizing. Core retail sales may even be starting to firm slightly (up in 2 of the past 3 months), but we will need to see another month or two of positive data to have confidence in that view. –Stephen Stanley, RBS

In addition, financial markets remain glued up by many metrics. Importantly, consumer credit growth is still significantly restrained, as is bank lending for commercial and industrial loans:

Given the steady anecdotal buzz surrounding the deterioration of the commercial real estate market, it is difficult to expect a rapid reversal of these trends. In short, if you think credit markets are still under stress, as the Fed certainly does, and are worried about the availability of credit to support future spending, also among Fed concerns, then shifting rhetorically to signal a tighter policy stance irrational. Moreover, it would seem inconsistent with plans to continue expanding the balance sheet via purchases of mortgage backed securities and TALF assets.

Now, the above are among the reasons many expect a relatively tepid recovery to emerge in the years ahead. Suppose instead that you, logically, believe that the economy is set to come roaring back on the straightforward hypothesis that deep recessions are always followed by strong recoveries. James Grant makes just such an argument in this past weekend's Wall Street Journal:

"At the business trough in 1933," Mr. Darda points out, "the unemployment rate stood at 25% (if there had been a 'U6' version of labor underutilization then, it likely would have been about 44% vs. 16.8% today. . . ). At the same time, the consumption share of GDP was above 80% in 1933 and the household savings rate was negative. Yet, in the four years that followed, the economy expanded at a 9.5% annual average rate while the unemployment rate dropped 10.6 percentage points." Not even this mighty leap restored the 27% of 1929 GNP that the Depression had devoured. But the economy's lurch to the upside in the politically inhospitable mid-1930s should serve to blunt the force of the line of argument that the 2009-10 recovery is doomed because private enterprise is no longer practiced in the 50 states.

One would have to wonder if Grant has ever seriously considered a different analysis of the path of the business cycle. After all, I have never heard it argued by the more pessimistic forecasters that the fundamentally reason for their concerns is that private enterprise is no longer practiced in the US. That this should be his line of argument seems silly. That aside, the post-1933 rebound is illustrated by the industrial production series:

What one could add to this story, however, is that despite the rapid growth of 1933-1937, unemployment remained unacceptably high and inflation remained sufficiently contained such that the price level never came close to regaining the ground lost during the depression:

And - critically for divining the path of policy - the growth in the 1933-1937 period was not sufficient to allow for policy tightening, as evidenced from the 1937 recession. One does not have to deny that the recession is over - and can even expect nontrivial growth - while still expecting a sufficiently weak outcome that prevents a significant reversal of the Fed's monetary stance. Or further fiscal stimulus, for that matter. Which is to say that those who see rapid growth as a reason for an imminent Fed reversal are looking in the wrong direction. Even rapid growth could leave the Fed on the sidelines for much, much longer than many anticipate - and they know it. Bernanke has schooled policymakers well on the lasting damage that typically follows the collapse of a debt-driven bubble.

Bottom Line: Economic activity is clearly on the upswing - but the durability and sustainability of the recovery remains in doubt. The FOMC statement will certainly take notice of strengthening economic data. But a resumption of growth is not the only issue that factors into policymaking. At this juncture, the focus to resource utilization - how long will persistently weak labor marks sustain downward pressure on wages and thus make a wage-price inflation spiral simply unattainable? For now, a seemingly long period of time. Indeed, I find it virtually impossible that Fed officials will dare shift from "sure, we can withdraw stimulus when needed" to "it is not necessary to aggressively withdraw stimulus" until the unemployment rate begins a sustained march downward. And for now, we are still waiting for the upward march to end.

Comments

[Roger Knights:]

Good article, but there's a typo: the 3rd and 4th charts are identical.

Sep 21 05:02 AM

[enigmaman:]

yes IMO the economy has turned the corner, recent economic reports should convince the naysayers that we have seen the wost Then you give us the proverbial "BUT!!!"
" Economic activity is clearly on the upswing - but the durability and sustainability of the recovery remains in doubt"

So as far as recovery goes your all in with "A definitely maybe its over" You give a very strong argument that you dont even believe!

Give me ambiguity or give me something else!

Sep 21 12:52 PM

[HardwoodFlo...:]

Here is why the "but" is so important- the footings for a recovery are there but not with a banking system that is acting in a retarded fashion- late to react and over reacting at that....

The reason that inventories are being rebuilt is that businesses don't have access to credit to rebuilt inventories. Because the recession has prolonged for such a duration they are also short on working cap to rebuilt those inventories on their own. As a result, no credit and little cash on hand, they cannot build inventories to get commerce going.

Without that don't expect dramatic improvement in the economy. It's lending stupid...e.g. business can't get credit to improve cash flows and crank GDP.

There is an important component to GDP. That is this- a manufacturer sells a product to a distributor for $100. That product is then bought and sold by the distributor for $100 and sold for (say 20% more) $120. There has been $220 of GDP created. This compounds as it gets down to the consumer.

However, the reason this economy, and GDP, for that matter cannot take off is that businesses- small businesses like a $100 million dollar distributor are being strangled by their stupid regional bankers. The reason is that regulators are hounding regional banks demanding more loan loss reserves and as a result creating a negative feed back loop to the broader economy.

When will these stupid bastards (government and banks) understand that they are wrecking business NOW. There is no hope for a recovery ever unless people are allowed to do business and idiots stop thinking that they can run these businesses better by pounding down on them.

If lending were to return to this economy then we would see double digit growth in GDP- it would take off like a rocket. But good businesses can't get credit right now. It's a disaster.

The story that is not being told is the story of small business. Small business is a fragmented and disparate group, yet, every small business owner I talk to is saying the same thing. “the bank is on my ass, they have cut my credit line, they are standing on my chest telling me that I need to reduce inventories but the reality is they are not here in the trenches fighting this fight. The more pressure they put on me the harder it is for me to manage my business.” The economy cannot recover without Credit- The belief that you will get paid back for your indebtedness.

Just an anecdotal story. In 2008, if you were in a a housing related industry and with a big bank- US BANK, WELLS, etc- you were kicked out. Here I'm talking about plumbing distributors whatever. This meant that you were forced to a smaller regional bank. In the process fo the shift your credit line was probably shrunk.

As a result of that you are forced to go to JIT inventories etc. This gives you NO competitive advantage over any other competitor. As such, you start to see margin erosion. You try and explain to your bank that you need a credit line increase in order to maintain market share and they say- "your cash flows don't justify it". You say, "well it's a chicken and egg proposition, I have to have the inventory in order to increase my cash flows".

It's a goddamn disaster out there. The whole thing has gone so well beyond delveraging and is grinding to a halt.

Manufacturers rely on distributors/dealers to get products to market. If distributors can't get access to capital to trade goods then the system breaks down. That is what is going on.

The reality is that distribution, no matter what it is, is a business that relies on a 22% GPM with operating costs (SG&A costs) that run 18%. It's thin margin. When you get price pressure, as a result of the competitive forces, then ontop of that you get volume decrease this equals commerce/profitability arrest.

NO CREDIT- NO BUSINESS.

If you want manufacturing growth to return credit has to get back on the street. Manufacturers cannot become the creditors of their customers. The system needs to work and in order for it to work banks have to start lending again and taking some bloody risk. It's called credit- derived from the Greek "belief": the belief that you will get your money back eventually.

Right now, I hear the term "banker" in the same vain as I hear the word "lawyer". If the sentimate towards bankers today isn't the same as it was during the great depression well, then, it's damn close.

Is sum, there are serious inventory shortfalls out there. If you were to try and build a facility right now your building would be out 6-8 months. Equipment and Electric are way out, ironically you would thin with things being as slow as they are that companies would be dying for business and service levels would be up but that is not the case.

But there won't be a huge inventory build becasue companies can't get lines of credit to build inventories so they can have products to sell. The system is all gummed up. Without credit to build inventories manufacturers can't gear back up and put people to work. Distributors cannot justify putting outside sales people back on the street. This is stifilling all matters of commerce including product innovation.

If you want to get a new prodcut to market that takes a massive amount of capital- bank or other wise. The reality is that no distributor wants to take on a new prodcut becasue they have no available credit to do it- bring in new products means investment in merchandizing AND new inventories.

I'm telling you until the banking system starts to work again this country is screwed.


So, one of two things or both need to happen: 1)the banks need to start working with customers no matter what. 2) the regulators have to get off the banks asses and let them work with customers instead of against.

If banks continue to pound away at small business the problems in this country will only conintue to be exasperated. It becomes a negative feed back loop that is where we are today- however, no one is talking about it it is the story that isn't ever told because small business is not one unified voice but, rather, small and unheard.

Sep 21 01:38 PM

[David Van K...:]

A long article to knock down a straw man: I don't know anybody who is looking to the Fed to reverse course anytime soon.

Sep 21 06:43 PM

[RiskAverseA...:]

Ben Bernanke saying it is a near-certainty we are out of recession is no more credible than Allen Schwartz claiming no liquidity problems at Bear Stearns two days prior to the firms collapse. The Fed is a hopelessly bankrupt shipwreck presiding over a bunch of well-dressed gangsta wannabes who are but one serious Congressional inquiry away from being transformed into so many scurrying rats, isn't that right Mr. Lewis?

If it was all manner of lying that brought about last year's crisis, then what could make anyone think truth suddenly reigns supreme? Equity remains dead money until such time as transparency and accountability are revived. And anyone believing otherwise plainly is a sucker bringing truth to the adage that, a fool and his money are soon parted...

Sep 22 07:55 AM

[reveigel@ms...:]

How anyone can say, with a straight face, that the recession is over is beyond any intelligent thinking. Almost 15 million individuals are unemployed, many are underemployed, talk in Washington about extending unemployment benefits, a larger, more intrusive and controlling government is in the offering, which in essence, restricts the growth of the job creating private sector. If the current rise in some stocks and stock market indexes is the basis for such optimism, so be it. It is not getting people back to work.

Sep 22 06:34 PM