By reducing uncertainty, Fed officials can actually improve the effectiveness of monetary policy. Three areas are critical: First, officials can update the baseline outlook and risks to it, and how they will react to changes. Second, they can map out their exit game plan, continuing to identify the tools they will use and the sequence for deploying them. Third, they can say what they do and do not know about the exit process, given that the Fed and market participants are in uncharted waters.
Outlook risks. As noted in the minutes from the September FOMC meeting, the Fed's baseline outlook has probably improved since late June, when the central tendency for growth over the four quarters of 2010 was a range of 2.1-3.3%, and the Fed projected core inflation to run about 1.5%. The revisions will probably reflect generally improving incoming data and a further easing in financial conditions.
Despite our conviction that the recovery will be sufficiently strong as well as sustainable, we'd be the first to admit that both are uncertain. Underlying vehicle and housing demand remains unclear following the expiration of ‘cash-for-clunkers' and the first-time homebuyer tax credit. With payrolls still declining and income growth weak, consumer spending strength is in doubt. And contributions to growth from capex, net exports and the government are uncertain. There is even more dispersion around the inflation outlook: Economic slack is unprecedented, while monetary stimulus, rising commodity prices and a weaker dollar might boost inflation expectations and inflation. Even the extent to which inflation has fallen is unclear: The Fed's preferred inflation gauge - the core PCE price index - rose only 1.3% in the year ended in August, but removing a sharp decline in the so-called non=market component of PCE prices yields a rate of 1.7%.
Clarifying the reaction function. Given that uncertainty, clarity on how officials will react to changes in the outlook will help market participants understand the roadmap for policy. Many will expect the Fed to tighten sooner if it boosts its growth outlook. However, even if its revised outlook for growth improves to match ours, with ‘core' inflation low and declining, we think that officials will keep policy accommodative through mid-2010. An ongoing improvement in financial conditions may promote a gradual unwinding of the quantitative/credit easing that the Fed implemented to offset the credit crunch.
Nonetheless, the current circumstances suggest that the existing guidance on interest rates - "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period" - is probably due for a change. A softening of the language at either the November or December FOMC meetings would be entirely consistent with our expectation that the first phase of the exit strategy (whether you call it reining in excess reserves, shrinking the balance sheet, or unwinding QE) will commence in 1H10 and that rate hikes will follow in 2H. Unlike in 2004, this language is highly conditional on economic conditions. By spelling out how much economic conditions have changed and what will be the response, the officials can help market participants understand the Fed's preferences and reactions. The "exceptionally low" language describes the stance of policy rather than its direction, so it is conceivable that it could still be applied to a 1% or even 2% funds rate target - especially with some small tweaks to the wording.
Tools to use. While there appears to be some disagreement regarding the timing and the triggers for exit, all Fed officials seem to agree that the exit strategy has two basic components: 1) shrinking the volume of excess reserves and 2) raising the policy rate. Reverse repurchase agreements (RRPs) will be used to address the former. But there are several unanswered questions: How and when will the Fed use reverse RPs to drain excess reserves, given the massive size of the job? Will it need other tools such as accepting term deposits or selling assets? Will paying interest on reserves give it control over the funds rate?
Here is some background. Thanks to aggressive expansion by the Fed, excess reserves - the surplus held by banks at the Fed over required reserves - currently total US$987 billion. We estimate that the excess will grow to about US$1.2 trillion by early 2010. The expected increase reflects three factors: 1) the ongoing impact of the large-scale asset purchases (LSAPs); 2) a looming slowdown in the pace of unwinding other Fed liquidity support facilities (the unwinding has provided significant offset to the LSAPs to this point but simply does not have much more room to go); and 3) the winding down of the Treasury's Supplementary Financing Program (SFP). Thus, far from exiting any time soon, the Fed will actually be adding more quantitative easing unless it takes offsetting action.
This means that an important near-term issue is whether the Fed passively accepts more QE or attempts to offset the growth that should soon appear in the balance sheet and bank reserve data reports. The hawks on the FOMC would appear to have a powerful argument if they want to push the issue: "OK, we understand the rest of you don't want to exit yet, but if the recession is over, why are we doing the opposite of exiting?" The counter argument from the doves will be that draining operations might send a confusing signal to financial markets, and as long as the reserves are merely being stockpiled in cash accounts at the banks, what does it matter if more are added? Indeed, this seemed to be the prevailing sentiment at the September FOMC meeting, according to the recently released minutes. Thus, while it will be interesting to watch this debate play out in coming weeks as excess reserve balances soar to new highs, we don't sense that the Fed is about to start draining reserves. At this point, our best guess is that draining operations won't commence until early 2010.
Whenever it does decide to start draining, the Fed will quickly enter uncharted territory. Although officials point out that reverse RPs are a standard component of the Fed's toolkit, the largest previous operations ever conducted with primary dealers were on the order of US$25 billion - and that was only for a relatively brief interval last autumn when the Fed was still attempting to sterilize the impact of all the new liquidity support facilities. Communications are critical here too: For example, the Fed has been conducting test reverse RPs, and to insure that investors understand the difference between policy and operational testing, the New York Fed issued a clarifying press release.
Fed officials have actually outlined three approaches to draining reserves: reverse RPs, term deposit accounts and asset sales. We doubt that the Fed intends to sell assets any time soon, since such action would probably be quite disruptive to markets - this is more of a long-run option. Moreover, while offering term deposits would appear to be a useful means of draining significant volumes of reserves, this is an untested innovation that carries some legal and technical complexities. The Fed seems to be moving forward most aggressively with the reverse RP option. Initially, there was some concern that dealer capacity for large tri-party reverse RPs was quite limited due to balance sheet constraints, so the Fed signaled that it might have to conduct operations directly with large investors, such as money market funds. However, it now appears that dealers may be able to absorb a much larger volume of operations than previously believed, which would avoid the need for the Fed to deal with a new set of counterparties. Since this matter is expected to be a topic of discussion at the upcoming FOMC meeting, we are likely to get additional clarity on the technical aspects of how reverse RP operations fit into the overall exit strategy following that session.
Finally, looking further ahead, the Fed has another tool - interest on excess reserves (IOER) - that, if effective, would enable officials to raise the policy rate without significant reserve draining. If the Fed hikes that rate, it raises the cost of borrowing; when banks can hold excess reserves on deposit with the Fed, they won't lend at rates below the IOER. Yet there are some institutions (in particular, the GSEs) that are not authorized to receive IOER, so there are leakages in the system. And at very low rates, IOER may not function properly. Therefore, the open market desk at the NY Fed may have to use the other tools noted above to execute the tightening as instructed by the FOMC.
Uncertain impact of exit on markets. Beyond when exit will start and how it will work, there are several questions about the impact of such policies on financial markets. Will banks deploy their cash assets into securities or loans, reducing market rates and expanding credit supply? Will the interest rate on excess reserves become the policy rate, at least for a while? What will be the impact on market funding rates of conducting large reverse RP operations?
The September FOMC minutes note that the Fed staff has examined the impact of very high reserve balances for bank balance sheet management and the economy. In tandem with the substantial volume of excess reserves, large banks that report weekly hold nearly US$1.2 trillion in cash assets on their balance sheets, or more than double the year-ago level. The staff believes that as banks grow more comfortable with the economic outlook, those now holding these balances for liquidity-management purposes could redeploy them into securities or loans. That shift in the asset mix would narrow spreads or increase credit availability; instead of boosting bank liabilities and the ‘money' multiplier, this would increase monetary stimulus through the asset side of banks' balance sheets.
Finally, we suspect that large reverse RP operations could put upward pressure on financing rates - with general collateral RP rates possibly trading well above fed funds. We will be exploring this issue in greater detail over the course of coming days because it opens the door to the possibility that the fed funds rate might lose its status as the main barometer of monetary policy.
Political constraints? Effective Fed communications will also help the FOMC navigate the current political environment. There is a deeply held concern that the Fed will be unable to execute an exit strategy due to political constraints. That's not surprising, given that criticism of the Fed is at its highest level in 70 years, according to some historians. And there will always be some politicians who criticize the Fed when it embarks on a tightening campaign.
Nonetheless, we believe that such concerns are overblown. Since the days of Arthur Burns, the Fed has largely managed to run policy independently, and there is a new and very powerful argument in favor of independence. Since many place the blame for the financial and economic crisis of recent years squarely on an overly lax monetary policy coming out of the last recession, it's going to be especially difficult to criticize the Fed for exiting this time around. In addition, Chairman Bernanke's campaign to communicate directly with the public at large has strengthened the Fed's hand and probably contributed to President Obama's decision to nominate him for a second term.
In the end, it's certainly conceivable that the Fed could delay exit longer than it should (just as it is possible that it moves too soon). But we are convinced that if the Fed was to wait too long, it would be because it misread the economy, not because of political influences.
Summary and Conclusions
Like other advanced economies, Italy appears to be past the worst of the global recession. But how quickly and to what extent will the country recover? In this report, we focus on Italy's medium-term prospects and on the outlook for the main drivers of potential growth, i.e., labour productivity and the labour force. We reach three main conclusions:
• First, the damage on both labour productivity and the labour force is likely to be substantial. We estimate that Italy's potential growth rate will be negative this year and the next, and remain at 1% between 2011 and 2014 - below our pre-crisis 1.2% estimate.
• Second, this implies a smaller - but still very large - output gap relative to the pre-crisis baseline, pointing to a period of disinflation ahead. Although we don't see outright deflation as a real possibility, we do see mounting disinflationary pressures.
• Third, without structural reforms aimed at raising potential growth, it will be difficult to bring down the public debt to an acceptable level. Based on our simulations, debt/GDP would decline only in our bull-case scenario of growth higher than 3%.
The main takeaway for investors is that extrapolating into the future the pre-crisis growth rate of potential GDP might be too far-fetched. If the recession lowered the pace at which the Italian economy can sustainably expand, as we believe, the rate of growth of aggregate corporate profits, at least over the long term, will be lower too.
Slowly Climbing Out of a Deep Hole
After the slump at the turn of the year, the outlook for the Italian economy has improved. Indeed, the latest data have been encouraging and - with Germany and France having already emerged from recession in 2Q - brought some comfort that economic growth might have come back into positive territory in Italy too, perhaps as soon as in 3Q. For example, business sentiment has picked up considerably from March's record low, firms' assessment of demand is now on an upward trend and the level of inventories looks close to ‘normal'.
The latest hard indicators are positive too, especially on three fronts. First, industrial production rose by a very substantial 7%M in August; even assuming a full payback in September, the chances are that industrial production will rise by about 5%Q in 3Q, quite a turnaround after five quarterly contractions in a row. Second, new car registrations surged over the summer, courtesy of the car scrapping incentives - which are likely to be extended. Third, exports to non-EU countries rose by 17.4%M in September and our forecast for global demand points to a further improvement to come.
Morgan Stanley's proprietary GDP indicator points to clear upside risks for economic activity in the short term. Taken at face value, this indicator suggests that the Italian economy expanded by a very strong 1.2%Q in 3Q - far above the latest published consensus forecast of 0.5%, in our view.
Morgan Stanley's GDP indicator is an econometric tool that provides a timely estimate of GDP growth by synthesising the information contained in several leading and coincident indicators - ranging from industrial production and orders to consumer confidence and the yield curve. Unlike most other econometric tools, this indicator has fully captured the extent of the downturn. Its ability to capture big swings on the downside suggests that it should not fail to do so on the upside too.
The upshot is that we now expect the Italian economy to expand by 1.2% next year compared to our previous forecast of 0.6%. What's more, we predict a milder contraction this year, to the tune of 4.5%, compared to our previous forecast of -5.1% (see Much Better on Bottom-Up, October 14, 2009).
However, this is not a V-shaped recovery. With the labour market still under severe stress, there seems to be little prospect for a significant reduction in households' saving rate to fund their spending. Accordingly, we expect the current period of anaemic private consumption growth to extend well into next year. What's more, although the annual rate of decline in domestic demand should slow in the coming months, an actual increase compared to a year earlier is still some way off.
In all, the short-term outlook appears to have improved, but the economic situation remains precarious: it will take until the end of 2014 for the level of GDP to regain the lost ground and reach the peak of 1Q08 - assuming a rate of growth of 1.2% from 2011 (which we estimate to be Italy's pre-crisis potential growth rate).
What's the Economy's Productive Capacity?
So, the short-term outlook has improved, though Italy will probably lag behind its European neighbours next year. But what do its medium-term prospects look like? Of course, this question is always important, but it is particularly relevant now as the most severe post-war recession has left a deep scar on the economy's productive capacity.
To see why this matters, let's focus on the main traits of a textbook recession: demand falls short of supply, causing high unemployment, as well as falls in consumption, production and investment. But when the recovery arrives, the resources left lying idle are brought back into production, making the economy grow faster than normal until it reaches the point where it would have been without the recession, thus running again at full potential.
However, if the shortfall in demand persists long enough, it can do lasting damage to supply, i.e., to the economy's productive capacity, and reduce the level of potential output or even its rate of growth. When this happens, the economy will never regain its lost ground compared to the baseline where recession had not occurred, even after demand accelerates during the subsequent recovery.
This is crucial for investors because their expectations for a country's economic performance - and hence in aggregate corporate profits - will be disappointed if they simply extrapolate into the future the pre-crisis growth rate of potential GDP. If the recession lowered the pace at which an economy can sustainably expand, the rate of growth of aggregate corporate profits, at least over the long term, will be lower too.
How can a persistent shortfall in demand hurt the economy's productive capacity? This can happen through four channels:
• First, if the period of joblessness is excessively long, the skills of the unemployed will atrophy, partly because of the lack of training on the job. When demand strengthens, they will struggle to find a new job, or a job providing the same earning power. In turn, this may result in an increase in the so-called structural or long-term unemployment.
• Second, if firms perceive that the lower level of activity will last for a long time, they will cut investment aggressively, thus ceasing to add to the capital stock. And they may even start scrapping some of it, either voluntarily or because they go out of business. Either way, the result is the same: the capital stock will shrink.
• Third, an impaired or over-regulated financial system might result in a higher cost of capital - perhaps because of competition for limited funding opportunities or tighter lending standards - encouraging firms to use less capital per unit of output. Accordingly, the economy's productive capacity might be negatively affected.
• Fourth, governments might decide to shield firms and workers from foreign competition through restrictions on foreign trade - such as tariffs on imported goods or restrictive quotas - or on foreign takeovers of local firms. This might delay or complicate the restructuring of the economy or encourage firms to relocate elsewhere.
We will discuss the above-mentioned channels in the following sections. What matters here is that an assessment of their impact is crucial to gauge Italy's medium-term prospects. In the IMF's latest World Economic Outlook, for example, an analysis of the impact of 88 banking crises over the past four decades shows that, seven years after a bust, an economy's level of output was on average almost 10% below where it would have been without the crisis - a huge gap.
Thinking Years Ahead - Not Decades
We have just seen that there are good reasons to think that Italy's potential output might have been hit by the recession, at least on theoretical grounds. Is there any empirical evidence?
To set the stage, it is worth clarifying what sort of timeframe we have in mind. Many people think of potential growth (or the rate at which the economy can expand without creating inflationary pressures) as a very long-term concept.
One simple way to approximate it is to average the rate at which the economy expanded over a period of decades or, alternatively, to use statistical smoothing techniques to remove short-term fluctuations from the GDP data. Another approach is the so-called production function framework, in which output growth is modelled as a function of the factors of production (labour and capital inputs) and technological change (for a discussion on the various methods see, for example, Furceri and Mourougane, 2009; or Cahn and Saint-Guilhem, 2007).
Italy is suffering from chronically low economic growth - regardless of the chosen methodology - by a large body of research (see, for example, the OECD's latest Economic Survey of Italy). In particular, potential growth has steadily declined from approximately 4% in the 1970s to less than 1.5% before the turmoil. In addition, since the start of this decade, Italy has expanded by a mere 1.2% on average, far slower than the euro area average of 2.0% and than its own post-war norm.
However, while this type of analysis does have its own value, what is most relevant at this juncture is where the economy is currently operating relative to its potential productive capacity, and at what pace it can grow over the next few years, say three to five. This is relevant for investors because, even if the economy is past the worst of the global recession, as long as there is slack in the economy, supply bottlenecks don't arise and firms operating in competitive markets do not have much pricing power. In this environment, upward price pressures are muted and policy can remain expansionary without the risk of fuelling inflation.
This cyclical phase is a ‘sweet spot' for risky assets because policy remains at recession-combating levels while investors see looming recovery. We will therefore focus on the next few years rather than on the decades ahead, and discuss whether and how the recession has taken its toll on Italy's productive potential.
One problem with this approach is that it is relatively easy to think of potential growth in terms of long-term developments in factors like demography, technology or education - which are unlikely to make a significant difference over the timeframe considered. However, in trying to assess a country's productive potential in one individual year, or in thinking about the impact of recent events, it is easy to confuse cyclical with structural developments: the former depend on demand-side factors; the latter - which are those that affect productive capacity - depend on supply-side factors.
For example, a decline in foreign and domestic spending has caused a cyclical drop in Italy's fixed investment; but as and when demand recovers, these dynamics will reverse. However, constraints on the supply of credit might have caused firms to cut back their investment by more than the decline in demand alone would imply, thus reducing the economy's potential growth.
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