Incoming data give the Fed a green light to ease further. There is frequent chatter from unnamed sources that the Fed can do more and will consider more at this Tuesday's FOMC meeting. The public stance of Fed officials is recent weeks has tended to downplay the necessity for action at this juncture. This combination leaves the outcome of this week's FOMC meeting in doubt. My baseline expectation is that the FOMC statement acknowledges the weakness in recent data, but leaves the current policy stance intact. There is a nontrivial possibility that the Fed either implicitly or explicitly ends the policy of passive balance sheet contraction. I believe it very unlikely that the Fed sets in motion an expansion of the balance sheet.
Much has already been written on the disappointing employment report. Excluding Census workers, the economy added a decidedly pathetic 12k employees. Private sector job growth came in at just 71k, while state and local governments shed 48k employees. While some commentators have highlighted the 630k private sector gain since the beginning of the year, the bulk of that gain - 399k - came in March and April. Since then, the private sector has added a scant 51k jobs a month. Enough jobs to be sustainable. Maybe, although this is even questionable given the decline in temporary help hiring, which may signal even softer numbers in the months ahead. But even if sustainable, certainly extremely vulnerable to negative shocks. And even if sustainable, the current rate is sure to decrease unemployment only if job seekers continue to exit the labor force.
Indeed, the labor force numbers turned south, sending the participation rate down as well. Although the technical recovery - at least as measured by GDP growth - has been in place for four quarters, participation rates still fall short of year ago levels. The gains of earlier this year appear to be as ephemeral as Census hiring. Indeed, it is likely that hiring, not any broader improvement in labor markets, drew people back into the labor force. Who says the government can't create jobs?
Not that below trend job growth should be any surprise given the trend in output growth. The math is easy on this one - the pace of growth has decelerated sharply since the end of 2009. Job growth is simply following this trend. Nor is their much hope for a substantial reacceleration. Factors that supported Q2 growth, especially inventory correction, residential investment, and government spending, are all expected to wane as the year progresses, while consumer spending growth is expected to remain lackluster. In that environment, it is even doubtful that the solid run of equipment and software gains can be sustained.
In reality, the story is effectively unchanged from four quarters ago. It has always been the case that meaningful labor market recovery required growth of real final sales of at least three times the numbers we have seen. That just is not going to happen without substantially more stimulus efforts.
Are such efforts forthcoming? I think that everyone has pretty much written off any possibility of fiscal stimulus coming to the rescue anytime soon. To be sure, there may be a few billion here, a few billion there that show up, but no one expects any serious effort to, for example, attempt to close the output gap. Administration efforts have shifted to trying to spin the data as a solid recovery. Along those lines, we saw US Treasury Secretary Timothy Giethner lift the "Mission Accomplished" move right out of the Bush II Administration's playbook with his NYT editorial, which can be summarized as "growth is positive, we did that, quit whining because you don't have a job."
Simply put, if the Administration is content with the numbers we see, they are effectively content with a sustained, substantial output gap and the associated unemployment. They must be, as there is no urgency to do more. The pendulum has shifted. The Administration must feel it necessary to believe the recovery is sufficient and intact, otherwise they will be accepting the Republican claim that the stimulus package failed. Moreover, I think they genuinely believe that the deficit needs to be brought under control sooner than later. This, I think, is the problem of an Administration that is a reload of the Clinton Administration. They believe Rubinomics will work its magic again, rather than recognize that the today's economic challenges are very different than those of the mid-1990's.
With fiscal policy off the table, our last hope is monetary policy. It seems clear that persistent unemployment tilts the odds towards deflation, but the Fed appears to be like a deer stuck in the headlights. Like Geithner, Federal Reserve Chairman Ben Bernanke showed no urgency in his speech last week to accelerate the path to achieving the Fed's dual mandate. Moreover, leadership at the Fed may be as out of touch as that in the Administration. As Mark Thoma and Dean Baker note, Bernanke expects higher wages to support spending in the months ahead, despite the weak incoming wage data. Remember - Bernanke gave that speech after having the weekend to dissect the GDP report.
Presumably Bernanke is referring to data such as the following (click to enlarge):
While Washington appears content with the numbers as long as they are trending in the right direction, I believe the focus should be the gap between where personal income less transfer payments would have been in absence of the recession, and the likely trajectory now. That trajectory, in my opinion, is clearly subpar. Enough so that it fills me with an increasing sense of urgency. This is lost income for Americans. Income that pays for food and shelter. Medical care and vacations. Retirement and college savings. The costs of failure are immense.
Did the July employment report shift the odds toward more easing? It should, but I believe the most likely scenario is that it merely confirms the Fed's priors - that the pace of labor market improvement will be glacially slow. They have never expected anything else. Indeed, to what extent is the data really that different from those expectations. It seems to me that what is most different is that the upside risk is essentially off the table - the V is not meant to be. Does the magnitude of the downside risk warrant additional action? Yes, with the V-shaped recovery off the table, so too are the "risks" of additional easing, notably the risk of higher inflation. Fed leadership, however, appears to view the downside risks as relatively limited given the amount of stimulus (expansion of the balance sheet and low interest rates) already in place. Any more is a venture into the unknown, a trip that is still unwarranted in the absence of economic freefall.
That said, despite Fedspeak that appears resistant to further easing, the press has been fueling speculation that more easing - albeit largely symbolic - is imminent. From where does this chatter emanate, other than unnamed sources? Perhaps from high ranking staff. Word on the street is that Fed staff are increasingly frustrated with the lack of action from leadership. Why exactly is Bernanke showing such deference to the more hawkish elements such as Kansas City Federal Reserve President Thomas Hoenig, Dallas Federal Reserve President Richard Fischer, and Philadelphia Fed President Charles Plosser? If you seek more easing, you are not alone. Board staff are increasingly your allies.
Why the lack of additional action? A set of possible impediments:
- As described above, incoming data is not sufficiently different from the Fed's forecast to justify additional action. This is my primary reason to expect little action from the Fed tomorrow.
- Similarly, additional action requires nonconventional monetary policy, of which the impacts are unknown. I think one of the potential impacts of concern is possibility that additional easing fuels a new asset bubble, in addition to the specter of inflation.
- Concern that additional easing will be interpreted as deficit monetization, and thereby unhinge inflation expectations.
- Fears that additional easing will trigger a disorderly devaluation of the Dollar. Of course, this may be exactly what we need.
- Possibly that more action will be a repudiation of the Administration's claim that the economy in on the mend.
That said, the internal and external pressure suggests the possibility for a small change at tomorrow's meeting. From the Wall Street Journal:
At their policy meeting Tuesday, Fed officials plan to discuss whether to take the small but symbolically important step of reinvesting proceeds from its portfolio of mortgage-backed securities to maintain support for the economy. The weak jobs numbers add to the case for taking action, though officials must assess whether taking even a tiny step could create expectations for larger actions in coming months.
Note the final sentence - the concern that more now is essentially a guarantee for more later. If the Fed eases more now, with the data largely in line with there already weak forecast, how could officials argue against additional easing later when the data continues to support their forecast?
Bottom Line: The incoming data appears largely consistent with the Fed's priors - especially expectations of glacially slow improvement in the labor market. Yet the probability of any upside risk to the forecast have diminished markedly. The V-shaped recovery has not emerged. The elimination of that upside risk argues for additional easing, but the Fed appears hesitant to do more. Uncertainty about the effectiveness of additional easing argues against more action, especially given relatively quiescent financial markets and positive, albeit lackluster, growth. Moreover, any additional action now is essentially a promise to do more later, even if growth remains along its current trajectory. All of these points argue against additional easing tomorrow, and that remains my baseline scenario. The case becomes muddied by internal, staff level pressure to do more now, combined with rising expectations of imminent easing given the steady flow of leaks to the press. This opens the possibility of a small policy adjustment that eliminates that passive reduction of the balance sheet. Any more is off the table.