Walking on Broken Glass December 24, 2009 Bob Eisenbeis, Chief Monetary Economist
Economic forecasting is difficult, especially during cyclical turning points and at times like the present when economic policies are unsustainable and likely to have unforeseen consequences. Some economists rely upon sophisticated models while others rely upon informed judgment and instinct. Regardless of the methods employed, forecast errors abound – some due to misreading of the evidence and others due to the occurrence of unforeseen shocks. So attempting to look into the future at the 2010 economy means that one has to be prepared to walk on the broken glass of New Year’s resolutions and predictions, most of which won't be kept or realized.
With that caveat, at a recent Cumberland client gathering we outlined why we think that the Fed means it when the FOMC says it will keep interest rates low for an "extended period of time." We argued that this means that low rates will likely persist at least throughout 2010. We think markets overreacted to a couple of "less negative" employment reports and to what proved to be an overly optimistic first reading by the BEA of real GDP when the agency reported 3.5% growth for the third quarter of 2009.
Let us first summarize a couple of key facets of the economy in 2009. We saw a recovery of the stock market that far exceeded the recovery of the economy, which was clearly stumbling along. Unemployment peaked at 10.2% and then drifted back for the month of November to 10.0%. Consumers continued rebuilding their balance sheets, spending was on life support, business investment continued to be curtailed, wage pressures and inflation signals were benign, and housing may have bottomed but was far from in a significant recovery mode.
What we don't know is what real GDP growth for 2009 will be. The FOMC in its November forecasts had a central tendency for year-over-year real GDP growth of between -0.4% and -0.1%. So compared with last year, the FOMC expects that real GDP will have declined somewhat, despite the BEA's positive, but significantly revised estimate of 2.2% annualized growth for the third quarter. This final 2.2% third-quarter number is far less than the initial estimate of 3.5% or BEA's first revision of 2.8%. Relative to the initial estimate, consumer spending was scaled back, as was business investment, including continued inventory reductions. One wonders whether, if this more sober view of the third quarter had been available, the stock market would have been as strong as it was.
Should we be as optimistic as some recent forecasters who see a stronger, recovering economy in 2010 and a possible Fed rate move? We think not. Using some back-of-the-envelope calculations, it is possible to estimate what would have to materialize through the end of 2009 in order to realize the Fed's most recent forecasts. For example, real GDP growth in the fourth quarter (which we won't be able to observe until next year) would have to average 4.8% to hit the higher range of FOMC's central tendency forecast ( -0.1%), and 3.6% to hit its lower estimate (-0.4%) for year-over-year growth. Given the initial reports on consumer holiday spending, continued sluggishness in both the housing and labor markets, we would be doing well to hit even the lower estimate.
For 2010 and 2011, the FOMC is equally or even more optimistic. It now projects year-over-year growth for 2010 of greater than 3%, and close to 4% for 2011. Even with what is likely to be above-trend growth, however, the FOMC sees virtually no progress on unemployment during 2010, and by the end of 2011 the anticipated unemployment rate is still seen as being well over 8%. All of this is with personal consumption inflation (PCE) well under 2%.
Keep in mind that the Fed tends to view the economy and its inflation dynamics through the lens of the so-called Phillips curve. Briefly, that framework posits a tradeoff between unemployment, resource utilization, and inflation. For example, as unemployment declines and resource utilization increasingly tightens, the economy reaches a point where employers begin to bid up wages. To maintain profit margins they must at some point to raise prices, causing inflation to increase.
Given that framework - right or wrong - and the structure of the FOMC forecasts, along with the extreme concerns about unemployment on the part of FOMC members as well as the administration and Congress, it is hard to see how FOMC members could have assumed significant rate increases, or any increases at all, in their current view of expected policy going forward. Consider, for example – to harp on the employment issue for a minute – how long it would take the economy just to earn back the 7.2 million jobs that have been lost, let alone provide for new entrants into the labor market. Again, back-of-the-napkin calculations suggest that if the economy were to grow continuously at between 3 and 4%, it would take somewhere between 12 and 17 quarters of such growth, based on past experience, to recoup the jobs that have been lost. Again, given this, we see the Fed with its foot on the gas – especially with no inflation on the windshield through 2010 – barring an unexpected pothole or unforeseen roadblock.
There is one more consideration that comes into play to condition this view of 2010, and that is the difficulty that the Fed will have in executing an exit strategy from its quantitative easing policy. At Cumberland, we have estimated that the Fed has very little flexibility to raise rates or to sell assets without incurring significant capital losses in its portfolio – a problem that has been exacerbated by it purchases of mortgage-backed securities, agency debt, and longer-term Treasuries.
St. Louis Fed president Bullard recently suggested at the conference at the Philadelphia Fed that there would be three phases as the Fed contemplates exiting its current quantitative easing and returning to a more normal implementation of monetary policy through changes in interest rates. The first step is the phasing out of the emergency lending programs, which is currently scheduled for about the middle of March. The second step is the period during which policy continues to be implemented through asset purchases. While that period is uncertain in length, it clearly will depend upon what happens to housing and to the ability of the GSEs (Freddie and Fannie) to finance themselves in the market, rather than relying upon the Fed's purchases. That isn't likely to happen in 2010. The final step, of course is the return to normal policy implementation.
Putting this all together, we feel that 2010 is likely to be uneventful from a policy perspective, which means more of the same in terms of interest rates. This should be positive for stocks and for US markets relative to the rest of the world.
While the Fed may be on hold, congress is likely to turn its attention and pass a financial regulatory reform bill before the end of 2010. What is abundantly clear, however, is that bill will not address the key causes of the crisis or what needs to be done to assure that it "never happens again."
I wish all of our readers a joyous holiday season and we look forward to another successful year in 2010.
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