Answering the Critics
This week is a busy week for economic data as the market may begin to judge the effectiveness and wisdom of quantitative easing (QE). The latest flare-up in the European fiscal saga will compete for attention this week with a cornucopia of U.S. economic data for October and November. The data, which includes reports on retail sales, industrial production, consumer and producer price inflation, housing starts and leading indicators for October, as well as the Empire State and Philadelphia Fed manufacturing surveys for November, may help answer several questions market participants, policymakers and pundits have been asking in recent weeks:
· Is the economic soft spot really over?
· Is QE working yet to push inflation higher and the unemployment rate lower?
· Was QE necessary in the first place?
The Federal Reserve’s (Fed) second round of quantitative easing (QE2), large-scale purchases by the Fed of Treasury notes, begins this week. QE2 is aimed at keeping interest rates lower for a longer time to allow both consumers and businesses to refinance and pay down debt thereby, in theory, boosting economic activity, lowering the unemployment rate and pushing up the inflation rate. Last week, the Fed, Fed Chairman Bernanke, and QE2 itself came under withering criticism from politicians, pundits, central bankers, and lawmakers both at home and abroad, leaving the market wondering how much more pressure the Fed can take.
Our view is that the Fed can manage the criticism in the short and medium term, but longer term, the severity of the QE2 “backlash” may prompt an early retreat from QE2, perhaps earlier than is necessary to foster an environment supporting sustainable economic growth. Congress has the ultimate authority over the Fed’s dual mandate of full employment and price stability. Thus, Chairman Ben Bernanke’s regular visits to Capitol Hill, especially when the new Congress is seated in January, will take on increased significance for markets. Although Bernanke is not scheduled to speak, a confirmation hearing this week in the Senate of one of President Obama’s appointees to the Federal Reserve Board of Governors (Peter Diamond) may provide some members of Congress with the platform to criticize QE2.
Some of the impact of the anticipation of QE2 will likely be on display in this week’s data. A weaker dollar is an indirect consequence of QE2. The dollar has declined by more than 7% since Bernanke first hinted that QE2 was a realistic possibility at a late-August speech in Jackson Hole, Wyoming (according to the Federal Reserve Major Currencies Index). More dollars in the system means that each dollar is worth less. In turn, a cheaper US dollar makes U.S. exports less expensive to foreigners. The October Industrial Production report, due out on Tuesday, November 16 is one gauge of how exporters have benefitted from QE2.
Similarly, housing is a direct beneficiary of QE2. The October housing starts report and the National Association of Homebuilders sentiment survey for November are due out this week. The Fed’s goal is to keep rates lower for a longer time, encouraging property owners (residential or commercial) to refinance at lower rates, and use the money saved on more spending, hiring or debt pay down. Housing affordability is at an all-time high and lending standards are easing, but it is probably too soon to tell if QE2 has affected the housing market yet.
Finally, retail sales for October will be scrutinized for clues about the upcoming holiday shopping season, but the effect of QE2 can be seen in this data set as well. At +1.2% month-over-months, October retail sales were stronger than expectations (+0.7% month-over-month) and stronger than September's +0.6% month-over-month reading. In addition, the September reading was revised upward. Some of the October strength in the consumer was overstated, given that building material store sales surged in October and those sales feed into gross domestic product (GDP) as business capital spending, and not consumer spending.
On balance, the October retail sales report supports the idea that the U.S. economy continued to reaccelerate in October, but that consumers remain cautious ahead of the crucial holiday shopping season. The October retail sales data is consistent with recent data points for October and November, which suggests the economy was reaccelerating out of the soft spot that began this spring. QE2 affects consumer spending via higher equity prices (boosting wealth), lower interest rates (more affordable to finance purchases), and more bank lending to both businesses (fostering job creation) and consumers (enabling more consumer loans).
Budget Battle Begins, but it is not Likely to End for a While
Last week, the National Commission on Fiscal Responsibility and Reform laid out a path to fiscal responsibility. The co-chairs of the President's bi-partisan National Commission on Fiscal Responsibility and Reform, Democrat Erskine Bowles and Republican Alan Simpson, announced their recommendations to reduce the deficit and debt. The report of the full commission will release its findings on December 1, but keep in mind that Congress chose to make these recommendations of the Commission non-binding. Thus, the plan put forth last week — as well as the one due out in a few weeks — should be viewed as the starting point for Congress to address this very important issue over the coming years.
As we discussed in last week’s Weekly Economic Commentary, it is not sustainable over the long run to have Federal spending running nearly twice as fast as tax receipts. As a result, over the longer term, our view is that both sides of the issue (revenues and spending) will need to be addressed. In addition, indeed, that is what the deficit commission report did. The report essentially put everything on the table, and provided a bi-partisan and fair assessment of the work that needs to be done to put the nation’s fiscal house in order:
· Tax increases
· Spending cuts
· Gasoline tax increases
· Cutting government waste and “pork barrel” spending
· Culling through farm subsidies
· Modifications to both social security and Medicare
· Curbing defense spending
Our best guess is that, despite the momentum this document provides, serious actions to address reducing the deficit and debt will not occur until after the 2012 Presidential elections.
Economy Appears to Be Reaccelerating, But at What Speed?
Although limited in scope and volume, last week’s batch of economic data in the United States continued to paint a picture of an economy that was reaccelerating out of the summer soft spot. Ironically, the soft spot began when Greek’s fiscal woes made headlines during the European fiscal flare-up up in March and April of 2010. Last week the issue flared again, but this time Ireland, not Greece, was the epicenter. Our view continues to be that deficit and debt issues in peripheral Europe will flare up from time to time (as they did last week in Ireland). However, because the market expects little or no growth out of Europe in 2011, (the consensus is calling for 1.3% growth in real GDP in the Eurozone in 2011) the main issue for markets will be the so-called “contagion effect” (i.e. will the sovereign debt issues in peripheral Europe spread to the banking sector in other parts of Europe and the United States). Thus far, the issue in Ireland has had little impact on the banking sector in the United States or the more fiscally sound European nations like Germany and France.
Turning back to the data in the United States last week, the following reports all pointed to an economy that had shifted into a higher gear as the weather turned cooler:
· Weekly retail sales for the week ending November 6
· Consumer sentiment for the first half of November
· Initial claims for unemployment insurance for the week ending November 6
· Banks loans for the week ending November 3
· Wholesale trade for September
· The National Federation of Small Business sentiment for October
· The Fed’s Senior Loan Officer Survey for Q4 2010
However, while the financial media’s favorite summertime refrain — double-dip — has faded along with the fall colors as we approach winter, the economy is by no means booming. Growth, as measured by real GDP, may have accelerated a bit early in the fourth quarter, but probably only pulled the economy out of stall speed and into a slightly more rapid trajectory.
The most notable of these reports was probably the weekly report on new claims for unemployment insurance for the week ending November 6. Initial filings for unemployment insurance fell sharply (24,000) in the latest week and have declined in eight of the past 12 weeks. Aside from a single week this past summer, claims have not been this low (446,500 per week) since the summer of 2008. Claims probably need to drop into the 350,000 per week range to convince markets that the labor market is capable of generating enough jobs (roughly 150,000 to 250,000 per month) in order to push the unemployment rate lower. In embarking on QE2, the Fed specifically noted that the unemployment rate (at 9.6%) was unacceptably high, so it is clear that the Fed is also watching the weekly initial claims data very closely.
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Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.
The Federal Reserve Major Currencies Index is a weighted average of the foreign exchange values of the US dollar against a subset of currencies in the broad index that circulate widely outside the country of issue. The weights are derived from those in the broad index. Countries whose currencies are included in the MAJOR CURRENCIES INDEX are the Euro Area, Canada, Japan, United Kingdom, Switzerland, Australia, and Sweden. The Euro Area includes Germany, France, Italy, Netherlands, Belgium/Luxembourg, Ireland, Spain, Austria, Finland, Portugal, and Greece.
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
The Producer Price Index (PPI) program measures the average change over time in the selling prices received by domestic producers for their output. The prices included in the PPI are from the first commercial transaction for many products and some services.
The Empire State Manufacturing Survey is a monthly survey of manufacturers in New York State conducted by the Federal Reserve Bank of New York.
The Philadelphia Fed Survey is a business outlook survey used to construct an index that tracks manufacturing conditions in the Philadelphia Federal Reserve district. The Philadelphia Fed survey is an indicator of trends in the manufacturing sector, and is correlated with the Institute for Supply Management (ISM) manufacturing index, as well as the industrial production index.
Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
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