Bank of America (BAC) Chief Economist, Mickey D. Levy, analyzes and forecasts national and international economic performance and financial market behavior and conducts research on monetary and fiscal policies. Levy, a widely quoted economic observer, is also an adviser to several Federal Reserve Banks.
H.L.: How strong is the U.S. economy in light of Middle East turmoil, rising oil prices, and continuing serious debt problems in Europe’s euro countries?
M.L.: The U.S. economy is gaining traction and has nice momentum which should carry through 2011, despite ongoing weakness in the housing sector and higher energy prices. Certainly, weak job gains stand out, but I expect business hiring to strengthen.
Household balance sheets have been repairing, and the Federal Reserve’s stimulative monetary policy since 2008 is starting to take hold. Consumer spending has picked up, and business confidence has lifted. This should lead to more business expansion and job gains.
Certainly, the high energy prices operate as a tax on households and businesses, and deserve close scrutiny. However, unless energy prices go sky high and stay there, the economic outlook will remain favorable.
H.L.: What’s happening in the housing market?
M.L.: The housing sector continues to struggle despite lower home prices and low mortgage rates. There’s still high inventory of unsold homes and house prices have experienced renewed modest declines. This is affecting demand. The several million distressed mortgages hang over the housing market like a gray cloud, and the quicker policy makers and banks address the foreclosure problem the better off will be the economy and virtually everyone involved. At best, 2011 is likely to be a transition year for housing.
The ongoing struggles in housing are a real drag on employment: Nearly 2 million of the total 7.5 million jobs lost since 2007 have been in construction. But the housing sector is a surprisingly small portion of total economic activity – exports are much, much bigger – and the economy will continue to expand.
H.L.: Is inflation a threat or a red herring, and can the Federal Reserve make the changes needed to control it without killing the recovery?
M.L.: These are two important questions. Certainly, the Fed’s large-scale asset purchases are unsustainable and do raise the risk of significantly higher long-run inflation. But that’s a long-run problem, and inflation pressures should rise only modestly, as there is slack in the economy. The excess liquidity that the Fed has pumped into global financial markets is having other effects. It has contributed to higher commodity and oil prices, distorted global capital flows, and pushed down the dollar. The decline in the U.S. dollar versus the euro, even amid Europe’s financial crisis, is quite striking.
The biggest risk in 2011 is not a sharp spike in inflation – I do expect modest increases in inflation pressures – rather, a spike in inflationary expectations that would push up bond yields. Higher bond yields would be reflected in higher mortgage rates and higher borrowing costs for businesses and could adversely affect the stock market.
The Federal Reserve is very aware of this risk, which brings up the second question: Will the Fed be able to shift gears and exit from its quantitative easing before inflation does rise materially? The Fed tells us publicly not to worry and that it will be able to do so. Time will tell, but this critical issue is a factor that is keeping financial markets nervous. I would put a very low probability on an abrupt Fed exit that would jar economic performance. However, don’t be surprised if interest rates rise when the Fed signals to financial markets its intentions to normalize monetary policy.
H.L.: What do you make of the stock market’s fluctuations, and where is it headed?
M.L.: A point of caution: I’m not a stock market strategist. However, the critical fundamental factors underlying stock market performance remain favorable. The economy should continue to expand, corporate profits are at an all-time high and should go higher, and inflation and bond yields are relatively low. Historically, these are favorable stock market factors. However, as we all know, a lot could go wrong. The turmoil in the Middle East and the spike in oil prices generate tremendous uncertainty and are costly to businesses and households. Nobody knows how long the uncertainty will last.
H.L.: How might the economy be affected if the stark divide between Republican deficit slashers and Democratic short-term spenders results in a failure to raise the federal debt limit by the March deadline, which shuts down the government?
M.L.: It should have no impact on economic performance. It may temporarily impact U.S. Treasury markets if it delays the normal schedule of Treasury debt issuance – but that’s only temporary. The periodic political grandstanding around the debt ceiling is really a silly and unproductive exercise. Keep in mind that the deficit spending has already occurred. Railing over the debt ceiling cannot change what has already occurred and does not constructively address the nation’s true challenges.
H.L.: What are those true challenges?
M.L.: Fiscal policy – that is, current tax and spending policies -- is on an unsustainable path. The gap between spending and taxes must be closed. Also, the federal budget is on a cash-flow basis and does not include the massive unfunded liabilities of the Social Security, pension, and medical entitlement programs. It is well known that coming to grips with the nation’s large fiscal gap requires addressing these entitlement programs. In the context of these massive problems, which are widely understood, the current angst and political maneuvering around the debt ceiling reflects the failure of our political process.
H.L.: What do you think of the strategy of radically cutting the deficit now or any other idea?
M.L.: I don’t think we need to radically cut the deficit now. But what we need to do involves a two-fold approach. Firstly, pass legislation now that significantly cuts future deficits through a combination of restructuring entitlement benefit structures and appropriate tax increases. Of course, the defense budget and non-discretionary spending programs also need to be made more efficient.
Secondly, and equally importantly, we need to reallocate national resources into activities that add to long-run productive capacity, including infrastructure, education and training, and research and development, etc. By infrastructure spending I’m not referring to the wasteful “shovel-ready” products in President Obama’s first stimulus package, rather, infrastructure with a purpose that truly improves transportation and communication and information networks with a long-term strategy in mind.
In addition, we desperately need a national energy strategy. How many wake-up calls do we need before we recognize that energy policy is not just an environmental issue but a national security issue?
H.L.: What do you think of permanently extending the Bush tax cuts for the wealthy?
M.L.: I think tax hikes for higher income and higher wealth individuals are appropriate and should be considered as part of a comprehensive fiscal reform that involves spending cuts in entitlements and other programs.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.