Bernanke Battles Back
In the days leading up to “Black Friday”, the traditional kick-off to the holiday shopping season, markets will digest news on inflation, manufacturing and home sales for October, as well as the minutes of the Fed’s November 3 FOMC meeting. Overseas, Europe’s rescue of Ireland’s finances is likely to dominate the headlines, although the refrain “who’s next” is already being heard in and around Europe. Around the globe, it is a quiet week for economic data in China, and the central bank meetings scheduled this week are limited to Israel, Poland, Georgia, Mexico, and India. Of that group, only Israel and India have been tightening policy recently, and many global central banks may begin to slow their policy tightening altogether in the coming months to offset the Fed’s actions to lower the value of the dollar.
A quick look at the reports due out this week in the United States finds that housing and manufacturing will be in focus. The October data on new and existing home sales is likely to be quite sluggish, and this week’s data is likely to lend support to the need for the full course of quantitative easing (QE2) ($600 billion by June 2011). On the manufacturing side, a weaker dollar (the dollar is down by more than 10% since mid-June 2010) has already begun to work its magic in the manufacturing sector, suggesting that durable goods shipments and orders for October should be solid. The November Richmond Fed Index will help financial markets further refine estimates for the November ISM report, due on December 1. The first two readings on the manufacturing sector in November were polar opposites: the Philly Fed Index was strong but the Empire State Manufacturing Index was weak.
The release of the October data on core inflation (known as the personal consumption expenditure (PCE) deflator excluding food and energy) will likely underscore the need for the full run of QE2 from the Fed in order to turn around the direction of prices. This measure of core inflation is preferred by the Fed and is likely to show that core inflation was running at just 1.3% year-over-year in October, one of the lowest readings in 45 years, and below the Fed’s unofficial comfort zone of 1.5 to 2.0% on core inflation.
Finally, the minutes of the November 3 FOMC meeting will be published on Tuesday, November 23. In addition to providing some additional “color” as to why the FOMC decided to embark on another round of QE, the minutes will also shed more light on the well-publicized internal dissention within the FOMC around the need for more QE and how to execute it. The FOMC will also publish its quarterly economic forecast alongside the minutes. The forecast will likely show a significant downgrade of the economic and employment outlook (versus the prior forecast made in June 2010) and reveal a downshifting of inflation forecasts as well. In our view, the FOMC will press on with QE 2 (despite the criticism) until its forecasts show inflation moving higher and the unemployment rate moving noticeably lower. There are two more forecasts (late January 2011 and April 2011) prior to the scheduled end of QE2.
The Battle Over QE2
As we wrote in last week’s Weekly Economic Commentary, “Answering the Critics”, the week after November 3 the Fed announced that it was planning to embark on QE2, the Fed, Fed Chairman Ben Bernanke, and QE2 itself came under withering criticism from politicians, pundits, central bankers, and lawmakers both at home and abroad. It did not get much easier for the Fed or Bernanke in week two (last week). The latest critics include a group of U.S. Senators (essentially Bernanke’s bosses) and a member of the U.S. House of Representatives who called for the end of the full employment portion of the Fed’s dual mandate (promoting price stability and full employment). In addition, a group of prominent economists, policymakers, and academics who wrote an open letter to Bernanke in the Wall Street Journal that was quite critical of QE2.
Last week, Bernanke pushed back with help from Warren Buffett and several members of the FOMC, as well as the head of the United States Chamber of Commerce. Late in the week, Bernanke himself delivered a passionate defense of QE2 at a conference in Europe, saying:
“…on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years. As a society, we should find that outcome unacceptable. Monetary policy is working in support of both economic recovery and price stability, but there are limits to what can be achieved by the central bank alone. The Federal Reserve is nonpartisan and does not make recommendations regarding specific tax and spending programs. However, in general terms, a fiscal program that combines near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve.”
Most of the criticism of QE2 and the Fed’s policies focuses on the impact of QE2 on inflation and inflation expectations. The critics believe that the Fed is throwing fuel on the inflationary fire by doing another round of QE. The Fed sees it differently, and believes that the current and near-term outlook for inflation is muted and that it can rein in QE2 before inflation and inflation expectations begin to accelerate. Some criticize the Fed for engendering another “asset bubble,” citing the abnormally low Fed funds rate in the early 2000s that was followed by the residential real estate boom (2002-2007) and subsequent bust (2007-present).
Of the two arguments against QE2, we find a bit more credence in the “asset bubble” argument than the “runaway inflation” argument against QE2. Given the huge overhang of unsold homes, strict lending standards, and regulators’ hyper-vigilance around the banking system, the risk of another residential real estate bubble is low. However, bubbles are always forming somewhere in the world and the Fed embarking on another round of quantitative easing may indeed be creating a bubble somewhere. However, the Fed has judged that the rewards of trying to revive economic growth in the United States in the near-term outweigh the longer-term risk of engendering another asset bubble.
Our long-held view is that while there are a few similarities between the economic and policy backdrop today and the run up to the 1970s/80s era inflation, the backdrop is much less inflationary today. This leads us to conclude that when inflation does return, it will not be anything close to the sharp increase in prices seen in the 1970s and early 1980s, when headline inflation was in the 10% to 14% per year range and core inflation was between 8% and 12% per year.
Inflation remained low throughout most of the early to mid-1960s, but began to creep up in the mid-to-late-1960s before exploding higher in the mid-1970s through the early 1980s. Some attribute the rise in inflation to the heavy spending on the Vietnam War and President Lyndon Johnson’s Great Society programs. We certainly can draw parallels to today, where government spending as a share of GDP has risen from 18.5% at the end of the 1990s to nearly 25% by 2009, the highest since World War II.
However, some of the other factors that likely contributed to the surge in inflation in the 1970s and early 1980s are not present today. Some of those include:
· Union membership had a potent impact on wage growth during the 1960s and 1970s. As a percent of the workforce, membership has fallen from close to 25% in the late-1960s to under 10% today.
· In the 1960s and early 1970s, wages were often tied to inflation rates via cost of living adjustments (COLAs), which created a “wage price spiral”. COLAs are far less prevalent in today’s labor market.
· The United States left the gold standard in 1971, and allowed the US dollar to float, which boosted inflation expectations in the early 1970s
· Today, the Fed has built up 30 years of inflation fighting credibility. It had virtually no inflation fighting credentials in the 1960s and 1970s.
· Explicit inflation targets exist today in some countries, and are being seriously discussed by the Fed. Explicit inflation targets were nonexistent in the United States and very rare elsewhere in the late 1960s and early 1970s.
· Long-term inflation expectations in the United States are low and have been relatively stable over the past 15 to 20 years; in the late 1960s, inflation expectations were higher than today, and rising.
· High inflation often leads to even higher inflation as it reinforces expectations. Over the past five years, core inflation has averaged 1.9% and has been decelerating for more than 25 years; in the late 1906s, core inflation averaged close to 4.0% and was already accelerating.
· Productivity has been quite strong in the past 15 years. In contrast, productivity was much weaker through the inflationary period from the mid-1960s through the early-1980s.
A key reason why we do not think a severe bout of 1970s-style inflation is in the cards for the U.S. economy in the years to come is excess capacity of both labor and capital in the global economy. The emergence of China as an economic power has been a big factor in the creation of excess capacity. In addition, the dynamics and composition of the U.S. and global economies today are vastly different, and far less inflation friendly, than they were in the late 1960s and early 1970s. In short, the starting point for inflation matters, and in that regard, we are at a much better starting point today than in the late 1960s.
Some examples include:
· Capacity utilization (which measures the percentage of U.S. factories’ production capabilities being utilized) hit a new all-time low in June 2009 at 65%, and has only recovered to 72.7% today. The global recession has dampened utilization, but even over the past five years, capacity utilization averaged about 75%. By comparison, during the late 1960s, capacity utilization averaged 88% resulting increasingly in being met by higher prices rather than additional output.
· The economy is much more global today than it was in the late 1960s. Capital and labor flow much more freely over international borders than they did in the late 1960s and early 1970s, which helps to eliminate the bottlenecks that can lead to inflation pressures. For example, before the global recession hit in mid- 2008, trade (exports plus imports) accounted for about one-third of U.S. GDP, more than three times as high as it was in the late 1960s.
· Wages account for about 70% of business costs. In the latest 12 months, wage growth is running at a 2.0% pace. In the late 1960s, wage growth was running at over 6%, and was accelerating.
Evidence That Economy is Reaccelerating is Mounting, but is it Sustainable?
We have been on “reacceleration” watch for more than a month now, and last week’s serving of data was supportive of the premise that the U.S. economy’s summer soft spot has faded, and supports our long-held view that a double-dip recession in the United States was not likely. The data however, does not suggest that the economy is growing fast enough to push the unemployment rate lower or the inflation rate higher (the Fed’s goals for QE2) and, therefore, it is unlikely right now that the FOMC would end its QE2 program early.
The following reports all pointed to an economy that had shifted into a higher gear as the fourth quarter began:
· Retail sales for October
· Manufacturing industrial production for October
· Business shipments and inventories for October
· Leading indicators for October
· Philadelphia Fed manufacturing index for November
· Weekly initial claims for unemployment insurance for the week ending November 13
· Banks loans to businesses for the week ending November 13
Some data, including the very weak Empire State Manufacturing Index for November, the near-disastrous readings on housing starts and building permits in October, along with week-over-week declines in the readings on mortgage applications and weekly retail sales, continue to suggest an economy that is still near stall speed, and in need of more aid from the Fed.
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The ISM index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.
Philadelphia Federal Index is a regional federal-reserve-bank index measuring changes in business growth. The index is constructed from a survey of participants who voluntarily answer questions regarding the direction of change in their overall business activities. The survey is a measure of regional manufacturing growth. When the index is above zero it indicates factory-sector growth, and when below zero indicates contraction.
The NY Empire State Index is a regional economic indicator published by the Federal Reserve Bank of New York and released around the middle of the month. It is considered an indicator of economic conditions in one of the most populated states in the U.S.
The Richmond Fed Index is a survey of manufacturing conditions in the fifth federal reserve district. It covers the Mid-Atlantic States of Maryland, North and South Carolina, Virginia and West Virginia.
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