The Fed's Pyrrhic Victory

by: e21

Recent data suggest that the mini revival in domestic economic fortunes is largely attributable to an increase in household outlays. This would be good news if the increase was due to household income growth. But, the increase is instead the result of households spending more out of the same income. This questions the durability of the expansion, as declines in savings are hardly a sound foundation on which to build income growth. The economy’s ongoing dependence on consumer outlays also puts a focus on the policy objectives of those on the Federal Open Market Committee, like Federal Reserve Bank of New York President William Dudley, who wish to use the threat of accelerating inflation to increase household spending. The U.S. will never be able to transform itself from a consumption-dependent, net importer as long as the penalization of savings remains the preferred mechanism to generate short-term growth.

The economy has received a spate of good news recently, raising hopes that growth will meaningfully dent the chronic unemployment problem. The economy added 200,000 net jobs in December and the narrow and broad unemployment rates fell to 8.5% and 15.2%, respectively. Many economists anticipate that the economy expanded at an annualized rate of more than 3%, due in part to the 1.5% of GDP liquidation of inventories in the third quarter. Even if final demand remains unchanged, the inventory rebuild will likely add more than one point to GDP in the fourth quarter. The momentum could raise 2012 first quarter GDP growth above current projections of 2.4%.

The problem with the optimistic interpretation of recent data is that the increase in growth is entirely explained by the reduction in households’ savings rates. In the first half of 2011, growth was below 1% and households saved about 5% of disposable personal income. In the second half, of 2011 growth is likely to have increased to 2.5%, but the savings rate is set to decline by a fourth to an average of just 3.8% of disposable income. After adjusting for inflation, personal income in November was largely unchanged from the first quarter, at $9.36 trillion versus $9.33 trillion (annualized). The increased consumption that accounted for 70% of GDP growth in the second half of 2011 was, therefore, almost entirely due to the fall in savings. Simply put, the boost in the economy is coming from a rise in the proportion of household income that is being spent, not an increase in household income.

The decline in savings also reflects the growth in consumer borrowing, which works to support current spending in the absence of income gains. In November 2011, consumer credit increased at a 10.4% annualized rate, the largest increase in more than ten years. Academic research has identified the “household leverage crisis” as a key driver of the broader financial crisis and great recession. Consumer borrowing generates the potential for crisis because future income is being pledged to support current expenditures. When the income fails to materialize because of job loss or other factors, the result is losses for the financial institutions that made the past loans and a decline in current consumption expenditures due to lower incomes and less incremental borrowing. Yet, despite having just endured the deepest post-war recession caused directly by these factors, the deleveraging process that was supposed to repair household balance sheets appears to already be in remission.

This turnaround is largely due to a Fed policy that has attempted, at every turn, to change the balance of risks facing households so as to encourage additional consumption. As profiled by e21 over one year ago, Reserve Bank of New York President William Dudley regarded insufficient consumption growth as the biggest problem facing the economy. At that time, his preferred solution was “price level targeting” which would have the Fed tolerate large increases in inflation if it they were “making up” for previous inflation rates below the informal 2.5% target. Expectations of higher inflation encourage more spending today, as households accelerate purchases to avoid having to pay higher prices later.

Fed policy also directly encourages spending by reducing nominal interest rates. The choice between spending and saving one dollar of disposable income depends on the expected rate of return on the saved dollar relative to the expected change in the price level. Although nominal interest rates are (generally) bounded at zero, real rates of return can be negative if expected inflation exceeds interest rates. William Dudley and some of his colleagues on the FOMC have advocated actively penalizing savings by turning inflation-adjusted interest rates negative, which makes a dollar spent today worth more than a dollar saved and then spent in the future. Through “operation twist,” the Fed has extended the average maturity on its portfolio to reduce bond yields. Rather than yielding more than 3.5% as in the first quarter of 2011 when savings rates were over 5%, the 10-year Treasury note now yields less than 2%. At this rate, households that anticipate inflation of greater than 2% would actually see their purchasing power decline through time if they chose to save an incremental dollar rather than spending it. After the income tax on interest income is included, current policy not only discourages savings but actively penalizes it. Unsurprisingly, the savings rate fell by 1.5 percentage points during 2011, in tandem with the decline in the nominal return on savings.

Ultra-easy monetary policy generally reduces the trade-weighted value of the domestic currency, which usually boosts net exports, as relative domestic production costs fall and imports become more expensive. However, this is unlikely to work in this context precisely because the policy so transparently aims to boost domestic spending. The penalization of savings through negative real interest rates results in lower borrowing costs, which helps cash-strapped households but does nothing to impact cash-rich businesses. The elasticity of business spending with respect to interest rates is close to zero because of the record amounts of cash business retain on their balance sheets. The problem here is not that interest rates are too high, but rather macroeconomic and policy uncertainty that lead business to conserve cash rather than invest it. Lower rates will simply encourage unsustainable consumption patterns with little to no impact on business investment. The result is a larger trade deficit, which reflects the difference between domestic savings and consumption.

Despite all of these “successes” in destroying savings to boost consumption, the Fed may not be done. Dudley recently gave a speech where he attributes the economic weakness to the housing bust. While part of this weakness stems from anemic new home construction, as usual, Dudley’s focus is on the way dysfunctional housing markets impact consumption. In a rare act of policy overreach from a New York Fed President, Dudley urged Congress to consider a number of policy options to address the housing bust, including a massive refinance initiative and “bridge loans” to keep mortgage borrowers in their homes. One gets the sense that action on these fronts could unlock a “QE-3,” where the Fed commits to buy mortgage-backed securities (MBS) in whatever quantities necessary to address the likely market volatility and potential dysfunction caused by government meddling on this scale.

There were hopes that the recession could result in a transformed economy, where the U.S. would be less dependent on consumption and housing going forward. Included among those hoping for such transformation was Treasury Secretary Geithner, who said in 2009 “saving rates will have to increase, and the purchases of U.S. consumers cannot be as dominant a driver of growth as they have been in the past.” Unfortunately, this goal was never really pursued as new regulations and the health care entitlement diminished businesses’ appetites for investment, leaving few options beyond a return to consumer-led growth or no growth at all. Bill Dudley and his allies on the Fed have succeeded in boosting household spending. The Fed’s sights now appear to be aimed at ways it can help further federalize the mortgage market. The outcome of this next chapter in the debate will help decide whether the American economy is even more dependent on housing and consumption as it was in 2007.