A Slow-Going Recovery

There will be no Weekly Commentary for the week of XXXXXX. Scott’s most recent commentary is available below.

On Thursday, the Bureau of Economic Analysis will release its advance estimate of 3Q09 GDP. Third quarter growth is widely expected to be positive, solidifying the view that the recession has ended. The early consensus is that GDP rose about 3% last quarter. However, this is the advance estimate and the government must make assumptions about September inventories, foreign trade, and several other components. Realistically, we could see a number anywhere between 2% and 4%. Now, 3% growth doesn’t sound bad. It’s certainly better than a decline. However, 3% annual growth, which many expect to be about the average over the next several quarters, isn’t enough to push the unemployment rate down much at all. In fact, the economy is expected to continue to shed jobs into the early part of next year. Normally, GDP growth is strong in recoveries. However, there are a number of serious headwinds.

During a recession, many individuals postpone big-ticket purchases (motor vehicles, new homes). When the recession ends, the pent-up demand helps contribute to a rapid recovery. However, in the current instance, while there is some scope for pent-up demand, sharp rebounds in vehicle sales and home sales are unlikely. The reason is that credit is restrained. Home sales have improved, but that’s partly due to the $8,000 first-time homebuyer tax credit. Auto sales led consumer spending higher in the third quarter, but that was largely due to the “Cash for Clunkers” program. Consumers have continued to pay down debt and increase savings. You’re not going to get strong spending growth without loan growth.

On the credit front, the crisis in high-level banking is over. A year ago, counterparty risk concerns kept the major global banks from lending each other money. Those strains have largely dissipated (the spread between Overnight Index Swaps and 3-month LIBOR is back to where it was in early 2007). However, the crisis fed quickly down through the banking system. The big banks have received federal aid, but it will take a long time for many small to medium-sized banks to recover fully. Smaller banks play a key role in lending to small firms – and in turn, small firms usually generate a lot of growth in an economic recovery.

Small firms, those with fewer than 50 employees, accounted for about a third of net job growth in the last two expansions. In the 2001 recession, small firms accounted for about 10% of net job losses. In the current downturn, small firms made up a much larger share (46%) of net job losses through the end of last year. A year ago, lines of credit were being scaled back or cut completely for many small to medium-sized firms.

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Bank lending to smaller firms should improve. However, it’s going to take some time. Many small banks escaped the worst of residential mortgage problems, but now face increased trouble in commercial real estate. Commercial real estate tends to be late in the cycle, rolling over late in the recession and continuing lower well into the recovery. Overall, the magnitude of commercial real estate woes will fall well short of recent residential mortgage troubles, but will be a major problem for many lenders.

The American Recovery and Reinvestment Act (ARRA) has provided over 33,000 loans (amounting to about $13 billion) to small businesses and about $4.3 billion in federal contracts have gone to small business. However, while these efforts are helpful, they appear to be working to offset bank lending constraints on small business rather than driving business activity forward. Further efforts would be welcome.

In the past, tax credits to support job growth have had mixed success, largely rewarding firms that would have hired anyway, but such efforts should receive bipartisan support.

Over the last year or so, policy actions by the Federal Reserve and the U.S. government have generated some concerns about the exchange rate of the dollar. Will exceptionally accommodative monetary policy fuel inflation and weaken the dollar? Will large budget deficits lead foreigners to abandon U.S. assets? Who speaks for the dollar? Will it fall further and can anything be done to prevent it weakening?

Let’s get this straight. The dollar falls under the jurisdiction of the U.S. Treasury, not the Federal Reserve. The Fed will not raise short-term interest rates to defend the dollar. However, the Fed may intervene in the currency markets, buying dollars and selling foreign currencies, but only at the request of the Treasury Department. Officially, Treasury has a “strong dollar” policy, but there’s no precise definition of what that means and what it would take for the Treasury to intervene in the currency markets. Moreover, the exchange rate of the dollar is a price and depends on supply and demand. Currency market intervention could help in the short-term, but there’s little that the Treasury can do to counter longer-term pressures on the dollar. Global policymakers are not upset about any particular level of the exchange rate, but they are concerned about “disorderly” moves and currency market volatility. Large, choppy moves tend to be destabilizing to global trade and financial stability. In the near term, we may hear some jawboning on the dollar, as a low-cost way to reduce volatility.

Global trade and capital flows are huge. In the U.S., we have a net current account deficit (mostly the trade deficit in goods and services) and a net capital surplus. The dollar moves to balance the two. The current account deficit widened a few years ago, reaching 6.4% of nominal GDP in 3Q06. It’s fallen significantly during the recession, to 2.8% of GDP in 2Q09. Net capital flows have also slowed during the recession, as there is less global savings to go around. What happens now? The current account deficit appears set to widen again as the U.S. economy recovers. Net capital inflows should be moderate, but any decrease without a corresponding drop in the current account deficit would put downward pressure on the dollar, which would, in turn, help reduce the current account deficit.

In early 2008, there were some signs that the weaker dollar was finally leading to increases in import prices. However, import prices fell amid the global recession. More recent monthly data suggest little inflation in imported consumer goods and capital equipment. Industrial supplies, outside of oil, are another story, implying a continued squeeze on U.S. manufacturing firms. Costs of raw materials are rising, but these firms have to compete with cheap imports of finished goods.

Growth differentials matter over the intermediate term. The U.S. economy appears to be in a recovery, but the pace of growth, at least initially, may not be all that spectacular in relation to the other major economies.

In the short term, central bank policies are clearly important. Last week, the Reserve Bank of Australia was the first major central bank to raise short-term interest rates, leading to speculation that others would follow, leaving the U.S. Federal Reserve in the dust. However, the RBA had slashed rates dramatically in the global recession. Australia’s growth has been better than expected – extremely accommodative policy is no longer needed. Other central banks will raise rates eventually, and most likely sooner than the Fed, but this seems to be already baked in the cake. Eventually, the Fed will have to take the foot off the gas pedal, which will help the dollar.

What about runaway federal budget deficits? The deficit for FY09, just ended, will be about $1.4 trillion (or about 10% of GDP), lower than projected a couple of months ago (some of that has to do with the accounting for expenses related to Fannie Mae and Freddie Mac). Net federal borrowing was $1.74 trillion in FY09 and the national debt rose by $1.89 trillion (due to increased liabilities for Social Security and Medicare). Did all this extra borrowing boost interest rates? No, they remain low. Granted, the Fed has been purchasing Treasury securities, but not a lot (only $300 billion) and that program is ending. Foreign demand at Treasury auctions has remained strong. The surge in the budget deficit has been cyclical (tax revenues fall in a recession, but rebound in a recovery) or temporary (related to the financial rescue and the fiscal stimulus). The budget deficit will settle down after the economy recovers and the temporary spending fades (to around 3.0% to 3.5% of GDP, according to the Congressional Budget Office).

Every couple of years, some OPEC official talks about pricing oil in euros, or a basket of currencies, or anything but the U.S. dollar. Does it matter if oil is not priced in dollars? Absolutely not. The U.S. would still buy oil in dollars and it would be converted to whatever the benchmark currency is.

The one major unknown is China. China continues to amass currency reserves at an unsustainable rate. However, just because it’s unsustainable doesn’t mean that it can’t go on for a lot longer. Over the last year and a half, China has stopped letting its currency appreciate against the dollar. Unless the trade deficit with China falls dramatically, the Chinese currency must be allowed to rise against the dollar at some point.

A variety of forces are at work on the dollar. The greenback may be a bit soft in the near term, but there’s no reason it won’t hold up against the major currencies over the long haul.

The recent economic data have been generally disappointing, but hardly a disaster – consistent with a gradual economic recovery. For those expecting a sharp V-shaped rebound, it’s been troublesome. However, the consensus view has always been that serious financial headwinds would limit the upside in the early stages of a recovery. Job losses would continue. The unemployment rate would rise further. There’s nothing in the recent data to dispel this view. However, many were critical of the fiscal stimulus package – not that it was too large or ineffective. Rather, it probably should have been larger and more focused on spending. A second stimulus package may be needed, but it will be difficult to achieve politically.

Economic data are always a bit mixed. In any given month, some figures will be stronger than others. Near the end of recessions and into the early part of the recovery, some indicators will be positive and others negative. That’s about where we are now. Of the four items in the Conference Board’s Index of Coincident Economic indicators, two turned higher in July, and personal income figures were about flat. So it looks as if the recession has ended. We won’t know for certain until the overall economy avoids another leg down, which seems likely, and the official ruling from the NBER’s Business Cycle Dating Committee will be many months away.

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Nonfarm payrolls are the one “coincident” indicator that has continued to fall. That’s because payrolls are coincident heading into the recession, but tend to lag coming out of a recession. In the major recessions of the 1970s and early 1980s, temporary unemployment was a bigger factor. Some workers were laid off as the economy slowed, then rehired when things picked up. In contrast, the most recent recessions have had much smaller increases in temporary unemployment. This recession has seen a sharper rise in permanent layoffs. Hence, payrolls are unlikely to turn up significantly anytime soon. Over 7.2 million jobs have been lost in the recession. It will take a long time for the economy to create that many new jobs. Note that the BLS’s preliminary estimate of the benchmark revision to March 2009 payrolls (based on tax receipts and to be implemented next February) will likely be -824,000 (or -0.6%, a relatively large revision). In other words, net job losses have been even worse than reported.

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The working-age population is rising about 1% per year. If one assumes that productivity growth will be 1.5% to 2.0%, then real GDP must growth faster than 2.5% to 3.0% for the unemployment rate to come down. Hence, given the gradual economic recovery scenario, the unemployment rate is expected to remain high over the course of next year. If real GDP rose at a 4% annual rate, it would take four to five years to get the unemployment rate down to around 5%.

It’s possible that we could see such strong growth as the recovery picks up steam in 2010. However, there are still significant headwinds. Credit remains tight, especially for small businesses, which normally play an important role in the recovery process. Commercial real estate typically lags in the business cycle, rolling over late in the recession and continuing lower well into the recovery. This will be a major problem for many small to medium-size banks over the next few quarters.

The fiscal stimulus is still ramping up and will provide important support into 2010. However, strains in state and local government budgets are countering a lot of the positive impact of the stimulus. The stimulus package did include aid to the states, but apparently not enough. Government payrolls have fallen over the last five months. A second smaller stimulus package may be needed to support the recovery after next year. Unfortunately, political difficulties will make that difficult to achieve. That’s something to worry about.

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