The June ISM manufacturing report came in as expected, and it is one more reason to ignore the -2.9% annualized contraction of the economy in the first quarter of this year. Growth will almost certainly rebound in the current quarter. There is no sign whatsoever in the manufacturing sector of an imminent or emerging recession. Period.
This is not an excuse for what remains an unimpressive period of economic growth. The economy could be doing a lot better if fiscal policies were more growth-friendly. Instead, we have an economy that is heavily burdened by high marginal tax rates (especially the corporate sector) and egregious regulatory burdens (e.g., Obamacare, Dodd-Frank). The after-tax rewards to new investment are barely enough to offset the uncertainties that arise from a lack of U.S. leadership in world affairs and from monetary policy that remains highly accommodative despite five years of an economic expansion which shows no sign of faltering.
The chart above shows two key, market-based measures of the Fed's monetary policy stance: the real Fed funds rate nd the slope of the Treasury yield curve. Note that every recession on this chart was preceded by a significant rise in real short-term interest rates (the blue line) and a yield curve that was flat or negatively sloped (the red line). Tight money, in other words, was the proximate cause of previous recessions. The Fed tightens monetary policy by raising real interest rates, and the bond market confirms that policy is very tight when long-term yields are equal to or less than short-term rates. What this tells us today is that monetary policy policy is just about the exact opposite of tight. Real short-term interest rates haven't been this low for so long at any time in modern history, and the yield curve, while not extremely steep, is quite steep by historical standards and has been for over 5 years.
Despite trying its best to help the economy, the Fed is nevertheless powerless to create growth. We've had over five years of super-easy monetary policy and yet growth has been unimpressive and the economy is operating far below its potential. Here's a better way to characterize what the Fed has been doing: they've been doing all they can to avoid placing obstacles in the economy's path. That's fine, and it has been quite helpful to the extent that if they hadn't engaged in massive QE, the world would have suffered from a severe shortage of much-needed safe assets during and following a period of great uncertainty, deleveraging and risk aversion. But it's not sufficient to generate stronger growth. For that we need the help of fiscal policy. Only the private sector can create meaningful growth if given the proper incentives. We've simply got to increase the after-tax rewards to work and investing, and we've got to reduce the regulatory burdens that have been placed on new, growing and existing businesses.
And a little more leadership in world affairs sure wouldn't hurt.
I remain hopeful that the November elections will lay the groundwork for favorable changes in policies in the years to come.
Argentina, Venezuela and the U.S. are the canaries in the government coal mine that are telling us what happens when government forcibly redistributes incomes and when government over-reach suffocates private sector initiative. Fortunately, the political pendulum in the Americas and in Europe is already swinging in a more growth-favorable direction. It started with the November 2010 elections in the U.S., and it is gaining momentum with the ongoing collapse of the Venezuelan economy and the inability of the Argentine government to service its debt obligations. The expansion of the Eurozone received some much-needed pushback in recent elections, and the U.K. and France have seen the negative results of trying to push marginal tax rates to unreasonably high levels. In the U.S., the utter failure of massive fiscal stimulus and the unravelling of the attempt to reorganize the entire healthcare sector of the economy were the beginnings of the end of the leftward-swing in the political pendulum. But the swing to more private-sector and growth-friendly policies won't be obvious for a few more years. When it does become obvious, equity markets all over the world are going to be much higher.
With so much going wrong in the world, it pays to remain optimistic. Things can change for the better, and important changes on the margin are already underway.