There will be no Weekly Commentary for the week of XXXXXX. Scott’s most recent commentary is available below.
This week, the Office of Management and Budget and the Congressional Budget Office will release revised budget projections. It’s been leaked that the OMB’s estimate will fall from $1.84 trillion (yes, that’s “trillion” with a “t”) to $1.58 trillion. That’s still a lot of borrowing. The increase in government borrowing will cause long-term treasury yields to rise right? Well, no actually…
Recall from Econ 101 that:
Y = C + I + G + (X – M)
Or output (Y) is consumer spending (C) plus business investment (I, not the same as financial investment), government consumption and investment (G), and net exports (exports, X, minus imports, M). Also recall that output is also equal to income:
Y = C + S + T
That is, income is either consumed, saved, or taxed. Subtracting the second equation from the first and doing a little algebra yields:
(M – X) = (I – S) + (G – T)
The trade deficit equals the shortfall in domestic savings (private investment less private savings) plus the budget deficit. Simply put, if we don’t save enough to fund business investment and balance the budget, we need to rely on foreign capital inflows (which happens to be the mirror image of the trade deficit).
Consider where we are now. The trade deficit has decreased and the budget deficit is higher. Therefore, the investment/savings shortfall must have decreased. Private savings has increased and business investment has fallen. In other words, the excess supply of credit (savings minus investment) has risen more than the increase in the budget deficit, and all else equal, interest rates should be lower. As with any recession, the increase in government debt happens exactly as the demand for safe assets increases.
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The increase in government borrowing has been offset by a decrease in private-sector borrowing.
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Do long-term interest rates depend on the demand and supply of money (monetary policy) or on the supply and demand for savings? J.R. Hicks showed us (several decades ago) that it depends on both.
Additionally, long-term interest rates can be thought of as a series of short-term interest rates. An expectation of the future path of short-term interest rates is embedded in the long-term rate (that doesn’t mean it’s a fool-proof predictor). The slope of the yield curve is perhaps the single best leading economic indicator. That slope is currently high, consistent with an improving economic outlook. Long-term interest rates normally rise as the economy recovers, but as we’ve seen recently, they should not rise too rapidly as they would threaten the recovery. Long-term rates are higher than they were at the start of the year, but that reflects the unwinding of the flight-to-safety (the economic outlook was much more worrisome earlier this year.
Still, while the increase in government borrowing is not a problem in the near term, investors are naturally worried about whether large budget deficits will persist. They won’t. This year’s startling increase in the budget deficit is the result of cyclical factors (tax revenues fall in a recession, but rebound as the economy recovers) and temporary spending (the financial rescue, the fiscal stimulus). The deficit will decline as the economy recovers and temporary spending programs fade away. Still, there is a structural deficit to deal with. Even after the economy recovers, the government will still spend more than it takes in, and strains will increase as the baby-boom generation retires (note that a main goal of healthcare reform, according to White House officials, is to reduce inflation in healthcare costs, including Medicare). Deficit reduction may require higher taxes, but only after the recovery is well entrenched.
The Consumer Price Index fell 2.1% in the 12 months ending in July, the sharpest decline in nearly 60 years. Ex-food & energy, the CPI rose just 1.5% over the last 12 months. With many sectors in the economy showing signs of stabilization, the threat of outright deflation has diminished. However, the economic recovery is expected to be gradual and the Federal Reserve will want to keep its options open. Inflation is unlikely to be a problem anytime soon.
The 2.1% y/y decline in the CPI is technically “deflation” (a fall in the general price level), but it is not the type of deflation we worry about (where declines in output and prices reinforce each other in the form of a downward spiral). The y/y drop in the CPI reflects the unwinding of energy prices, which peaked a year ago.
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Core inflation has trended lower. Excluding the rise in tobacco prices this spring, the core CPI would have risen 1.2% in the last 12 months (instead of 1.5%). The moderation in core inflation is partly reflective of the glut in housing, which has reduced rent increases. The CPI measures the shelter value for homeowners, not the price of the home or the mortgage payment – to do so, the BLS constructs a rental equivalent. Owners’ Equivalent Rent (OER) accounts for nearly a quarter of the overall CPI and nearly a third of the core CPI. The OER, which is a six-month moving average (regions are divided into six panels, each sampled twice a year), rose at a 1.4% annual rate in the 12 months ending in July.
The low inflation figures would seem to give the Fed some time before they have to raise short-term interest rates – but remember, the Fed is concerned with future inflation (which it can do something about), not past inflation. Inflation is a monetary phenomenon, but the money supply measures have long been an unreliable gauge for monetary policy. Instead, the Fed looks to resource utilization measures – the unemployment rate, capacity utilization, and commodity prices.
Commodity price increases have a tough time working through to the consumer level. There are processing costs, distribution costs, labor expenses, and so on, at various stages in the production process. The exception is oil, which has a more direct and immediate impact of the prices of consumer energy goods and services. Beyond energy, import prices fell sharply in the second half of 2008, reflecting the collapse of global trade. Global trade has shown signs of improvement in recent months. Import prices are no longer falling, but they’re not putting any upward pressure on inflation.
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The Employment Cost Index rose just 1.8% in the year ending in June. Productivity growth has remained strong. There is no inflationary pressure from the labor market and elevated unemployment should continue to keep such pressures contained for a long time.
With the threat of deflation fading, the Fed does not need to buy Treasury securities. However, inflation is likely to remain low for some time, allowing the Fed to keep short-term interest rates at unusually low levels.
The headline figures from the July Employment report were better than expected, but the details remained relatively weak. Excluding seasonal adjustment issues in the auto industry, job losses remained large and widespread across industries. Yet, the pace of job destruction is not as severe as was seen earlier in the year, which is good news. It’s going to take some time before the labor market improves (as opposed to getting “less weak”), and it will be years before we get the unemployment rate back down to 5%.
Nonfarm payrolls fell by 247,000 in July. That’s the smallest decline since August of last year. The 3-month average, at -311,000, was substantially less than 645,000 average monthly job loss from November to April. However, that’s still very weak by historical standards. The July payroll decline was reduced partly by seasonal adjustment issues in the auto industry. Auto plants shut down for model changeovers in early July. Given the recent weakness in the sector, the layoffs associated with these shutdowns was a lot lower this year, adding about 50,000 to the adjusted figure.
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Still, after accounting for this quirk, the pace of job losses has slowed. As with any recession, job weakness has been more concentrated in the goods-producing sector – not just in production, but also in distribution and sales. Here too, the trend in job losses is significantly less than it was a few months ago.
Average weekly hours advanced in July, which is normally an encouraging sign for employment, as longer hours imply more work, eventually leading to new hiring down the road. However, the hours figure was also boosted by the auto seasonal adjustment (aggregate weekly hours in auto production rose 12.0%).
The unemployment rate edged down to 9.4% in July, vs. 9.5% in June. However, labor force participation dropped from 65.7% to 65.5%. Otherwise, the unemployment rate would have risen to 9.6%, as expected. To be counted officially as “unemployment” (and to receive unemployment insurance benefits in most states), one has to be actively looking for a job. Give up looking, and you’re not counted as unemployed. As unemployment insurance benefits run out, people are more likely to exit the labor force, making the unemployment rate look better. Conversely, an extension of unemployment benefits leads many to reenter the labor force. About 1.6 million are expected to exhaust their benefits by the end of the year, which would put downward pressure on the unemployment rate. If benefits are extended again, which they probably will, the unemployment rate will rise further.
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Fed Chairman Bernanke and Christina Romer, the Chair of the President’s Council of Economic Advisors have been frank in stating their expectations that the job market will likely continue to weaken even as the economy begins to recover. However, better corporate profits, arriving fiscal stimulus, and temporary hiring for the census should lead to job market improvement into the early part of next year. It’s a long road to recovery.
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