Is A US Boom On The Horizon?
I believed from the beginning that the effects of QE II would be negative for the real economy. The primary effect of the policy was a reduction in real interest rates through higher inflation and inflation expectations. That did produce the portfolio effect Bernanke expected by driving down the future expected returns for a variety of assets. The most dramatic effect was on the dollar and commodity prices but stocks benefitted as well.
Despite the positive effect on asset prices, the effect on the real economy has been as negative as I expected. Bernanke also expected a reduction in real rates to induce lending but that hasn't happened for several reasons.
First, lending prior to QE II was weak because there was little demand for loans from credit worthy borrowers and that hasn't changed. Large corporations were already sitting on large cash balances and have access to public markets if they want to borrow. Small companies were not as creditworthy and were also being more conservative with their capital structure. QE II didn't change that and may have made it worse by raising commodity costs. For both large and small companies a significant factor was - and still is - a lack of credible investment opportunities. Individuals were - and still are - saving more as a cushion against future volatility.
Second, while reducing real rates might theoretically increase the demand for credit, raising inflation expectations reduces the supply. Bernanke seems to have assumed that he could raise inflation expectations for borrowers while having no effect on the expectations of lenders. A falling dollar and rising inflation is not a friendly environment for lenders who will be paid back with depreciated dollars.
Finally, even the portfolio effect of QE II was a net negative for the economy. The rise in commodity prices was either passed on to consumers or absorbed through reduced profit margins. We also know from reams of research that the wealth effect from stock market gains is weak at best.
Not only that but the wealth gain was skewed to higher income individuals while those hurt most by the recession are overwhelmingly concentrated in lower income groups who have been hurt by the rise in energy prices that is a direct consequence of QE. Like every other program initiated by the Fed over the last few years, QE II has been a boon for those who needed no help and a bane for those who did.
If one believes as I do that QE II has been negative for the economy it is logical to now anticipate the opposite as we near the end of the program. Just as the effects of QE II were felt before its actual implementation, so too will the effects of its end be anticipated. That appears to be happening now. Commodity prices that started rising before the start of QE are now peaking before the end. Interest rates that rose with QE are now falling.
For the economy, the end of QE should be positive as commodity prices ease and inflation expectations wane. The US dollar appears to be stabilizing within the range that has existed since 2008. In fact, with large existing short dollar positions, a US dollar rally seems likely.
Lower commodity prices should ease some of the pricing pressures reported this year by the ISM and allow companies to maintain profit margins. Lower gas and food prices from a stronger dollar should provide much needed relief to lower income consumers. The end of QE could also extend the tentative rise in lending we have seen the last couple of months. Bankers should feel more comfortable lending if interest rates, the dollar and inflation expectations stabilize.
Looking out a bit further, the outlook for US growth could - and I emphasize could - improve significantly. In fact, I am beginning to wonder if the pieces might be falling into place for a boom no one currently expects. There is a lot that must go right for it to happen but it is certainly possible and would catch the markets by surprise.
The key to any marked improvement in the economy is residential investment. Gross private domestic investment is down roughly $500 billion from the peak in 2006. The change in private residential fixed investment accounts for almost all of the drop. Real investment in equipment and software has already passed its previous peak set in 2008.
The prospect for a rise in residential investment is not as far-fetched as it might seem. Housing starts are currently annualizing at around 500,000 units (which includes multi-family starts) and the inventory of new homes is quite low at around 200,000. The key to a rise in residential investment is household formation. Over the last decade new household formation averaged about 1.3 million annually. In 2009 and 2010 new households formed at a rate of about 400,000 annually. Thus there is a pent up demand for about 1.8 million new households.
There seems little doubt that an excess inventory of existing homes still exists; prices are still falling. Existing home sales are annualizing at around 5.1 million and reported inventory is around 3.5 million. There may be more inventory being held off the market in the form of future foreclosures but from the standpoint of residential investment that would seem to be irrelevant - those people will have to live somewhere.
On the other hand, apartment vacancies are falling and rents are rising. If the economy can continue to add jobs and household formation returns to its longer term average, residential investment will have to start rising fairly soon. A doubling of housing starts over the next few years - which would only bring them back to the lower end of the range of the last 50 years - is certainly possible and I think likely.
Getting residential investment back on a more normal path would improve GDP growth greatly but it wouldn't be enough to create a boom. That will require policies that raise and then stabilize the value of the dollar. To see how a boom could develop one need only look to the emerging markets. It is not coincidence that countries with rising currency values are booming right now. One might also remember the late 90s when a rising dollar helped produce a boom in the US. Capital flows to where the best opportunities exist and right now that is almost anywhere except the US.
The positive fiscal policy changes required for a boom may be on the horizon as well. A cut in the corporate income tax seems to be something on which everyone agrees and would increase the demand for the dollar. Any movement to solve the budget deficit would also be a positive for the dollar. If the politicians can just improve policy a little now, the natural market forces at work in the housing market and a stronger dollar may be enough to produce a boom that makes the deficit problem easier to solve. We'll find out soon.