The Efficacy of Monetary Tightening Within a Context of Global Economic Instability Part 2: The Data Refutes the Hawks' Case
"Just because unemployment is falling that's not a reason to raise rates.…There is no harm in having low unemployment in the country except insofar as that generates wage pressures and that shows up in inflation. But I don't see that in my inflation outlook."
-Dr. Narayana Kocherlakota, Federal Reserve Bank of Minneapolis President.
The current Federal Reserve Chair, Janet Yellen, has followed a very different pathway when it comes to monetary policy than the one outlined in part one of this article. The doves policy acknowledges the need for over accommodation given the risks that exist in the economy. The hawks' viewpoint is clearly concerned about asset bubbles forming, and the Fed being unable to deal with them. However, in order to make the case for raising rates in the current economic environment, one would have to ignore the vast amounts of data coming out of the economy:
- GDP for the entire recovery has averaged 2.3% and Real GDP growth has averaged 1.9% since 1Q 2009, hardly robust economic growth. The persistent large debt overhang largely drives these low GDP figures. As I noted in previous articles, the academic literature is quite clear about the deleterious impact of over indebtedness on GDP growth rates.
- In 2010, Carmen M. Reinhart and Kenneth S. Rogoff, concluded in Growth in a Time of Debt that "across both advanced countries and emerging markets, high debt/GDP levels (90 percent and above) are associated with notably lower growth outcomes."(p.577)
- Reinhart and Rogoff, along with Vincent R. Reinhart, authored Debt Overhangs: Past and Present - Post 1800 Episodes Characterized by Public Debt to GDP Levels Exceeding 90% for at Least Five Years, in which they state: "Consistent with Reinhart and Rogoff (2010) and other more recent research, we find that public debt overhang episodes are associated with growth over one percent lower than during other periods. Perhaps the most striking new finding here is the duration of the average debt overhang episode. Among the 26 episodes we identify, 20 lasted more than a decade. Five of the six shorter episodes were immediately after World Wars I and II. Across all 26 cases, the average duration in years is about 23 years. The long duration belies the view that the correlation is caused mainly by debt buildups during business cycle recessions. The long duration also implies that cumulative shortfall in output from debt overhang is potentially massive." (p. 1)
- In The Real Effects of Debt, authors Stephen G. Cecchetti, M.S. Mohanty, and Fabrizio Zampolli conclude: "Our examination of debt and economic activity in industrial countries leads us to conclude that there is a clear linkage: high debt is bad for growth. When public debt is in a range of 85% of GDP, further increases in debt may begin to have a significant impact on growth: specifically, a further 10 percentage point increase reduces trend growth by more than one tenth of 1 percentage point." (p.21)
- Cristina Checherita and Philipp Rother's piece, The Impact of High and Growing Government Debt on Economic Growth, An Empirical Investigation for The Euro Area, states: "on average for the 12-euro area countries, government debt-to-GDP ratios above such threshold would have a negative effect on economic growth. Confidence intervals for the debt turning point suggest that the negative growth effect of high debt may start already from levels of around 70-80% of GDP, which calls for even more prudent indebtedness policies. We also find evidence that the annual change of the public debt ratio and the budget deficit to-GDP ratio are negatively and linearly associated with per-capita GDP growth." (p.6) They further conclude: "a higher public debt-to-GDP ratio is associated, on average, with lower long-term growth rates at debt levels above the range of 90-100% of GDP. The long-term perspective is reinforced by the evidence of a similar impact of the public debt on the potential/trend GDP growth rate."(p.22)
- Andreas Bergh and Magnus Henrekson's paper Government Size and Growth: A Survey and Interpretation of the Evidence, found that as government size increases, GDP growth declines.
- The output gap is likely to persist, delaying any rise in rates, and staving off inflationary pressures for much longer than most believe. The market expects the Federal Reserve to hike rates this year, however assuming a constant 3% growth rate in GDP; the output gap would not close until 2019. I believe a constant 3% GDP rate is rather unlikely, and we are already off to a rough start in 2015 with the Atlanta Federal Reserve expecting a 0.01% GDP growth rate for Q1.
- PCE sits below 0.5%. While a short term rise in oil prices has resulted in an uptick in CPI, I believe the trend line for inflation remains intact, and I expect further readings of PCE to show weakness, as deflationary pressures continue.
- U-6 Unemployment remains at 10.9%. While employment seems to be moving in the right direction, and the U-6 has been on a relatively steady decline, it has remained quite elevated when compared to historical norms.
- The Employee Participation Rate is at the lowest level since the 1970s at 62.7. While it is true that a portion of the reduction in the labor force participation rate can be attributed to baby boomers retirement, it is also true that the U.S. has many more workers that are discouraged now than before the crisis. To what extent weakness in the labor force participation rate is caused by discouraged workers versus retirement, is a topic in itself, and beyond the scope of this writing. Suffice it to say that the weakness in the current labor force participation rate is caused by more than just an increase in retirements, and will likely have a deleterious impact on the U.S. economy for some time. In short, it is clear from the data that the unemployment rate is going down for the wrong reasons.
- The U.S. middle class suffers from stagnant wages, and has not seen an increase in their standard of living in over 20 years. This is not sustainable in a consumer-based economy. At some point, debt availability will run out and consumers will have to drastically lower their level of consumption, triggering a drop off in economic activity.
"…the U.S. Federal Reserve Board has a tough decision to make later this year on when to start raising interest rates again to head off inflation as the economy takes off again. Bets are on that with continued declines in unemployment, the Fed will start raising rates in mid-year. But, says Wharton's Capelli, stubbornly sticky wages may mean the Fed should consider conducting its monetary policy differently now. In the absence of easy wage gains, he says, "the economy could run hotter without concerns about inflation. So there are fewer concerns about the need to moderate expansionary monetary policy." Source
- ISM-March ISM came in at 51.5, a decline of 11% from the October 2014 high of 57.9, and the 12-month average of 55.5. ISM is showing a slowing economy.
- Velocity on M2 remains the weakest level in over 50 years at 1.5.
- Debt Levels remain elevated, while savings rates remain subdued. During the Great Depression the savings rate fell to 4.7% in 1929. Currently, we are sitting at 5.8%. While the savings rate has come off of the December 2013 low of 4.1%, the trends in the personal savings rate seem inconsistent. According to the data, consumer debt levels are rising, which is having a real effect on the PSR.
- Productivity is sluggish and moving in the wrong direction. In the fourth quarter of 2014 we saw non-farm business productivity come in at -0.1%. This is a real concern.
- US Dollar Strength
In the past year, the U.S. dollar index has increased by over 20%, illustrating the massive weakness in the rest of the world's currencies. This appreciation of the dollar index has created a tightening effect that will likely support the idea that the Fed will stay on hold for some time.
- Europe in Deflation
In a recent article entitled "Deflation: Why Europe's Problem is Everyone's Problem" from Knowledge@Wharton, the research site of the Wharton School at the University of Pennsylvania, the author makes an astute observation concerning the negative effects of deflation, and the susceptibility of the US economy to suffer the effects of European deflation:
"Unfortunately, deflation is not just Europe's problem. It's a trend that has an effect on countries around the world, especially major economies like the U.S. and China. "Europe is big enough to effectively 'export' its deflationary problem to the rest of the world," notes Krista Schwarz, a Wharton finance professor. "Europe is 25% of the global market," adds Mauro Guillén, Wharton management professor and director of The Lauder Institute. "The U.S. and China sell in Europe. The problem is essentially that deflation will produce very slow growth worldwide…Global trading links are so dependent that not only do exports cross oceans, but deflation can as well. Inflation could fall further, and that could get entrenched in inflationary expectations and have negative consequences." The deflationary contagion has the possibility to spread worldwide. Schwarz notes, "inflation expectations have moved down, and that can be a self-fulfilling prophecy." Source
The realities for the eurozone remain that while the ECB has engaged in a massive QE program, the effectiveness of this measure will not be the same as in the U.S. If in fact the effect comes in weaker, what affect will that have on inflation across the eurozone, much of which is mired in deflationary forces? I continue to believe that European deflation remains a serious risk for the United States, and a major driver to maintain over accommodative monetary policy.
- The Economies in Much of the East are Slowing
In 2014 China grew at 7.4%, higher than the 7.3% expectation, but lower than Beijing's 7.5% expectation. This year the expectation is even lower at 7%. While the U.S would beg for growth rates like this, for China, a country at a different stage of economic development, it may be a sign that difficult times are ahead. The negative effects of European economic weakness and lower incomes in the U.S., remain a serious weakness to China's mainly export economy. This is forcing China to develop their domestic economy more robustly. In Japan we see weakness across the board, as consumption remains tepid, and GDP growth came in at 2.2% well below estimates of 3.6% for the 4th quarter 2014. Japan's economy faces a host of challenges as Mr. Abe tries to raise prices and wages concurrently. Russia sits on the brink of recession, as GDP growth comes in at 0.65%, and geopolitical risks remain.
It is clear that the Russian economy and the Asia region continue to show evidence of slowing.
In conclusion, while many of the more hawkish market participants believe that interest rates should rise imminently, I believe they will be sorely disappointed, as the current economic data simply does not support this contention. The key question for policy makers to consider at this point is what effect rising interest rates might have on the real economy? I would contend that history has proven to us that given the risks overseas, and the unstable nature of this economic recovery that we have been experiencing in the U.S., any increase in the Federal funds rate could have severe negative consequences for the U.S. economy. If the Fed should raise rates and the economy would take a turn for the worse, they would have repeated the errors of 1937. Given the fact that we believe the risks outweigh the benefits of raising rates in 2015, we continue to be invested in a portfolio of select equity securities and long term zero coupon U.S. Treasury securities, which we believe will serve as a port in the global storm, as yields are driven to all time lows in much of the globe. What does all of this mean for investors? We will explore this in part III.
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