Monthly Economic Outlook - October 2010
The WYSIWYG Economy
You are entering the no-hype zone: What You See Is What You Get (WYSIWYG). There is no double-dip or V-shaped recovery. Every economic recovery is a new-normal - the 1960s were very different than the 1970s, the 1970s were very different than the 1980s, and so on... The new normal is not anything new - it happens every economic cycle. In contrast, what we see is what we have to deal with: moderate economic growth, fiscal deficits, low inflation and a central bank that is going to explore new paths of monetary policy.
Until the tax season passes in early 2011, the economy will still be characterized by modest, but positive, economic growth of around two percent, driven by gains in consumer spending, equipment & software spending as well as federal government spending. Commercial real estate will still be a drag. Inventory rebuilding has come to an end and will no longer boost growth. Net exports will be a modest positive.
The story of the next three quarters will include turnarounds in residential construction and inflation. Our expectation is that housing starts have bottomed and will increase steadily for the next four quarters. Employment and income gains will support demand. Meanwhile, mortgage rates remain low and housing affordability is another plus. Demographics of household formation will begin to boost demand as well. Finally, the Fed has said inflation is too low and they have the tools to combat low inflation - in the short run, that is. In the long run, well that is a story yet to be written.
Slow Growth Now, Improvement Ahead
Every economic recovery is different - both in the overall pace of growth and its component parts. Meanwhile, the challenges to fiscal and monetary policy are also different. For decision-makers, in both private and public sectors, the task is to adapt to the differences while retaining the same institutional goals.
Moderate economic growth will continue to be the story until tax season passes in early 2011. On the plus side, gains in consumer spending, equipment & software spending as well as federal government spending will keep the economy moving forward. For the next three quarters, we anticipate that consumer spending will benefit from a streak of positive, yes positive, employment reports and by mid-2011, lower unemployment rates and rising real personal income will be present. Spending will not be as strong as in the past phases of early recovery, but will be positive nonetheless. This recovery is different and decision-makers need to deal with what we have: moderate growth, not a V-shaped recovery.
Equipment & software spending as well as federal government spending will continue to support growth. Solid equipment & software spending has a second effect that is of interest: productivity gains from better/more equipment are usually associated with better real earnings and corporate profits. Both these effects are positive for the recovery longer-term. On the negative side, commercial real estate will still be a drag. Inventory rebuilding has come to an end and will no longer boost growth. Net exports will be a modest positive. The drag in commercial real estate reflects current high vacancy rates and limited risk-taking. By mid-2011, however, we expect commercial real estate to break into the positive column. The inventory boost to GDP will gradually phase out over the second half of this year. State & local spending and its contribution to growth will depend upon the willingness of Washington policymakers to continue to support spending below the federal level.
Turnaround Stories: Housing Starts and Inflation
The surprise story of the next three quarters will be the turnarounds in residential construction and inflation. Our expectation is that housing starts have bottomed and will increase steadily for the next four quarters. Employment and income gains will support demand. Meanwhile, mortgage rates remain low and housing affordability is another plus. Demographics of household formation will begin to boost demand as well. Finally, the Fed has said inflation is too low and they have the tools to combat low inflation - in the short run, that is. In the long run, well that is a story yet to be written.
Policy and Politics
November's election results and the reaction in Washington will dictate the framework for policy going forward. At present it appears that the House will turn Republican while the Senate remains a toss-up. Our expectation from this is that fiscal policy will turn more conservative and so further stimulus spending will be limited, including support for state & local governments. Recent discussion has focused on the Clinton precedent in policy; though whether Obama will work with a Republican Congress or choose to follow a different path is yet to be determined.
Regarding monetary policy, the operating policy appears to be quantitative easing to increase the inflation rate to a more comfortable pace. At present, the Federal Reserve appears to be focused on the downside for growth and inflation. So the bias in policy will be to engage in financial asset purchases to boost growth and inflation. Therefore, in the short run, we expect the liquidity effect will generate lower rates, but over time we are concerned that a weaker dollar, rising inflation and continued large federal deficits will produce a quick upside move for longer-term rates, catching many investors by surprise.
Slow Growth and the Potential for a "Currency War"
Recent data suggest that global economic growth remained positive in the third quarter. However, growth rates in most economies appear to have slowed from earlier this year, and the risk of mild deflation is not insignificant if the global economy were to stagnate. Although another global downturn in the near term is not likely, major central banks may soon undertake further quantitative easing (QE) to minimize the probability of another global downturn. Expectations of further easing by the Federal Reserve have contributed to the dollar's recent depreciation.
Dollar weakness has led to consternation in some foreign countries as those currencies have strengthened. In an attempt to resist yen appreciation, the Bank of Japan (BoJ) expanded its quantitative easing program and engaged in foreign exchange market intervention. The Brazilian government enacted a tax to discourage speculative capital inflows, and the Brazilian finance minister recently said "we're in the midst of an international currency war."
A "currency war" could be benign if it induces central banks in major economies to ease policy further, thereby supporting economic growth. However, we fear that the downside from any "currency war" outweighs any upside that may ensue. Taxes designed to discourage capital inflows distort global capital flows, and a protectionist backlash could ensue if governments perceive that other countries are trying to manipulate their exchange rates to gain commercial advantage.
Slow Growth and the Potential for a "Currency War"
Although no major economy has released official GDP data for the third quarter yet, monthly indicators suggest that foreign economic growth remained positive in the July-September period. "Hard" data show that Eurozone industrial production in July was 0.4 percent above the second quarter's average, and purchasing managers' indices for the manufacturing and service sectors remained within expansion territory in August and September (see chart below). Many Asian countries will release third quarter GDP data within the next few weeks and positive growth rates - not only on a year-over-year basis, but also on a sequential basis - are widely expected. Economic growth in Latin America appears to have remained buoyant in the third quarter as well.
However, the available data generally show that economic growth rates in most regions of the world have downshifted relative to earlier this year. Perhaps some deceleration in global economic activity was inevitable as inventory-fueled bounces from the first half of the year ran their course. However, economic recoveries in the United States, the euro area, and Japan do not appear to be truly self-sustaining yet, and some analysts worry that the global expansion could stall as fiscal consolidation gets underway. With inflation non-existent in most major economies, the risk of mild deflation is not insignificant should another global downturn ensue.
Therefore, some major central banks are contemplating additional easing measures. Because policy rates are about as low as they can go in many advanced economies, additional easing steps would take the form of unconventional measures rather than rate cuts. For example, the BoJ recently announced it would expand its quantitative easing (QE) program via the purchase of ¥5 trillion (about $60 billion) worth of government bonds. We expect that both the Federal Reserve and the Bank of England will soon embark upon a second round of QE, although we believe that the inflation-phobic European Central Bank (ECB) will refrain from expanding its limited QE program, at least for the foreseeable future.
Expectations of further Fed purchases of Treasury securities have caused yields on U.S. government bonds to decline markedly. For example, the yield on the 10-year U.S. government bond has dropped more than 60 bps since the end of June, declining more than the comparable yield in Germany (see chart on page 1). As yields in the United States have declined relative to many foreign economies, the greenback has depreciated versus many foreign currencies. Indeed, the weighted average value of the U.S. dollar has declined about 7 percent since the end of June (bottom chart).
One of the apparent rationales for the BoJ's foray back into QE is to resist the upward pressure on the value of the Japanese yen. Many developing countries have seen their currencies strengthen recently. Moreover, high rates of return in those countries have attracted increased capital inflows. For example, the Brazilian real has risen to a two-year high versus the greenback, prompting the Brazilian government to enact a tax that is designed to discourage speculative capital inflows. Furthermore, Finance Minister Mantega made headlines recently when he said "we're in the midst of an international currency war."
A "currency war" could be benign if it induces central banks in major economies - in which rates of economic growth are generally lackluster at present - to ease policy further via additional QE. We fear, however, that a "currency war" would do more harm than good. Taxes imposed on capital inflows distort global capital flows. In addition, a protectionist backlash could develop, which would impose long run economic harm if governments perceive that other countries are trying to manipulate their currency's value for commercial gain. In our view, the current environment of sluggish economic growth significantly raises the risk of a policy accident occurring.