Tuesday, May 26, 2015

Tiptoe Through the Soft Patch
The song “Tiptoe Through the Tulips” was originally published in 1929, just before the Great Depression, and famously revived by Tiny Tim in 1968. Fed Chair Janet Yellen and her colleagues on the FOMC have been tiptoeing all year through the economy, hoping that it will grow fast enough to handle the first rate hike in nine years without triggering a financial calamity that sets off another Great Recession.

On Friday, Yellen gave a speech on the economic outlook, observing, “As you all know, the economy is still recovering from the Great Recession, the worst downturn since the terrible episode of the 1930s that inspired its name.” She doesn’t seem to believe that it is completely over, though saying that it “began more than seven years ago.” Let’s have a closer look at her views:

(1) Labor market is laboring. Surely, she must recognize that the labor market has fully recovered. She answered her own implicit question: “Are we there yet?” by only conceding that it is “approaching full strength.” She then accentuated the negatives, noting that too many people have dropped out of the labor force, too many working part-time want full-time jobs, and wage gains remain too low, running around an annual rate of 2%. Notice that she highlighted the wage inflation shown in average hourly earnings rather than the wage component in the Employment Cost Index, which rose 2.7% y/y during Q1, the highest since Q3-2008. While she did mention the latter in a footnote, Yellen is certainly tiptoeing.

(2) Some homes still underwater. She also said that the economy continues to face some “headwinds.” The housing crash left lots of households with less wealth and more debt, leaving many of them “underwater.” Maybe so, but the Fed’s own flow of funds data show that real estate held by households has increased in value by $4.5 trillion from Q2-2011 through Q4-2014 and that owners’ equity as a percentage of household real estate has rebounded from a record low of 36.9% during Q1-2009 to 54.5% during Q4-2014.

(3) Less fiscal drag. A second headwind that “is mostly behind us” is the decline in fiscal spending. In real GDP, federal spending seems to have stabilized over the past three quarters after falling 13% from Q3-2010 through Q2-2014. State and local spending has recovered very gradually after falling 8% from Q3-2009 through Q4-2012.

(4) Global weights. The third and final headwind in Yellen’s list is the weakness in the global economy. During most of the US recovery, the biggest overseas problem was the renewed recession in the Eurozone. Now it seems to be a slowdown in emerging economies, especially China. She indirectly mentioned that the strong dollar might also have weighed on US exports. However, this too should pass, in her opinion.

(5) Headwinds still blowing. In any event, monetary policy will remain accommodative. She said that “the headwinds facing our economy have not fully abated, and, as such, I expect that continued growth in employment and output will be moderate over the remainder of the year and beyond.” She thinks that residential investment “is likely to improve only gradually.” Business investment will continue to recover modestly, though energy capital spending is likely to be weak.

Yellen said it all adds up to real GDP growth of about “2-1/2% per year over the next couple of years.” Given that real GDP excluding government spending has been hovering around 3.0% since 2010, Yellen seems to believe that the headwinds will shave about a half a point from growth.

(6) One and done. The Fed chair then laid out the implications for monetary policy. She came close to saying that there will be just one rate hike this year:
For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy.
That is as long as the labor market continues to improve and she is “reasonably confident that inflation will move back to 2 percent over the medium term."

She should certainly be pleased to see that the four-week average of initial unemployment claims during the week of May 16 fell to the lowest since April 2000, indicating that the pace of firing remains very low. Last week’s CPI news for April should make Yellen reasonably confident about achieving her inflation goal.

(7) Tiptoeing for many years. Finally, Yellen reiterated that the process of monetary normalization may take a very long time:
If conditions develop as my colleagues and I expect, then the FOMC's objectives of maximum employment and price stability would best be achieved by proceeding cautiously, which I expect would mean that it will be several years before the federal funds rate would be back to its normal, longer-run level.
Yellen’s term as Fed chair expires on February 3, 2018. That might be how long the Fed continues to tiptoe—unless she is reappointed for another four-year term by the next US president.

In my opinion, the Fed’s tiptoeing has significantly contributed to the weakness of the current economic expansion:

(1) By keeping interest rates near zero for so long, risk-averse savers have had to accept bupkis for returns on their liquid assets. Many of them have been saving more, thus spending less: The 12-month sum of personal saving has been running around $700 billion since the end of the financial crisis in 2008, double the 1990s pace.

(2) Ultra-easy money attracted investors rather than nesters into the housing market following the 2008 crisis. They bought up all the cheap homes and drove home prices back up to levels that may be unaffordable for many first-time homebuyers.

(3) Thanks to the Fed, corporate bond yields have been trading below the S&P 500’s forward earnings yield since 2004, providing companies with an incentive to buy back their shares and engage in M&A rather than invest in plant and equipment.

Cheap money did stimulate some business investment, but the increased capacity wasn’t matched by more demand, resulting in some deflationary pressures. Stock prices have soared, but this has exacerbated the perception of widespread income and wealth inequality. Nice job, Fed!
(Based on an excerpt from YRI Morning Briefing)

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